Missed Opportunity
The 2018 Global Pension Assets Study published by the Thinking Ahead Institute of Willis Towers Watson, one of the leading providers of investment consultancy services to corporate pension schemes globally, reported six key findings from 20 years of global pension assets growth. Interestingly, one of their findings was that over this period ´the number one missed opportunity was stewardship´.
“The 20-year story is one of missing the opportunity to influence and mitigate corporate misalignments – like executive pay, and other poor leadership and boardroom practices”.
The capital allocators within the pensions industry – investment managers, investment consultants and scheme trustees – missed the opportunity to exert their stewardship role more actively to hold companies to higher governance standards.
Good governance goes hand in hand with building sustainable companies, companies focused on creating long term value in partnership with stakeholders, including the environment. It is a way of thinking as much as applying a set of rules or principles.
Perhaps the last 20 years in financial markets might have been dramatically different if governance procedures had brought bubbling issues to the fore a lot sooner. Would the dot-com crash have been less severe? Or what about the great financial crisis that erupted in 2008? Could better governance have reined in the reckless and unsustainable lending policies years earlier?
At a company specific level the scandals continue. Most recently there was the emissions scandal in the auto industry and money laundering scandals at leading global banks. This resulted in billions in fines, damaged reputations and negative impacts on society. In all cases, should the stewards of capital have asked more questions? Who is failing to ask the tough questions?
Who is responsible in pension schemes?
This can often be a lot more difficult to answer than you might expect, given the many layers between a member of a pension scheme and the underlying company he or she is invested in via an investment fund.
For example, take the average pension member invested in a fund that has an allocation to equities. The member will have selected the fund based on the fund´s risk and return characteristics, focusing on the fund at a high level. However, at a constituent level they are effectively the owner of a broad range of companies across industries and sectors.
Individuals perceive it as irrelevant given the size of their investment in the context of the wider global financial system. However, collectively, pension scheme members control a large amount of shares and hence voting power to influence company behaviour. How can members be sure the corporate executives are running the companies in a sustainable manner?
The chain of responsibility starts with the board of directors who provide the first check on the management team. The next layer of oversight on company practice is the fund manager who has invested in the stock (actively or passively, which raises a separate debate). Then there is the investment consultant who will have recommended the fund option to the trustees of the scheme. Finally, the trustees, who appoint the investment consultant, play a key role in the development and oversight of the investment offering they have put in place for members.
The challenge for members is that along this chain of responsibility, a plethora of factors, including issues of independence, diversity, knowledge gaps and relationship dynamics, can all compromise the governance standards that need to be upheld.
If we look at the scandals of the last 20 years and two market crashes, it is hard not to agree with the authors of the 2018 Global Pension Asset Study that stewardship has been the number one missed opportunity. The fact is that every party along this fiduciary chain is failing to some degree in their stewardship role.
Looking ahead
Looking ahead to the key issues for pension schemes to consider in the next 5-10 years, the same report notes that: “Opportunities are being missed in the overlapping areas of sustainability, ESG, stewardship and long-horizon investing. Investors need to combine both investment beliefs and wider sustainability motives in their strategy”.
However, the reality is that these issues need to be considered immediately and trustees will have to be at the forefront of this change for the benefit of members.
A recent report by the Principles of Responsible Investment (PRI), “Working towards a sustainable financial system – Investment Consultant Services Review”, written with input from Mercer and Willis Towers Watson, highlighted the challenges inhibiting the integration of the Environmental, Social and Governance (ESG) criteria into investment policies at pensions schemes. (The focus of the report was the US, UK and Australia.)
The investment consultants interviewed for the report cited a variety of reasons to explain the inertia around the integration of the ESG criteria. The failure of the education syllabus & professional exams to cover this area of finance is an obvious one that needs to be addressed. “Professionals may spend 3-10 years in training without understanding the importance of ESG issues and be unprepared to bring it to their clients.”
As an industry, they point to “a lack of public commitment on ESG issues made by most consulting firms”, which “limits the incentive for individual consultants to raise these issues with their asset owner clients”. At the same time, consultants see advice as client led and so they are “reluctant to raise issues that are not requested by the client”. “If the client´s initial response is that they are not interested or not aware, consultants rarely revisit this question”.
The important takeaway from the report? Operating in a competitive and concentrated market the consultants are not going to push the issue of responsible investing and ESG integration. So as the final gatekeepers for how pension scheme money is invested it will be on the trustees to take the lead on these issues for the benefit of members. Anecdotaly, the sense is that interest and commitment from trustees is still quite low, which should be a concern.
The investment managers are offering and developing new solutions but without consultants and trustees on board the adoption across pension schemes will be slow. There needs to be much greater collaboration between all parties involved. At the same time, the regulatory bodies and some of the industry organisations are also way behind where they should be in terms of leading on these issues. They need to provide far more practical guidance to trustees on how to incorporate the likes of the ESG criteria and the 2030 Sustainable Development Goals.
Leadership needed
Governance is a fundamental part of a responsible investment strategy but if responsible investing is just seen as product then the status quo will continue. To take the opportunity on stewardship, leadership across all links of the fiduciary chain is urgently needed.
For trustees, it is not a case of jumping to the end of the process and picking the best ESG fund or the best impact investment fund. They need to start by setting clear values for the pension scheme and articulating their responsible investment philosophy, including their plans to integrate ESG criteria and their commitment to the 2030 Sustainable Development Goals.
Trustees do not need to throw out the traditional investment process. It can be augmented with a new impact framework that will empower them to take a more active stewardship role. This is not about sacrificing returns, it´s about achieving better long term outcomes for pension scheme members and society in general.
Of course, we also need a more informed population to ask tougher questions about where their money is being invested and the values and standards that companies are being held to. Would you be happy if your pension investment included an allocation to a bank carrying out money laundering for the Mexican drug cartels? Or a mining company that is destroying the environment? These things have happened and most likely your pension fund owned shares in these companies.
Conclusion
Finally, it is important to point out that there are many global companies embracing the value of better governance, explicitly considering their impact on stakeholders and the environment. There is a growing momentum behind how companies are thinking about sustainability, helped by the 2030 Sustainable Development Goals.
The stewards of capital can play their role by being more discriminatory between sustainable and unsustainable investments in their capital allocation process. They can move the conversation forward with all companies regarding the pursuit of long term value creation and delivering a positive impact on society.
I know this change will take time, but for trustees it´s about getting started. It´s about approaching the issue of stewardship and responsible investing with an open mind. It requires putting in place the right foundation to be able to have much more meaningful discussions with all parties involved, rather than just adding another product to the existing investment offering.
It´s time to align the values of a pension scheme with the values of its members.
End
Vincent McCarthy, CFA
Join the discussion – Currently in Mexico, Vincent will be in Dublin next month hosting a workshop in the Shelbourne Hotel on December 6th, bringing together a small group of trustees and industry participants to provoke discussion on the concept of impact and practically applying a responsible investment philosophy in the real world.
For more information e-mail vmccarthy@coterraimpact.com
Sources:
Global Pension Assets Study – 2018
https://www.willistowerswatson.com/en/insights/2018/02/global-pension-assets-study-2018
Working towards a sustainable financial system – Investment Consultant Services Review