Should a Pension Fund Try to Change the World?

BRIAN KENNY: Everyone loves a villain, or so they say in Hollywood. And, since the earliest days of film, writers and directors have found ready-made foils on Wall Street. Exhibit A, Gordon Gecko, the character played by Michael Douglas in Oliver Stone’s 1987 classic “Wall Street.” Gecko, who’s even named after a lizard, is the soulless corporate raider who became the poster image of excess and greed that Wall Street has never really been able to shake. A stereotype for sure, but one that exists for a reason. Because, whether it’s life imitating art or the other way around, business at large has too often lived down to the villainous image. So, is it possible to flip this script? Will there ever be a time when business plays the hero? Today we’ll speak with professors Rebecca Henderson and George Serafeim on their case entitled, “Should a Pension Fund Try to Change the World? Inside GPIF’s Embrace of ESG.” I’m your host Brian Kenny, and you’re listening to Cold Call recorded live in Klarman Hall Studio at Harvard Business School.

Rebecca Henderson’s work explores how organizations respond to large-scale technological shifts, most recently in regard to energy and the environment. She also created the course, “Reimagining Capitalism” in the MBA program, which she co-teaches with our other guest, George Serafeim, whose research focuses on measuring, driving, and communicating corporate performance and social impact. Welcome, both of you.

REBECCA HENDERSON: Hi, Brian. It’s a pleasure to be on the program.

GEORGE SERAFEIM: Thank you very much Brian for having us.

BRIAN KENNY: And, Rebecca, this is your second time around on Cold Call, so this is… This is the first time we’ve been able to get George on here, so this is going to be great.

REBECCA HENDERSON: It’s going to be fantastic.

GEORGE SERAFEIM: It’s always great to talk to you.

BRIAN KENNY: Rebecca, can you do me a favor? Set up the case for us. Who’s the protagonist? And what’s on their mind?

REBECCA HENDERSON: Sure. The protagonist is Hiro Mizuno. He is the Chief Investment Officer of the GPIF, which is the Government Pension Investment Fund of Japan. It controls 1.6 trillion dollars in assets. That’s large enough that the fund owns about 10% of the Japanese stock market and about 1% of the world’s stock market. It’s one of the largest pools of capital in the world. The case opens with Hiro settling back into his plane seat as he watches San Francisco disappear underneath him. He is thinking to himself, “Am I doing the right thing? I’m pushing all the people who manage this money to think really seriously about environmental, social, and governance issues, about ESG issues. Is that a good idea? Is that what I should be doing?” He’s pretty sure it’s what he should be doing. What he’s really wondering is if it’s enough to change the world. But, the case is also about, “Is that the right thing to do?” If he’s managing all this money, shouldn’t he be focused on making money? Why is he worrying about the environment and social issues and governance issues? That’s really what the case is about.

BRIAN KENNY: Those are some radical ideas that we’re going to get into as we discuss the case further. What prompted you to write this case? How did you hear about GPIF and what they were doing?

REBECCA HENDERSON: I actually heard about it from George. This was George’s idea, but I was the one that got on the airplane and flew to Japan. George’s research for a long time has looked at whether and how the financial sector might be able to play a major role in making the economy more sustainable and more just. He got really deeply interested in a group of investors that we call Universal Investors. These are people who have so much money, either because they have so much money or because they are invested in what are called passive funds where you can’t move where your money is invested. You just have to hold, say, the Fortune 500. He got really interested in whether these investors could really change the world, because for them, and this is the key issue at the heart of the case, if you have to hold every equity on the planet you can’t diversify away from risks to the whole economy. For Hiro, the risk of climate change is not some abstract thing that might happen to some other firm. He believes that the whole economy is at risk, and that Japanese economy is at risk from these issues. The sort of central question, the broader research question is whether these very large asset owners could, in fact, be a very powerful force for good in the world.

BRIAN KENNY: So George, let me ask you then, since you are the one that brought GPIF to Rebecca. Where does GPIF sit in the landscape of, I guess not just in the Japanese economy but sort of in the global economy, and where it relates to pension funds?

GEORGE SERAFEIM: This is a great question, Brian. Let’s put it a little bit in perspective in terms of how we understand the whole capital market, right? You can think about traditional investing. In traditional investing we tend to think about, “Do you buy PepsiCo? Do you buy Coke?” And, you’re thinking about this whole competitive landscape, right? Also, we tend to think about it in terms of fairly short-term horizons. You buy them, and you maybe buy them for months or for a year or something like that, and then you turn over your portfolio. When you are thinking about an institution like GPIF or many of those large pension funds that Rebecca mentioned as universal loaners, they are at the extreme of those two scales in terms of exposure, widely to the industry or to the market, or exposure to very long term horizons when it comes to ownership. When you have institutions like GPIF that have very long-term horizons and they have very broadly diversified ownership, many of the things that traditionally are public goods problems for them and you have free-rider problems, they don’t exist for you anymore because effectively you’re interested in the marketplace. There is almost in this horizontal ax of time horizon and the vertical ax of common ownership of competitors within industries, there is a set of investors that are at the extreme end of that. GPIF is one of them, and then, you have other investors that are right there. You can start thinking about other large pension funds, but also very large institutional investors, especially index managers like Blackrock, Vanguard, and many of those other institutions that tend to exhibit those characteristics. I tend to lump all those types of investors together and really call them stewards of the commons, because for them, actually stewards of the commons is compatible with stewards in both client asset. You really care about the quality of the market for those types of institutions.

BRIAN KENNY: This ties a lot to your work in ESG, and I’m going to ask you to explain what that means. And, also just the concept of integrative reporting, because that becomes and important aspect of the case as well. Just if you could, describe those two things.

GEORGE SERAFEIM: Absolutely. ESG stands for Environmental, Social and Governance issues. You can think about it in the environmental bucket, about climate change, about waste, about water issues, and so forth. In the social bucket, we tend to have issues around employees, employee safety, employee satisfaction, engagement, but also issues of employee diversity and of course customer related issues in terms of product safety, access to products, to affordable products, and so forth. On the governance side, we have issues of diversity of the board, anti-corruption issues, and some of those governance related aspects to it. Then the question that we have been asking for a long time is the extent to which those issues tend to be financially material or issues that are just pure public good. I think the answer that we’re getting there is, “It depends.” It really depends on the industry you’re that you’re operating in. Now, we have started to develop this understanding of what makes some of those issues material within industries, and as a result, investor relevance. Something that GPIF should pay attention to and should try to drive corporate performance towards that. Integrated reporting. Let me start by saying that actually what is more important is integrated thinking. Integrated reporting is a reflection of what is happening inside the firm in terms of integrated thinking. What is integrated thinking? Is actually the management of not only your financial capital, but really your social capital, your natural capital, and human capital? Through that management then is about communicating how you’re co-managing all these forms of capital and being able to show importantly their relationship. That’s what integrated reporting is supposed to be doing. Reflecting the integrated thinking inside the firm. It’s really interesting. Over the last ten years, we have seen a tremendous development in terms of integrated reporting. Now with thousands of larger organizations releasing some type of self-labeled integrated report, but of course, there is wide variation when it comes to the quality of those reports.

BRIAN KENNY: I’ll bet there is. Everybody is accustomed to seeing annual reports. That’s been a common practice. But, that focus is almost exclusively on the financial aspects of things, but what you’re describing is fundamentally different than that.

GEORGE SERAFEIM: It is fundamentally different. It’s something that has robust metrics. It has accountability mechanism. It has targets. It has a forward-looking prospective, and it really concentrates on what is material for the business and how actually driving performance towards some of those ESG metrics ends up driving performance for the business itself in terms of return on capital, in terms of growth, in terms of cost of capital, and some of those things.

BRIAN KENNY: And this becomes really important in the context of what GPIF is trying to do, so we’ll talk more about that as well. Rebecca, can you just describe Japan’s public pension system? It’s a big complex thing. I was actually surprised because the case has a lot of detail about both GPIF and the other players that are in it, but also about some of the concerns that seem to exist out there and the criticisms of their approach.

REBECCA HENDERSON: Sure. The reason we go into a little bit of detail about the nature of the pension plan, is we’re hoping actual pension plans will use this case. If you’re working for pension fund you want to know what’s going on, so in brief, there’s about three trillion dollars worth of pension fund assets in Japan. GPIF manages about half of them. Everyone in Japan has a mandatory public pension, whether they’re an employee in private business or whether they’re a private individual. GPIF manages two those large funds, which is about half of the total pension fund. There is concern in Japan that there aren’t sufficient assets in the fund to cover payments, and so the fund is under some pressure to demonstrate that what it’s doing in the long-term interest to pensioners and will generate a significant financial returns.

BRIAN KENNY: As we get into the case, it goes back in some detail over the evolution of GPIF and their strategy. Can you describe, George, what the strategy was before the new mandate, and then we’ll get into the new mandate.

GEORGE SERAFEIM: The first thing to understand is that GPIF is really a giant actual organization when it comes to assets, but it’s actually pretty small organization when it comes to people, number of people. That introduces a certain number of complexities. For example, you can’t really manage with organization that you have right now, the assets internally. As a result, you choose external managers, and then the choice of those external managers becomes really, really important who you choose and being able to choose wisely. Traditionally, what has been happening with GPIF is that most of the assets were allocated in bonds and fixed income. For a long time, I think, that led to some under performance in relative terms for the fund and not to the types of return expectations that you would need in order to cover future obligations that Rebecca mentioned before. As a result, there was a reevaluation of that investment practice, and one of the recommendations was actually to move more toward equities and more also diversifying the portfolio outside of Japan, so increasing foreign exposure. Of course, to do that that goes to my first point that you need to have actually the expertise to choose the right asset managers. Part of that was also an embrace of ESG investing as a practice and as a tool to culturally change GPIF and become more open-minded, toward new opportunities in order to drive performance for the pension fund forward.

BRIAN KENNY: There was an interesting anecdote in the case about what may have prompted Mizuno to start thinking about ESG more seriously. Do you recall that?

GEORGE SERAFEIM: It’s a real interesting conversation with then Secretary General Koffi Annan over dinner and at some point Koffi Annan asked Hiro why people in Japan don’t care about ESG. Hiro actually asked, “What is ESG?” because there are so many acronyms. Once he understood that, he said, “It’s not clear to me that actually people don’t care. I think people care about those issues.” Then he went back to Japan. Hiro had a career in London before that, and he went back to Japan. He actually realized that indeed the Japanese asset managers, but also the business community, was not advanced when it comes to ESG issues. He didn’t have the supply of information, so very few companies were actually internally managing ESG issues and also reporting and communicating information on ESG issues. At the same time, most asset managers were not taking into account those types of issues.

BRIAN KENNY: Rebecca, just from your work, looking at firms across the spectrum, how radical was this idea that Hiro was proposing? This notion of let’s start to think about these three integrated subjects together in a different way.

REBECCA HENDERSON: It’s interesting. The radical part was thinking about all three. Many Japanese assets managers and investors were worried about governance. Historically, Japanese firms have not been very receptive to investor input for reasons we can talk about, and that there’s a lot of evidence that’s negatively affected their performance. Focusing on governance, focusing on, “Gee, that was not radical at all.” It was the idea that you should focus on E and S as well, that everyone was like, “Whoa! Why are you doing that?” That was very counter-cultural.

BRIAN KENNY: It’s interesting in the Japanese culture, the relationship with the environment has always been a really important part dating back 1000s of years in Japanese culture.

REBECCA HENDERSON: Part of what was going on is most Japanese experience themselves as being very good environmentalists. The streets are clean. People aren’t discharging huge amounts of toxic waste. But, it turns out on fossil fuels, for example, Japan is really a laggard among the community of developed nations. Partly because of the Fukushima disaster. They took nuclear power from about 10% of total power in Japan to 1%. Japan is like 92% fossil fuel powered, which is really an outlier. The Japanese don’t perceive that. They don’t think of themselves as having an environmental problem.

REBECCA HENDERSON: On the social issues, the issue that Hiro focuses most on is that of inclusion of women in the workplace. Japan as a nation is one of the least advanced in terms of gender equity in the world. It ranks 105th out of 136 countries by one measure, and 114 out of 144 by another measure.

BRIAN KENNY: Does this tie back again to Japanese culture? Is there a tradition here that has made it harder for women to have equality in the workplace?

REBECCA HENDERSON: It’s a complicated issue, but there are two major factors going on. One is that women have historically not played senior roles in government or in business. The other is that women have had major responsibility for childcare, and men have worked extremely long hours. It’s still a business culture in which one of the signs of success is working punishingly long hours in every sector, and the women are supposed to be home taking care of the kids. As someone who’s been a single mum myself, I mean the idea that you do your full-time job and then you come home, and you do all the childcare? This is really really hard, and then the tax code reinforces the idea that women should fundamentally be staying home. So, women who have excellent educational attainments, a lot of them go to university, when they come out and join business, they’re funneled into a second tier track. There are two tracks, the managerial and the clerical, and women are overwhelmingly funneled into the clerical. When you visit Tokyo, and I was really surprised by this, you visit… I mean Tokyo is the most beautiful modern city, and you go into huge skyscrapers of concrete and glass with glorious views, and you come to the office, and the man stands up to greet you and he’s surrounding by a cloud of beautifully dressed, clearly very intelligent and on-the-ball women, who are serving tea. What’s that?

BRIAN KENNY: Seems very arcane doesn’t it?

REBECCA HENDERSON: It seems incredibly arcane by Western standards. One of the things that’s going on here is the Abe administration looking at the demographic crisis that Japan is facing, because their birth rate is dropping faster than almost anywhere else in the world, and they’re not open to immigration. One solution to the demographic crisis is to bring in many more women into the workplace. That’s why the S in ESG. It’s a major issue but very controversial.

BRIAN KENNY: George, I’m going to kick this one to you. How does GPIF… How does Mizuno and his team impact this? Is it the companies that they look to invest in? Is it the asset managers that they’re working with? What’s their approach to this?

GEORGE SERAFEIM: So you’re asking the question of what are the tools of influence? There are multiple ones. One of them of example is index construction and construction new indices. Why that may be particularly useful under certain cases is because actually you’re isolating companies that end up not being included in those indices. For example, they constructed one index that is around women specifically, on the issue of diversity that Rebecca mentioned. In that index what happens is that companies that don’t have practices for inclusion in their workforce of women and diversity, they don’t get included in their stock market index. That has really driven change inside some companies. It’s complicated why. Some people might argue that this is because they are ashamed not to be included in the index. Some other people might argue that because if enough investors want the index, and they don’t invest in those companies that could increase cost of capital for firms eventually and so forth. So, there are multiple mechanisms. It’s not clear which one is operating, but one of the things that we found in the case speaking to some of the companies that it was clear that this was putting pressure and was incentivizing companies to start changing practice and take that into account. Another component was actually pushing asset managers to actively engage with the companies that they are investing in. So, not avoiding them, but investing in the ones that they want to drive change and then engaging with the companies to drive change in some of those issues.

BRIAN KENNY: And, that’s different than they had been in the past.

GEORGE SERAFEIM: And that is different. And that is different, and I think that is actually different for many asset managers. Really where it gets really really interesting for the case is, “How do you consider engagement from a passive manager’s perspective?” You can have actually active managers doing research and actively choosing stocks and so forth, and they understand the companies because they’re in the active managing space. But, how do you incentivize really passive managers that are constructing indices to engage with companies? Because they’re not doing research, they don’t understand deeply any one company. Also, they have very very low fees. To give you a sense Brian, an active manager could be getting for example eighty basis points or one percent as an expense ratio on the management fee for that fund, but the passive manager could be getting ten basis points or five basis points. What is really the business model? How do you compensate people for engaging with companies?

BRIAN KENNY: How do they address that? That sounds like a huge issue.

GEORGE SERAFEIM: It is a huge issue, and that’s where it gets really animated in the classroom as well. I can tell you that. When we ask students, “What is the business model? Design the content for me.” What happens is that Hiro really pressured asset managers, and especially passive asset managers, to come up with a contract, come up with a solution to that. There was a lot of push back from the asset managers saying, “Hiro you’re destroying our business model. We don’t understand why you’re doing that. We don’t understand how to do this.” I think Hiro rightly responded saying, “I’m the customer. You need to come up with that, with a business model and a contract.” By the end of the case, what happened is that three different asset managers came back with three different models of engagement, and as a result, tying fees to the outcomes of those engagements or the activities of those engagements. This is a really interesting decision point for the case as well, which is “how are you thinking about designing that contract?” For example, are you thinking that this contract needs to be designed around the inputs or around the outcomes?

BRIAN KENNY: The more we hear about this Rebecca, the more this sounds like an incredibly complicated thing that GPIF is trying to make happen. It sounds like a movement more than just like “hey we’re going to try a new approach here.” Are they really trying to move the whole market with them? Is that what Hiro’s goal is?

REBECCA HENDERSON: Absolutely. He’s trying to move all the other big asset owners to focus on these same set of issues. This is one of the reasons I love this case. Because sometimes when people talk about corporate social responsibility or shared value it sounds like it’s really easy and “yeah, you just make money and you change the world at the same time”. What I love about this case is we have a protagonist who’s absolutely trying to change the world. He’s on planes all the time. He’s talking. He carries enormous weight, because he’s managing 1.6 trillion dollars.

BRIAN KENNY: He’s got leverage.

REBECCA HENDERSON: He says, “Everyone in the world returns my phone calls.” He’s really trying to demonstrate a new way of thinking about investment, and he’s hoping that will take fire across other asset owners who have similar characteristics.

BRIAN KENNY: This is a question for either of you. How does this tie back into the course that you’re teaching, “Reimagining Capitalism” and some of the ideas? Is this kind of the central idea behind some of the course?

GEORGE SERAFEIM: It’s one of the ideas I would consider it. The way to understand the course is really trying to go through different unit of analysis for the students. One of them is on the individual firm level. What can you do as a firm? There we do a lot of the examples of doing well by doing good. We do business modeling innovations; practice innovations; changing actually your processes, your business model, your product; and recreating a good social outcome and at the same time making more money. But, what we always say is “that this is not enough.” Why? Because fundamentally every business will engage up to the point that makes sense, economic sense, from an ROI perspective. So, you might find an electric utility company that will go five percent renewable, but not fifty percent renewable, right?

BRIAN KENNY: Right.

GEORGE SERAFEIM: And also, you might find cases where they engage only on the issues that make sense from an ROI perspective. Then, when we ask the question about what can really move the system, then you need to start to get around some of those free-rider problems and around some of those tragedy of the common problems. So we are trying to elevate the unit of analysis much more to the market level. Then we find some of those institutions that really are… Their interests are aligned with interest of the market overall rather than an individual company. I think exemplifies this case, exemplifies that kind of point, that in society we really have institutions that take into account all these externalities, and they internalize them as we do. I think, and I go out on a limb a little bit and say, that as we do all of us, eventually as pensioners for example, we invest our money in where we’re interested in sixty-year outcomes, fifty-year outcomes, forty-year outcomes. As a result, many of those issues of inclusiveness, of climate change, of proper governance, and robust market institutions are things that define the long-term economic outcomes for any given country, and as result, our own prosperity.

BRIAN KENNY: So, short-termism is a problem that we have to overcome to have these kinds of ideas really take root?

REBECCA HENDERSON: I think there two problems. One is time horizon and the other is collective action. Because, while I might really care about whether climate change will change the planet, if I stop flying and stop eating meat, but everybody else keeps right away using fossil fuels and doesn’t care, my actions won’t make any difference. So, I have to be both focused on the long-term and find a way that all of us move together. What’s interesting about the GPIF case is Hiro has both a very long-term horizon, he’s on the hook for pensions for the next hundred years, and he has a way to bring everyone together. Because he owns so much of the market that it’s… You know, if he acts, it really makes a difference, and it increases the odds that everybody else will act.

BRIAN KENNY: Impacting change at the market level is really the key.

REBECCA HENDERSON: At the institutional level. It can seem like a kind of intimidating word, but if you think, one of the problems we have in capitalism as a whole is we’ve really focused on me, right now, and now we have serious long-term problems and “us” problems. We’re not thinking about the collective goods. How have humans historically solved that kind of problem? Well, through families. You know, we spend a lot of time teaching our two-year old that, “No, you have to look at the long-term,” and “It’s not just about you.” Local communities and faith traditions and governments and all those institutions are under a lot of stress right now. So, one of the big questions in the course is “can business step in and sort of help support or grow new institutions that might help us focus on the long-term and on the collective good?”

BRIAN KENNY: So back to GPIF specifically, they’ve had some time try this out. How’s it working?

REBECCA HENDERSON: So far so good. I think Hiro would be the first to say that this is a work in process, but certainly we see a very significant percentage of Japanese firms changing their behavior. As George suggested, being left out of the index, it sort of makes everybody a little nervous, so a lot of firms are changing their behavior. Asset managers have gone from “you’ve got to be kidding” to “okay, you’re really serious,” and so a number of them are starting to develop capabilities to engage with firms. I think that’s very encouraging, and I think just the fact that GPIF is making this much progress is having effects across the world. I hear about what GPIF is doing when I talk to other major assets managers all over the world.

BRIAN KENNY: George, I’ll give you the final word on this. You’ve taught this case in class before. You mentioned some of the turning points in the class. Any big surprises that you’ve heard from people? Any students from Japan who had a unique perspective to share?

GEORGE SERAFEIM: What is really interesting about the case Brian, is that most of the students are not used to thinking about the institutional level. They’re very good about thinking about individual firms and developing strategies about individual firms, but developing an understanding of how you move a system and developing systems thinking is something for many them actually, it’s a new perspective. For example, how you change incentives from the asset monitors becomes real important. How do you construct those indices becomes really important. How you engage with companies and the depths of dialogues that you have becomes really important in order to get the outcomes that you want and not perverse incentives in the system and unintended outcomes, and then how do you scale up some of those efforts. How do you bring other pension funds and other asset owners to the table? That becomes a really interesting exercise in class.

REBECCA HENDERSON: Could I add one thought to this?

BRIAN KENNY: Please.

REBECCA HENDERSON: I asked the students in my class which case and which protagonist they like best, and Hiro did the immense honor of flying to Boston to be in our classroom when we taught this case. He was hands down the favorite protagonist of the students. I asked them why and they said two things. They said, “Well, he’s amazing,” and the second thing they said was, “And, this might really work.”

BRIAN KENNY: Could be a harbinger of something new.

REBECCA HENDERSON: Exactly.

BRIAN KENNY: Thank you both so much.

GEORGE SERAFEIM: It was a pleasure.

REBECCA HENDERSON: It was a great pleasure. Thank you.

BRIAN KENNY: If you enjoy Cold Call you should check out other podcasts from Harvard Business School, including After Hours, Sky Deck, and Managing The Future Of Work. Find them on Apple podcasts or where ever you listen. Thanks again for joining us. I’m your host, Brian Kenny, and you’ve been listening to Cold Call, an official podcast of Harvard Business School brought to you by the HBR Presents Network.