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WHY LOWER DRUG PRICES BENEFIT INSTITUTIONAL INVESTORS CORGCorporate Governance: An International Review0964-8410 2007 The Authors; Journal compilation 2007 Blackwell Publishing LtdMay 2007153455466ORIGINAL ARTICLESWHY LOWER DRUG PRICES BENEFIT INSTITUTIONAL INVESTORS Why Lower Drug Prices Benefit
Institutional Investors: an application
of universal ownership theory
Steve Lippman*, Daniel E. Rosan and Adam Seitchik Changes in prescription drug prices have broad ripple effects across the diverse portfolios
that most institutional investors hold. Lower prices cut into pharmaceutical company profits,
but improve the overall productivity and profitability of other investable sectors of the
economy. This paper considers the net impact of cuts in drug prices on investor portfolios. We
find that falls in pharmaceutical company profits resulting from price cuts would be largely
if not fully offset by a combination of health plan cost-savings and increases in consumer
spending power. Furthermore, falling drug prices benefit investors through the dynamic
benefits from a healthier workforce with greater access to prescription drugs. We conclude
that, from the perspective of the broadly diversified “universal investor”, support for lower
drug prices is consistent with a fiduciary duty to seek attractive long-term returns at the
portfolio level. Strategies for shareholder activism should be expanded, including engagement
with corporate health care purchasers and advocacy for public policy reform.
Keywords: Drug prices, pharmaceutical pricing, health care costs, shareholder activism,
universal owners, universal investors, shareholder resolutions, socially responsible investing,
fiduciary duty
Introduction
access to care have sparked debate amongpolicymakers at all levels (Arnst, 2005; Pear, 2006).1 All elements of healthcare costs have called upon in their roles as fiduciaries to risen dramatically, with the cost of prescrip- consider complex environmental, social and tion medicines consistently among the fastest- governance (ESG) questions, from corporate growing segments (Smith, 2004). Drug prices governance reforms to climate-related busi- are one of the most visible health care expen- ness disruptions. A growing body of legal ditures to consumers and have become a hot theory supports consideration of ESG issues political issue. For example, a 2005 Kaiser within fiduciary duty (United Nations, 2005).
Additionally, trends towards index investing thirds (65 per cent) of Americans support more make the application of universal ownership government regulation of prescription drug theory relevant to an increasing number of prices (Kaiser Family Foundation, 2005a). The institutional investors and fiduciaries. As a National Conference of State Legislatures case study, we apply concepts of universal reported that in 2005 more than 600 separate owner theory and fiduciary duty to a specific bills and resolutions in all 50 states were pro- real-world issue fiduciaries currently face: posed to address policies affecting access, efforts to stem increasing drug prices in the affordability and control of prescription drug Trillium Asset Management,715 NE 60th Street, Seattle, WA Healthcare spending is now 16.0 per cent of GDP, up from only 13.6 per cent 10 years ago and rising healthcare expenditures and lack of source: institutional investors. These investors 2007 The AuthorsJournal compilation 2007 Blackwell Publishing Ltd, 9600 Garsington Road,Oxford, OX4 2DQ, UK and 350 Main St, Malden, MA, 02148, USA efforts to evaluate the impact of pharmaceuti- benefit from profits generated by high prices.
cal price constraints on the portfolios of uni- Nonetheless, a diverse set of public pension versal shareholders. We seek to fill this gap.
funds, religious institutions and labour funds have filed a wide variety of shareholder reso- pharmaceutical market and impacts on pub- lutions addressing high drug prices and these licly traded US companies only. Our analysis resolutions have gained strong levels of support rests on research that suggests that lower drug from other investors (Welsh, 2005).
prices will yield social benefits from increased Support for a shareholder proposal calling rational utilisation of pharmaceuticals and on Pfizer to report on efforts to contain price that price reductions need not impact other increases of its most-prescribed drugs to levels social goods such as private-sector research at or below inflation doubled from 5 per cent in 2004 to 11 per cent in 2005.3 In 2004, Gover- research literature and basic economic theory, nor Tim Pawlenty (R-MN) travelled to Pfizer’s we examine the effects of lower drug prices on annual stockholder’s meeting to speak for the the profitability of US businesses (and hence, resolution, arguing “the current price struc- diversified portfolios) under two sets of as- ture for prescription medicines is unsustain- sumptions: a static case which introduces able. As shareholders, it’s appropriate that we the major potential winners and losers from ask how business strategies can be changed falling drug prices, and a dynamic case which and improved to address the current reality” reviews some of the broader beneficial impacts of lower drug prices. These thought experi- ments lead us to conclude that the impact of drug makers to not constrain the reimporta- lower drug prices on investors broadly ex- tion of prescription drugs into the US by limi- posed to the US stock market will range from ting the supply of drugs in foreign markets neutral to modestly beneficial. Finally, we were sponsored by the American Federation provide some implications for trustees of in- of State, County & Municipal Employees, the vestment institutions, the boards of pharma- ceutical companies, and US businesses as a Employees Retirement System, the New York State Common Retirement Fund, Ohio Public For the universal investor, the analytical frameworks we present suggest that share- holder efforts to constrain pharmaceutical Vermont State Teachers’ Retirement System.
price increases are not in conflict with in- These funds have combined assets of US$183 stitutional investors’ responsibilities as fidu- billion.5 The proposal received a high water ciaries. In fact, while fiduciary action may mark of 23 per cent support at Wyeth, while a not be viewed as legally required, investors similar proposal that called for a report on the could rightly see such activism as an exercise risks of fighting re-importation filed by the of their fiduciary duty. Of course, one of the Minnesota State Board of Investment received obstacles facing these types of resolutions at the support of 28.5 per cent of Pfizer share- drug companies is that lower prices may not be perceived as in the narrow financial inter-est of pharmaceutical company shareholders,or the corporate boards acting on their be- Scope of this paper
half. Benefits to shareholders may instead ac- Given this real-world backdrop, we intend this crue at the total portfolio level. As such, the paper to help inform decisions by institutional fiduciary push for lower prices could also be investors about whether, as fiduciaries, they pursued in other ways, such as with compa- should be supportive of lower drug prices. In nies where pharmaceutical purchases are a particular, we seek to answer the question: major expense, or through the public policy “What impact does pharmaceutical pricing have on the profitability of American business,and what are the implications for ‘universalowners’ that are invested broadly in the USstock market?” Foundations of our analysis:
The vast majority of institutional investors background on the pharmaceutical
pursues broad diversification, and hence are market and on institutional investors
“universal owners”, with extensive exposure as universal owners
to all major sectors of the equity market. Insti-tutional investors, in aggregate, also hold the In this section, we explain key aspects of the controlling interest in virtually all US publicly pharmaceutical industry and of institutional traded corporations. We are not aware of past investing which underlie our analyses.
Journal compilation Blackwell Publishing Ltd. 2007 WHY LOWER DRUG PRICES BENEFIT INSTITUTIONAL INVESTORS The special nature of the pharmaceutical
ducts to pharmacies, to intermediaries such as market
wholesalers, to pharmacy benefit managers, toemployers, to governments or to insurance The first dose of a drug produced by a phar- companies. Before a drug reaches a patient it maceutical company as part of a commercial is “touched” by several of those players.
batch costs an immense amount of time and money. A commonly cited 2003 study by the ceuticals was US$223.5 billion, according to Tufts Center for the Study of Drug Develop- the Centers for Medicare and Medicaid. Of ment estimates that on average, it costs about that amount, private insurance paid 47 per US$802 million and takes 12 years to bring cent, with out-of-pocket costs financing an a new drug to market (DiMasi et al., 2003),6 whereas the marginal cost of producing an grammes paid 24 per cent (Heffler et al., 2005).
additional tablet or pill is often mere nickels We expect the new Medicare Part D benefit, (Berndt, 2002). The fixed costs associated with which came into force in 2006, will increase developing a new pill include basic research, animal testing, human clinical trials and regu- latory approval. In addition, manufacturers have to develop facilities to ensure that each pill is exactly the same. After spending the because of the pharmaceutical market’s struc- hundreds of millions it typically takes to ture. Patents give drug makers market exclu- manufacture and market the first pill, the sivity. They negotiate different prices among diverse buyer groups with varying elasticities Of course, that is an overstatement. But the of demand. For instance, third-party buyers marginal cost of production of pharmaceuti- who represent large groups of consumers and cals is quite low, and bears very little relation have high price elasticity have their own nego- to the cost of the product. In this way, drugs tiating tools. Buyers demand discounts or are similar to software, music, movies or video rebate schemes in exchange for volume sales.
games. In all intellectual property industries, They use formularies – a list of approved getting to the first product is very difficult and medications – to negotiate (Berndt, 2002).
costly, but the marginal cost of production of Insurance companies and benefits managers additional products approaches zero.
typically have a “two-tier” or “three-tier”method to contain pharmaceutical spending, Incentives to innovate
charging consumers a low co-payment for a generic drug and a higher co-payment for a because of the incentive system created by patents. Patents are one of a variety of ways covering certain branded drugs. Therefore, in- to create government-sponsored incentives for clusion in formularies represents a substantial innovation.7 Patents on drugs create a trade- market advantage. For brands, which are not off: companies disclose how the drug works included, patients pay higher out-of-pocket and its formula, and in exchange the govern- expenses and are likely to switch to a com- ment prevents any other party from selling the drug during the patent life. A patent’s dura- companies and pharmacy benefits managers tion is 20 years from the date of filing with The all negotiate in this way. Despite these tools, United States Patent and Trademark Office.
the drug makers’ monopoly position gives Patents are granted prior to market approval them an advantage, as evidenced by continu- by the Food and Drug Administration, how- ever, so companies typically get about 12–14 In contrast to bulk purchasers, uninsured individual buyers have low price elasticity and limited power to influence pricing (Con- able – indeed, encouraged – to charge monop- gressional Research Service, 2001). They can- oly prices during the patent life to attract the not go elsewhere or forgo taking essential investment capital necessary to fund the initial drugs, and are consequently charged higher research and development costs associated prices. Many buyers fall in between these end- points, with negotiating power determined bytheir potential sales volume. Price discrimina-tion yields higher profits because drug makers Drug pricing
sell products at a different price to each seg- Once a drug is on the market, companies take ment according to its buying power and price additional steps to maximise profit as part of a series of negotiations with healthcare pur- The complex nature of pharmaceutical con- chasers. Drug companies may sell their pro- sumers also hinders market transparency and Journal compilation Blackwell Publishing Ltd. 2007 favours differential pricing. Indeed, no other prices would stifle innovation and the devel- opment of new “breakthrough” drugs, and one player (the doctor or nurse practitioner) consumed by a second player (the patient) and funded by a third player (the health care reductions could eventually impact research, Finally, other players in the pharmaceutical the relationship between price, profitability value chain, such as pharmacists and whole- and R&D is not so straightforward, for five salers, add surcharges onto the initial drug prices. Different patients find considerable First, when prices and profits have been variation in drug prices, depending on the at historic highs, pharmaceutical company re- nature and presence of insurance coverage, search productivity has been low. There does place of purchase and the structure of parti- not appear to be a correlation between profit- cular pharmacy benefit plans (Frank, 2001). In ability and research productivity in a given year. For instance, while retail prescription Services calculated that the median price dif- prices increased an average of 8.3 per cent a ference between cash payers and third-party year from 1994 to 2004 (triple the annual in- payers for the 200 most commonly prescribed flation rate of 2.5 per cent), manufacturing drugs was 14.6 per cent (United States Depart- R&D spending as a percentage of sales actually ment of Health and Human Services, 2000).
fell from 17.3 per cent in 1994 to 15.9 per centin 2004 (Kaiser Family Foundation, 2005b).
Pricing transparency
Further, analysts have not found higher ratesof R&D investment or levels of innovation The low marginal cost of production and the high sunk capital costs of drug development those based in countries where drug prices are incentivise manufacturers to make a sale even significantly lower than in the US (Light and if revenue is relatively low, as long as revenue remains above the marginal cost of produc- sources to marketing, sales and administration turers do not want other customers to know than they do to research and development. In they have done so, because that reduces their 2002, Fortune 500 drug companies channelled ability to segment the market. The lack of 17 per cent of revenue into profits, 14.1 per pricing transparency is thus an important cent into research and development and 30.8 per cent into marketing and administration.9 Drug companies do report a wide variety of The Kaiser Family Foundation reports that in price points to government regulators, but 2004, drug makers spent a total of US$38.8 because of the complicated system described billion on R&D, versus US$11.9 billion for ad- above, they bear little resemblance to the vertising and another US$15.9 billion on the retail value of drug samples (Kaiser Family chasers (currently a source of a great deal of Foundation, 2005b). Direct-to-consumer ad- litigation). Therefore, the industry lacks the vertising reached US$4 billion in spending, 15 pricing transparency that is an essential times greater than ten years earlier (Kaiser foundation for well-functioning free markets.
Third, much of pharmaceutical company in- Lipitor, Zocor and Crestor, which have com- vestment is dedicated to “me-too” or “follow- parable quality, safety and efficacy profiles, operate in a tight oligopoly in which firms devoted to copying blockbuster drugs rather compete on the basis on advertising, mar- than addressing unmet medical needs. Less keting and relatively minor differentiating investment is required to develop follow-on attributes, rather than on price. This allows for drugs because they are modifications of exist- the continuation of non-competitive pricing ing drugs (National Institute of Health Care Management, 2002). We do not discount thevalue of research into follow-on drugs; these Relationship of prices to research
drugs produce clinical and economic benefits,including reducing side effects and improving & development
efficacy profiles, reduction in adverse drug Pharmaceutical managers justify high pre- reactions and drug-to-drug interactions, dif- scription medicine prices to policymakers ferent dosing schedules and delivery systems and the public by pointing to their significant (Wertheimer et al., 2001). However, the notion research and development costs. Often drug that all research and development is spent on makers and their surrogates claim that lower cutting-edge therapies is simply wrong.
Journal compilation Blackwell Publishing Ltd. 2007 WHY LOWER DRUG PRICES BENEFIT INSTITUTIONAL INVESTORS In addition, a great deal of funding categ- tive of overall risk and return. No matter how orised by drug makers as research and devel- diverse the underlying strategies, an institu- opment is used to market drugs to doctors tional board or investment committee prop- erly focuses on the overall wealth generation such studies have clinical value, by for example of the whole, as well as its volatility character- finding a new application for an existing drug.
istics in the aggregate. Academic theory and Often they are motivated at least in part, how- empirical research suggests that the primary ever, by a desire to engage and compensate doc- determinants of these overall financial returns tors for prescribing the drug (Relman, 2001).
are a Fund’s relative exposures to asset classes such as stocks and bonds, and the long-term patent system to continually re-invest in re- returns accruing to those asset classes. Since search and development because they know, most institutional investors have the majority often to the day, when their current level of of their assets invested in domestic publicly sales for a given product will plummet. Even traded securities, the long-term total returns companies that cut staff will typically protect of broad-based US stock indices will be a announced 7,000 job cuts but specifically The importance to large-scale institutional informed analysts that R&D funding would be investors of overall market returns is reflected maintained at existing levels (Clark, 2005).
in their healthy demand for passive, low-cost Finally, in a capital-constrained environ- index investing. Indexed investment funds ment, companies can plausibly argue that to now account for approximately 30 per cent attract the large concentrations of capital necessary to do research and development, (Fender, 2003). How any one company or in- they must provide superior returns. We do not dustry performs may be of great importance believe the American investment environment to an active fund manager, but in fact has little to be capital-constrained. Furthermore, in 2004 influence on the overall financial perform- pharmaceutical companies generated 16 per ance experienced by institutional investors cent profits as a percentage of revenues com- engaged in index investing and other forms of pared to 5 per cent for all Fortune 500 firms, will likely continue to attract investors even generated from the domestic stock market are the most important influence on institutional investor performance, it is important to pay Industrial organisation research has long attention to the key driver of those returns, noted the extraordinary levels of profitability which is the overall profitability of the eco- in the pharmaceutical sector, suggestive of nomic system. The importance of profits to investors can be seen by breaking the total competitive industries. This indicates ample return from the stock market into its three room for price cuts before profits fall to a component parts: (1) the yield from dividends (2) growth in profits and (3) changes in valua- tion, i.e. a movement up or down in prices for study by Abbott and Vernon found that signi- a given level of profits. In the long run the ficant price cuts (along the order of 50 per cent) most important of these three drivers of stock would have appreciable impacts on R&D, but market returns is the growth rate of profits, that modest cuts on the order of 5–10 per cent which itself is primarily a function of overall Drug research and development is a critical This bird’s eye view of institutional invest- social good generated by the private sector.
ing leads rationally to an emphasis on system- However, modestly lower profits caused by wide, long-term, sustainable profit growth. As more transparent and competitive pricing has a very low probability of impacting the degree argued, “A universal owner owns a small but representative fraction of most of the compa- development. Furthermore, reduced company nies in an economy. Thus its ability to satisfy profits are only one of several possible scen- its fiduciary duties depends heavily on overall arios stemming from lower drug prices.
macroeconomic efficiency and performancerather than on performance of any particular Institutional investors as universal
firm it might own” (Hawley and Williams,2002, p. 284).
owners
Institutional investors appropriately evaluate their clients about the prospects for a single their financial performance from the perspec- company or sector, this in fact should be of Journal compilation Blackwell Publishing Ltd. 2007 little interest to the institutional investor. From the bottom-line perspective of overall fund tion of finite demand, falling drug prices rep- performance, the profits of any single com- resent a zero-sum game, where the financial pany or sector are important to the large-scale losses to the drug companies are exactly met investor only insofar as they impact on the by the gains to their retail, government, in- profits of the whole. As such, the investment consequences of a fall in pharmaceutical com- incidental benefits or costs. In the following pany share prices should be approached holis- section, we provide for greater realism by tically, incorporating the potentially negative impacts on pharma company profits as well as explore the potential dynamic impacts of fall- the potentially positive benefits to the profit- ing drug prices on consumers, producers and ability of other publicly traded companies in – most importantly for this report – investors.
In determining the impact of lower prices on drug manufacturers’ profitability, it isworthwhile reviewing the basic relationships Analysis of the static case of drug
between cost, pricing and profits. As previ- price cuts: pharma pricing as a zero-
ously noted, prescription drugs have a high fixed cost of development, with a low mar-ginal cost of production. It is in the pharma In the next two sections we examine the effects company’s profit-maximising interest to ex- of a fall in drug prices on pharmaceutical com- panies, institutional investors, consumers and below incremental revenue. Total profits equal employers. While there are several prospec- total revenue minus the sum of fixed and mar- tive outcomes from a reduction in pharma- ginal selling costs. Imagine, for example, that ceutical prices, we find that overall the mark- a drug with US$1 billion in annual revenue down benefits the universal investor could has an annualised amortised cost of develop- have only modest impacts on pharmaceutical ment of US$200 million, ongoing production/ profitability and is socially beneficial.
distribution/marketing costs of US$300 mil- lion and profits of US$500 million. A 10 per cent reduction in prices would, with no impact demand, regulatory changes, pressure from stakeholders or the government, or a combi- nation of all of these factors. High levels of From the narrow perspective of an investor profitability in the pharmaceutical sector indi- solely exposed to pharmaceutical companies, cate price-setting power that stems from less- than-competitive markets. Within such mar- board and the pharma stock analyst, this is kets, cuts in prices spurred on by stakeholders a clear negative, especially under the static are likely to lead to increases in both supply assumption we make in this section that the and demand, as long as prices remain high price cut has no impact on either the supply enough to generate at least a normal level of profit and cover both average and marginal assuming no impact on sales or production, costs. In microeconomic theory, monopolistic however, this narrow perspective on the im- pricing creates a “deadweight loss” due to pact of price reductions is not the end of the inefficient use of resources. The efficiency story for the broadly diversified institutional benefit from falling prices and higher output investor. Revenues to pharma companies rep- leads to greater economy-wide productivity.
resent costs to consumers who purchase drugs We begin our analysis with the simplifying directly, and to the vast majority of publicly assumption that the drug company responds traded companies that offer prescription drug to stakeholder pressure to cut prices in the benefits. In 2005, approximately 60 per cent of context of perfectly inelastic demand, and thus US employers offered health insurance as an the price cut has no impact on production, employee benefit and 98 per cent of those plans included a prescription drug benefit itself. Under this highly conservative assump- tion, the only immediate impact of a fall in Research and Educational Trust, 2005). Thus a drug prices is to reduce pharmaceutical com- pharma company’s price reduction is mir- pany revenue and profits. However, that loss rored exactly by their customer’s drop in of profits represents direct savings for cus- tomers, including the corporate customers The savings from lower drug prices repre- that often fund prescription drug benefits. So sent additional income elsewhere in the sys- even with no increase in output, falling prices tem. If it accrues to insurers, this could benefit investors directly via increased insurance Journal compilation Blackwell Publishing Ltd. 2007 WHY LOWER DRUG PRICES BENEFIT INSTITUTIONAL INVESTORS company profitability. If the government no impact on consumer demand, but clearly gleans savings, the benefits to investors could this is not the case. Affordable access to phar- come via higher levels of consumption, gov- maceuticals is an important public policy is- ernment spending in other non-medical areas sue, and a number of studies have shown that or lower interest rates resulting from smaller high costs reduce access to drugs – in other words, that demand is sensitive to price.
Drug purchases by corporate buyers or their Lower drug prices could modestly increase covered employees represent a pure business expense. If US$1 billion in purchases becomes payments, expanded private insurance cover- US$900 million via a price cut, then the impact age and improvements in state benefits. As the on business costs and profitability is direct and immediate. Every dollar of lost revenue and maker to a price-taker, output should increase profit in the pharma sector becomes a dollar as long as pricing allows for at least a normal of lowered cost and additional profit for rate of profit and remains above marginal and industrial, financial, consumer and technology average costs. The economy realises efficiency companies. While profits have been redistri- gains as the supply of pharmaceuticals ex- buted, the overall profitability of the portfolio pands and the “deadweight” allocation ineffi- has not been negatively impacted, and the ciency from monopolistic pricing is reduced.
impact on the broad-based investor should be In the case of drugs bought directly by con- sumers, the dollars saved by lower drug prices (P1 / P0). For example, if price went from have the same impact as a tax cut or a rise in family income. Given the very low savings reduced by (1 − 9/10), or 10 per cent. If in fact rates in the United States, this extra discretion- demand grows as prices fall, then profits ary income will largely get recycled as part of would not shift from drug companies to other economic sectors on a zero-sum basis. Under and profit within diversified sectors of the American economy. Since only about 15 per revenue is dependent not only on price, but cent of American GDP is traded with other also on demand. Specifically, the percentage countries, most of this income and spending impact on revenue is 1 − (P1 / P0 * Q1 / Q0). So will accrue directly to the United States corpo- if demand rose by 11 per cent as pricing fell by rate sector (United States Department of Com- 10 per cent, the impact on overall revenue merce, 2004). Furthermore, at least some of the would be 1 − (0.9 * 1.11), or 0 per cent. If leakages abroad would be captured in inves- demand is even more “elastic” than this, then tor portfolios as revenues and profits accru- revenues could actually increase as prices fall.
ing to US multinationals or foreign publicly Rex Santerre of the Center of Healthcare and Insurance Studies, University of Connecticut School of Business, found the out-of-pocket drug prices may impact pharma profitability, own-price elasticity of demand for pharma- but within the context of shifting profits from ceuticals to be inelastic with a point estimate one sector of the economy to the other – in of −0.48. The relatively price-inelastic estimate other words it is a classic “zero-sum game” in of −0.48 suggests that a 10 per cent decrease in which losses are largely if not fully offset by the out-of-pocket real price of prescription gains. If lower drug prices neither spur addi- drugs increases the quantity demanded of pre- tional demand nor choke off existing supply, scription drugs by about 4.8 per cent, ceteris there is likely to be little or no impact on over- paribus.12 A previous estimate looking solely at all corporate profitability in investor port- elderly populations found an estimated price folios. Given that the buyers of drugs are elasticity of −0.34 (Coulson and Stuart, 1995).
American corporations and consumers, this is not a surprising result, but one that is gener- prices fall is through a reduction in consumer ally not considered by investors as they work co-payments. Average co-payments for pre- through the likely impact of lower drug prices scription drugs have risen sharply as em- ployers have responded to steady increases inprices. For instance, between 2000 and 2005,co-payments for preferred drugs rose 69 per Analysis of the dynamic case for
lower drug prices
doubled (Kaiser Family Foundation, 2005b). Areduction in drug prices could stem this trend For simplicity’s sake we assumed in the previ- of higher co-payments, or even lead to lower ous section that lower drug prices would have nominal co-pays over time. As the real cost of Journal compilation Blackwell Publishing Ltd. 2007 co-payments falls as a percentage of employee ately attributable to indirect costs, such as income, the demand for prescription drugs access for workers currently left out of the clearly lessens this burden (Claxton et al., system. The number of companies in labour- intensive industries such as retail offering pre- Lowering the price of pharmaceuticals pro- scription drug benefits would likely increase.
vides consumers and employers an opportu- Similarly, coverage within state-sponsored nity to allocate more resources towards health, plans might improve. The broader the fall in while at the same time diverting resources to drug prices, both in terms of companies par- other goods and services. This investment has ticipating and medicines covered, the more the potential to yield long-term economic pay- powerful the likely impact on coverage and offs for individuals, families, employers and the economy as a whole due to the improved If pharmaceutical companies believed that lower prices would increase their profitability, (Claxton et al., 1999). Affordable prescription then they would presumably have already cut prices, and not spend millions of dollars lobbying against government-imposed price cuts. Thus it is unlikely that cuts in pricingwould be profit-enhancing or even revenue-neutral to the pharmaceutical companies Implications and conclusions
themselves, but it is quite likely that therewould be at least some positive revenue Institutional investors have an interest in see- impact.13 This would allow for cuts in drug ing the broad universe of American business prices to become a positive-sum game overall: increase its profitability, and be well posi- tioned to sustain profits over an extended time industry profits than it does on profitability horizon. Insofar as that happens, the profit- ability of any particular holding is less impor- tant. Our finding is that lower pharmaceutical could extend well beyond the direct economic costs have the potential to increase the profit- benefits of higher utilisation. Better access to ability of American business, with varying possible impacts on the pharmaceutical sector.
healthier, more productive workforce. The In summary, the impact of lower drug prices on investors heavily exposed to pharmaceuti- problems are significant, and improved medi- cals could be slightly negative, or could cal care would increase production, revenue and profitability in a broad cross-section of demand significantly. The impact of lower industries (Davis et al., 2005).
drug prices on universal owners is likely to be It is estimated that the lost economic output either neutral or positive, and universal own- resulting from the combination of not work- ers who also purchase health care services for ing, sick days and inferior productivity on the their beneficiaries may see additional benefits job totalled US$260 billion in 2003 – roughly from lower drug prices. For the majority of 2.4 per cent of gross domestic product (Davis institutional investors, then, the downside risk et al., 2005). Unsurprisingly, workers without of pursuing lower drug prices is contained, health benefits or with minimal health benefits and quite likely to be exceeded by the poten- are less productive on the job than those with There are a number of implications: differ- Health Economics reported that the net bene- ing fiduciary duties between universal owners fits to employers from having workers take and narrowly-defined investors; potential prescription medicines for their chronic ill- actions by universal owners on pharmaceuti- nesses are substantial and result because cal prices; and broader questions about the prescription medications substantially lower role of universal owners in the health care absenteeism among chronically ill workers (Rizzo et al., 1996; see also Goetzel et al., From the perspective of the investor, fidu- 2004). As a more specific example, the Journal ciary duty varies depending on whether they of Occupational and Environmental Medicine looked at the economic toll of depression.
narrowly, or in diversified portfolios. A recent They found it is high relative to that associated report on fiduciary duty by a leading global with other acute and chronic illnesses, and law firm notes, “[T]here is no duty to ‘maxi- that this economic burden is disproportion- mize’ the return of individual investments, but Journal compilation Blackwell Publishing Ltd. 2007 WHY LOWER DRUG PRICES BENEFIT INSTITUTIONAL INVESTORS instead a duty to implement an overall invest- such work, and one of us (Rosan) advises insti- ment strategy that is rational and appropriate tutional investors on shareholder activism to the fund” (United Nations, 2005, p. 8). Thus, strategies. We do not argue such activities are for diversified investors, shareholder resolu- required by fiduciary obligations, merely that tions and other actions to reduce drug prices they are permitted. We encourage these actions would be consistent with fiduciary obliga- because, we argue, they are likely to have a tions. Fiduciaries owe no duty to other stock- positive impact on the overall portfolio.
holders, or to the companies in which they invest, but only to their own beneficiaries. And broader questions about the role of universal owners in the health care policy environ- have a neutral or even positive impact on the ment. Corporate boards, including directors of pharmaceutical companies, have their own There are a number of potential actions uni- fiduciary duties to act in the long-term inter- versal owner fiduciaries might take to reduce est of company shareholders. As part of this drug prices. Most often, investors have simply duty, they could certainly decide to moderate pharmaceutical price increases to avoid the toward drug price restraint. They have done risks of price controls or other policy meas- ures that would threaten future profitability.
(Indeed, some major pharmaceutical manu- • Increasing shareholder pressure on phar- facturers have at times voluntarily limited their price increases to rates of inflation, although we are not aware of companies with • Improving the governance structure of com- such a policy currently in effect.) However, they are unlikely to act to benefit universal investors at a material expense to their own • Attempted to reduce the barriers pharma- company’s profitability and shareholder ceutical companies erect to re-importation returns. For this reason, universal investors of drugs from other markets (i.e. Canada).
could benefit from supporting public policies In addition, investors might also consider: that advance their overall interest in limitingdrug prices.
• Pursuing shareholder advocacy outside the In our view, institutional investors would be pharmaceutical industry to push for lower safely within their fiduciary bounds to seek improved public health care policy. While fur- tivity and profitability broadly across the ther research is called for – and we have not considered policy solutions here – health care represents an enormous challenge for the pri- address the profitability drug health care vate sector from cost, productivity, competi- costs represent for American business, and tiveness and management perspectives. Yet institutional investors, with the exception of For several years, the authors have been affili- some state pension and labour funds, have ated with the Interfaith Center on Corporate been largely absent from the public policy Responsibility (ICCR), which is one of several investor groups practising active shareholder We believe that public policy solutions to strategies. ICCR and several state pension the health care crisis are urgently needed. It is in the interests of most firms, and thus institu- designed to directly or indirectly reform drug tional investors, for the United States to pricing. Institutional investors should con- reform health care and shift costs from the sider expanding their activism to address the private to the public sector. Other industrial- negative impacts high pharmaceutical prices ised nations have put in place policy solutions, which accomplish the dual benefits of lower- would be an opportunity for corporate buyers ing system-wide health care costs and increas- to put downward pressure on pharmaceutical ing access to health care, with the attendant costs, and thus improve investment perfor- economic and public health benefits. We see no reason why the United States cannot do the same. More research is needed in this area to A word of caution – some reviewers of our evaluate the proper role for universal owners, but our discussion of pharmaceutical pricing requiring fiduciaries to engage in shareholder leads us to believe that there is a role for activity or public policy engagement as part of broadly diversified investors to play. We hope their duties as universal owners. Some of us the result of such engagement would be health care reform, which brings a more productive, Journal compilation Blackwell Publishing Ltd. 2007 and profitable economic system generating 11. See for example, Dimson et al. (2002). This is a improved long-term returns for diversified comprehensive global study of 102 years of In conclusion, broadly diversified investors 12. See Rexford Santerre and John Vernon’s piece benefit from drug price moderation, and can for the university of Connecticut’s Center forHealthcare and Insurance Studies.
pursue this goal through a variety of mecha- 13. See for instance the analysis by Alan Sager and nisms. Since pharmaceutical costs are signifi- Deborah Soclar (2004) that if more than 44.53 cant for virtually any company offering health per cent of prescription drugs re-imported from insurance, activism should move well beyond Canada to the US are new prescriptions, US the shareholder resolutions that have so far drug makers’ profits actually increase from re- been focused on the pharmaceutical compa- importation despite the lower prices paid.
nies themselves. Activism across the portfolio,along with public policy efforts to lower drugprices and increase access to health care, maywell be the most productive strategies for the References
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1. For more information on the debate and the Berndt, E. (2002) Pharmaceuticals in US Health increase in spending, see the Employee Benefit Care: determinants of quantity and price, Journal Research Institute’s Fact’s from ERBI section of Economic Perspectives, 16, 45–66.
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2. The National Conference of State Legislatures’ Claxton, A. J., Chawla, A. J. and Kennedy, S. (1999) website has a detailed breakdown of the 2005 Depression, Journal of Occupational and Environ- www.ncsl.org/programs/health/drugdisc05.
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Congressional Research Service (2001) The Cost of 3. Interfaith Center on Corporate Responsibility’s Prescription Drugs for the Uninsured Elderly and Legislative Approaches, Transportation and cessed October 23, 2006) includes shareholder Industry Analysis Section Resources, Science, proposals for 2004–2005 as well as 2005–2006.
www.governor.state.mn.us/Tpaw_View_Article.
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Coulson, N. E. and Stuart, B. C. (1995) Insurance One of the authors of this paper (Rosan) also Choice and the Demand for Prescription Drugs, Southern Economic Journal, 61, 1146–1157.
5. Author’s calculations based on latest available Davis, K., Collins, S., Doty, M., Ho, A. and Holmgren, A. (2005) Health and Productivity 6. Note this estimate is much disputed by, for example, the Consumer Project of Technology, which has posted criticisms of DiMasi on their productivity_USworkers.pdf) (accessed October econ/rndcosts.html) (accessed October 23, DiMasi, J., Hansen, R. and Grabowski, H. (2003) The Price of Innovation: New Estimates of Drug 7. James Love of Consumer Project on Technology Development Costs, Journal of Health Economics, has done work on other ways to fund and pro- vide incentives for R&D (Love, 2003).
Dimson, E., Marsh, P. and Staunton, M. (2002) Tri- 8. For an overview of the patent term restoration umph of the Optimists. Princeton, NJ: Princeton Employee Benefit Research Institute (1995) term.htm) (accessed October 23, 2006).
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National Institute of Health Care Management Steve Lippman is Vice President of Social
(2002) Changing Patterns of Pharmaceutical In- Research and Advocacy at Trillium Asset Man- issues of corporate social responsibility. Steve Pawlenty, T. (2004) Governor Pawlenty’s Remarks to the Pfizer Inc. Shareholders Meeting, press was a founding co-chair of the Social Invest- release, Office of the Governor, Minnesota, 22 ment Research Analysts Network (SIRAN), a working group of the US Social Investment Pear, Robert (2006) Growth of National Healthcare Forum. Prior to Trillium Asset Management, Spending Slows Along With Drug Sales, New York Steve spent four years working in the Environ- ment Program at Business for Social Respon- Pharmaceutical Research and Manufacturers of sibility. He earned his bachelors degree from America (PhRMA) (2003) Pharmaceutical Industry Profile 2003. Washington, DC: PhRMA.
Resource and Environmental Policy from the Public Citizen (2003) 2002 Drug Industry Profits: University of Michigan’s School of Natural Hefty Pharmaceutical Company Margins Dwarf documents/Pharma_Report.pdf) (accessedOctober 23, 2006).
Daniel E. Rosan is the Program Director for
Relman, A. (2001) Separating Continuing Medical Public Health and Access to Capital at the Interfaith Center on Corporate Responsibility, Journal compilation Blackwell Publishing Ltd. 2007 a faith-based corporate accountability organ- Management. Prior to joining Trillium, Adam isation. There he drafts shareholder resolu- was Chief Global Strategist for Deutsche Asset tions, conducts research, and acts as a media Management in London, where he led a team responsible for allocating over £40 billion in assets. He also has experience as an analyst Kenya and Botswana, and authored Bench- and portfolio manager at Wellington Manage- marking AIDS: evaluating pharmaceutical com- pany responses to the public health crisis in Research for John Hancock’s Investment and emerging markets. Beyond ICCR, he serves on Pension Group. Adam holds a PhD in econom- the board of Jews for Racial and Economic ics from Boston University and early in his Justice, has a BA cum laude from Vassar career was an assistant professor of Economics at Wellesley College. He became a CharteredFinancial Analyst in 1993.
Adam Seitchik is Executive Vice President
and Chief Investment Officer of Trillium Asset
Journal compilation Blackwell Publishing Ltd. 2007

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