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The Actuary The magazine of the Institute & Faculty of Actuaries

Socially responsible investment for pension funds

Socially responsible investment is not new. Even before the Disclosure Regulation, pension
schemes, particularly in the public sector,
had been approached regarding aspects of SRI. These approaches were generally along what might be described as traditional SRI lines, ie a desire to exclude investments affected by, or implicated in, a particular moral or political viewpoint. Examples might be apartheid in South Africa or the so-called sin stocks of tobacco, drink, and gambling.

Beneficiaries’ interests
Advocates often advanced sophisticated reasoning to support their particular viewpoint on investment as well as moral grounds. Generally, they fell foul of the same flaw, ie the prime responsibility of any group of trustees is to safeguard the financial interests of the beneficiaries and not to fetter their discretion by giving precedence to other concerns, however sincerely those beliefs might be held.
This gave rise to a simple view that it was impossible to reconcile SRI with pension fund investing and the simple formulae of ‘you can’t do it’ or ‘it’s not legal’ or ‘it involves too much risk’ came to be fairly standard advice.

Changing attitudes
However, during the 1990s there was some evidence of a changing attitude regarding investment and social responsibility. The Goode Committee said that there was nothing wrong with trustees having a SRI policy. However, the report gave no further help or definition.
EIRIS, the ethical investment research provider, published the results of an opinion poll that it had commissioned which, at the very least, tended to show that there was a measure of sympathy for a socially responsible awareness or approach to investment.
Some pension funds were very publicly looking at SRI. While not alone, Nottinghamshire County Council was very prominent with the publication of a book outlining its research called ‘Pensions and the environment’.
Finally, the Institute and Faculty of Actuaries made their own contribution with a paper in June 1997 entitled ‘Business ethics the new bottom line’.
The new Labour government was kindly disposed to SRI and the Disclosure Rules proposal became regulations in July 2000.

Significant issue
Despite all the apparent difficulties, it was clear that SRI might become a very significant industry issue and there could be reasonable numbers of clients, particularly in the public sector, who would wish to have a SRI policy.
We felt that it was important to find a way which allowed trustees to develop and implement a SRI policy without compromising investment structures or pension fund returns or their fiduciary responsibilities.
The introduction of the Disclosure Regulation changed nothing regarding the duties of trustees. That duty can still be comfortably paraphrased as seeking the best financial return for beneficiaries, commensurate with a reasonable level of risk, and they are at peril if they fetter their judgement with considerations that are not relevant to their prime responsibilities.
There was, however, a suggestion that, where issues could potentially adversely affect investment, trustees might be negligent if they did not consider them. That seemed to be something new.

Widening the field
There are a great number of topics that can broadly be described as socially responsible. EIRIS covers more than 40 broad subjects, some with several subcategories. This number may grow as activists seek to solicit the support of institutional investors for the particular topics that exercise their minds.
Some issues may be described as moral judgements. They may represent sincerely held views about particular industries, but they do not have an obvious systematic investment or financial content. They are views about perfectly lawful businesses to which some people, but by no means all, have an objection . It is a mistake to exclude companies from the investable universe on the basis of what they do it is better to concentrate on how they go about their business.
Issues that are primarily concerned with the way that companies go about their business are likely to have implications that affect shareholder value. These financial implications may be seen either in terms of direct cost or indirectly through the loss of reputation or public support that ultimately affect earnings and the share price.
Those issues with the power to affect shareholder value in some way are the relevant issues for institutional investors to concentrate on. Indeed, it is difficult to see why a pension fund trustee should concern him or herself with an issue that does not have this power.

Traditionally SRI has been dominated by screening with a view to exclusion. In most cases, however, screening was based on non-financial judgements that seemed to be outside a person’s remit when acting as a trustee. Negative screening seems an inappropriate way forward for pension funds unless there is clear evidence that investment in certain broad categories of stocks could be shown to be always disadvantageous. There is no such evidence that we can find.
The only viable alternative is engagement, which can be regarded as an extension of corporate governance. It is surely the mark of a responsible investor to take a sufficiently interested approach in investee companies to responsibly exercise the pension fund’s votes whenever the opportunity arises.
Such an approach should not:
– require a change of investment manager;
– result in the deselection of stocks on other than the judgement of the investment manager, taking all relevant factors into consideration.
It therefore focuses attention on issues of a social, environmental, or ethical nature that can reasonably be believed to have the potential to affect shareholder value. It envisages that where such issues are found, where there is prima facie evidence that they may have a material impact on shareholder value, then those issues should be raised and discussed with management. The response and actions of management should be monitored and factored into the investment decision-making process.
A gradualist approach to SRI is advised, which has several implications:
– accepting that the fund’s existing investment managers are not necessarily the most experienced/
best-equipped SRI managers available;
– as UK equities are supported by the best SRI research, it is the most appropriate starting point;
– managers should tackle only those companies that seem to offend most against the policy in the first instance, on the basis that it is better to do a few things well than a great number of things poorly.
Managers will be expected to assess the extent to which a particular issue threatens shareholder value and it is not expected that the issue would be viewed in isolation from other matters affecting the prospects of a company. Thus it will be possible for managers to continue to hold stocks in a client portfolio that offend against the client’s SRI policy. However, the manager will be expected to be able to give an account of his actions and the reasons for his decision.

The way forward
To date we have spoken, on behalf of clients, to nine active fund managers who between them are responsible for managing about 30% of UK pension fund assets.
All of them have indicated a willingness to implement a SRI policy for clients and have committed themselves to acquiring or assigning resources to SRI. Clearly, it will take time for managers to organise themselves and some will make a better job of it than others, so that a certain amount of ‘catch up’ will be required. However, we regard these results as very encouraging, particularly as none of these managers is of the group who by virtue of the in-house resource or history of SRI activity might be regarded as the leaders in this field.
Nevertheless, to have the support of so influential a group of managers for some part of their funds indicates that SRI, in terms of its growing influence, has already come a long way since the publication of the Disclosure Rules proposal. There is every reason to assume that this trend will grow.

Striking the balance
Investment managers have to strike a difficult balance in determining who should lead SRI within the company. If the company is to eventually successfully integrate social responsibility within the mainstream investment process, whoever leads the project requires internal credibility. Equally, to provide the necessary drive, commitment, and external credibility the company needs recognisable SRI credentials. Probably some combination of an existing ‘greenish’ fund manager within the company, combined with a senior SRI researcher recruited externally will provide the sort of option that most companies eventually select for the foreseeable future.

Some concerns
I do have some concerns for the approach outlined:
– Some trustees might find engagement to be too low-profile or unable to deliver results with sufficient speed or attribution. Measurement of the success or effectiveness of engagement will prove an extremely difficult issue.
– Service delivery will be an issue. Some managers will be better than others at developing socially responsible investment, or integrating it into the investment process and some will exercise more influence via engagement than others.
Should that be a concern? The answer is ‘yes and no’. There are already differences between managers in the degree of success enjoyed by their investment process. SRI is simply becoming another facet of that process to research and take into account. The weight that is attached to SRI will vary over time and between circumstances.
However, SRI is here to stay and will become an increasingly powerful force for good in the years to come. I have little doubt that the City will adapt to successfully meet the challenges that SRI raises.