While corporate plans are legally distinct from their sponsors, plans and their beneficiaries can benefit from responsible investment in several ways.
- Responsible investment practices can improve investment performance
- Responsible investment fulfils fiduciary duty and helps manage regulatory risk
- Responsible investment can better align external managers and third-party advisers
- Responsible investment can support deficit management
- Responsible investment can boost sponsor credibility and employee retention
1. Responsible investment practices can improve investment performance
“The trustees agreed to a set of responsible investment beliefs based on the academic and practitioner evidence that we put to them. They believe that ESG integration into the manager selection process will lead to better risk adjusted returns in the long term.”
Douglas Clark, Head of Manager Selection, BT Pension Scheme Management, UK
Among many corporate pension plans, there remains the perception that ESG issues do not add value to investment decision making. These views are out-dated. Incorporating ESG factors can improve investment performance through:
- lower volatility and higher risk-adjusted returns;
- lower probability of drawdowns during times of market stress;
- enhanced asset allocation.
ESG issues are not new to investment analysis. They have been considered by pension plans and investment managers for decades, often without reference to an “ESG” label. For many years, corporate disclosure regulatory frameworks have also required the reporting of ESG-type information – for example on how boards are structured and composed, workplace policies and practices and raw material procurement. What is new is the extent and sophistication of ESG analysis undertaken by investors, whether in portfolio construction or in making buy/sell decisions. One key reason for the rapid increase in ESG analysis by investors is the growing evidence, from academic circles, that sustainability practices have a positive influence on investment performance.
Important new academic research findings on ESG issues include the following:
- ESG analysis provides investors with early warning signs of corporate governance failures, enabling the identification of value-destructive behaviour, meaning investors can select corporations with strong management and sustainable business models.
- Investors that engage over time on corporate governance and through the use of shareholder rights can see enhanced risk-adjusted returns.
- Companies that disclose their carbon emissions through the CDP enjoy more favourable lending conditions than their non-disclosing counterparts and those with higher Co2 emissions levels (relative to their peers) pay higher interest costs on their loans.
- According to a recent meta-study of more than 2,000 academic studies on sustainability by Deutsche Wealth and Asset Management and the University of Hamburg, the “business case for ESG investing is well-founded” and “investing in ESG pays off financially and appears stable over time”.
As with other features of investment analysis, there is a degree of discretion and judgement in weighing the valueimpact of ESG issues per sector. Within financial services, for example, governance issues, including regulatory and legal risk oversight, employee pay and conflict of interest management, are more likely to be material to security value than environmental or social factors. Within extractive industries like mining, however, which are often communitybased, retaining the social license to operate is likely to be influenced by an owner’s track record on health and safety, labour standards and environmental management.
2. Responsible investment fulfils fiduciary duty and helps manage regulatory risk
We believe excluding ESG analysis hurts our fiduciary duty. Therefore, we integrate ESG issues in our corporate pension scheme. This decision is taken independently from our corporate sponsor.”
Dr Roger Otten, Investment Manager, Stichting Philips Pensioenfonds, The Netherlands
Corporate pension plans owe fiduciary duties to their beneficiaries. Fiduciary duties exist to ensure that those who manage other people’s money act in the interest of those beneficiaries, rather than serving their own interests or those of the corporate sponsor. Despite this, some corporate pension plans have defined the fiduciary duties they owe to their beneficiaries in narrow terms, arguing that they prevent them considering ESG issues in the investment process. As set out more fully in the PRI’s recent report Fiduciary duty in the 21st century this view incorrectly interprets ESG issues.
Fiduciary duty is not a barrier to responsible investment. Ignoring ESG issues, where they are material, represents a breach of fiduciary duty, as ESG factors are often critical to performing effective risk and return analysis to help correctly interpret accounting statements and appropriately judge future investment performance. It is not the origin of the factor or its label that matters when complying with fiduciary duties, but whether the factor is financially material.
The requirements and understanding of fiduciary duty are increasingly being reinforced by the growth in regulation relevant to responsible investment. The PRI’s recent report, The global guide to responsible investment regulation, identifies almost 300 pieces of regulation that require or encourage responsible investment, half of which were introduced in the past three years.
These developments are in many ways supported by the understanding of fiduciary duties to which corporate directors are subject. These too had been interpreted narrowly to require short-term profit maximisation and, in some jurisdictions, the consideration of shareholders to the exclusion of other stakeholders such as employees, communities and creditors.
However, recent legal analysis and business commentary has increasingly focused on the importance of the creation of sustainable corporate value over the long-term, which requires an assessment of the dependence on ESG issues of a corporation’s business model. Crucially, fiduciary duty concerns fullfing duties to beneficiaries; it cannot be outsourced like other activities.
3. Responsible investment can better align external managers and third-party advisers
“There are 17,000 employees. There are five employees who work on the scheme.”
Hiroichi Yagi, Managing Director, Secom Pension Fund, Japan
Corporate pension plans are often resource-constrained organisations with few professional staff and no direct investment specialists. Without the necessary specialist investment skills in-house, most plans outsource some or all of their asset management to third party managers. As such, many plans do not have the sufficient scale, capacity or expertise to influence:
- the range of ESG-related strategies and solutions available in the investment industry;
- the suitability of such products to corporate plan management and design;
- the extent to which ESG issues are being considered, in practice, by their managers.
Because of this, corporate plans may not have a strong sense of the most relevant or challenging questions to ask their managers and other advisers about ESG-related performance.
These constraints cause corporate plans to lean heavily on their investment consultants for advice. Such consultants provide critical infrastructure for a plan and its staff. They help with strategic asset allocation, the range of investment strategies considered and the overall performance objectives of the plan. They also provide assessments and operate as a selection mechanism for the plan’s investment managers.
Most large investment consultants now have specialist responsible investment capabilities. However, without the commercial pull from their clients, many consultants have yet to integrate well-established responsible investment practices into their core advisory services. Organisations like the PRI can provide valuable insight to assist corporate pension plans in obtaining the best possible outcomes from their scheme advisors and service providers.
For example, corporate plans can:
- incorporate ESG issues into investment policy statements or statements of investment principles;
- expand fiduciary training for trustee or governing body members to encompass ESG issues;
- add ESG questions into selection, appointment and monitoring of investment managers.
As corporate pension schemes are not subject to the same scrutiny or regulatory frameworks as boards of public companies, there tends not to be equivalent oversight on their governance bodies. They may be slower to adopt new practices such as ESG incorporation. Corporate plans should ensure they keep up to date with emerging governance practices to enable them to manage their beneficiary funds as effectively as possible.
4. Responsible investment can support deficit management
“When you discuss responsible investment, there is often someone who asks, ‘We have spent two hours talking about ESG issues, what about our deficit?’”
Mark Walker, Global Chief Investment Officer, Unilever Pension Funds (Univest Company), UK
Deficits in defined benefit (DB) corporate pension plans are common. The overall trend in global pension provision is of risk transfer, with plans switching from DB to defined contribution (DC) and entering into de-risking arrangements on their DB plans when their funding position allows.
Reducing the scale of plan deficits and risk transfer often dominates the agenda for scheme governing bodies and their advisers. Deficit discussions can put strain on the relationship between plans and sponsors. While large unfunded pension liabilities can create a negative market perception of a corporate sponsor’s financial health, plugging large deficits will, in most cases, require significant value transfer by the sponsor, most likely requiring it to waive future dividends or take on greater financial leverage.
The scale of such value transfer and the “notional” nature of deficit computation can make sponsors reluctant, if not unable, to plug such deficits, which will change over time. As a result, plan trustees typically devote considerable time to reviewing funding levels and deficit management issues, meaning that attention to responsible investment issues can be overlooked.
By broadening and deepening a plan’s investment policies and procedures, responsible investment considerations can be part of a suite of measures that contribute positively to deficit management. The integration of ESG issues into investment processes and decision making does not necessarily raise directly assessed scheme costs and can be implemented through retained scheme advisors. Through a more holistic approach, plans can have a better understanding of investment risks and make better asset allocation and manager selection decisions.
5. Responsible investment can boost sponsor credibility and employee retention
“We must make pensions and investment interesting and relevant to the needs and to the values of younger members.”
Mark Thompson, Chief Investment Officer, HSBC Bank Pension Scheme, UK
The shift from DB to DC for many corporate plans has created new opportunities for their trustees to implement responsible investment practices to meet changing employee expectations and needs. DC pensions offer beneficiaries significantly less certainty in terms of income replacement. As DC pensions effectively transfer liability for investment performance from a sponsor or plan to a member, beneficiaries have to be more engaged in making their own investment choices. With this shift in responsibility, beneficiaries not only have more control over the investments that are made on their behalf, but also, in many cases, are increasingly interested in knowing whether these choices are responsible and sustainable.
In the context of corporate purpose, corporate pension plans have become part of the broader package of employee well-being initiatives. Employees have a heightened awareness of the potential impact of their consumer and investment decisions and an increasing interest in ESG issues. Many of them want to work for companies that factor sustainability into their corporate values. As such, corporate pension plans that cater to such demands with an appropriate range of investment choices and related information can benefit, or reinforce, the reputation of their sponsors, as sustainable businesses, and may be used as a tool to help recruit and retain employees.
In response to this growing demand, the number of plans providing “green”, “ethical” or “SRI” badged funds as alternative investment choices has greatly increased over the past years. However, as most employees choose a default option, both plan and sponsor have more to gain by embedding responsible investment considerations within their default DC plan.
In this regard, the new HSBC UK default DC pension option is a ground-breaking initiative. The strategy was adopted partly in response to heightened awareness among HSBC beneficiaries about ESG-related issues. The pension scheme proposed and adopted a multi-factor fund with a climate change ‘tilt’ as the equity default option for its defined contribution (DC) scheme. Valued at more than £2bn, the Future World Fund, managed by Legal & General (LGIM), uses a FTSE Russell index which reduces exposure to high carbon-emitting stocks and increases exposure to lowcarbon alternatives. The fund is expected to deliver better risk-adjusted returns for members than the capitalisationweighted global equity fund it replaces. If successful, it is possible the fund may also replace HSBC’s equity allocation in its UK DB scheme.
The shift to DC pensions creates an opportunity for corporate sponsors and their plans to realign their relationship with their employees. As such, having a DC scheme that offers suitable, cost-effective responsible investment choices is an important and valuable branding proposition, reinforcing a company’s commitment to sustainability to its employees and other stakeholders.
How to make your plan more sustainable
As this publication shows, there are many opportunities for corporates and their pension plans to adopt complementary approaches to sustainability while maintaining plan independence. Supported by PRI resources, corporate plans can start their responsible investment journey in a number of ways. For example they can:
- start conversations within their governing bodies and with the corporate sponsor on responsible investment and its relevance to the objectives of the plan and the corporation;
- seek feedback from their beneficiaries on their attitude to responsible investment as part of their annual schedule of plan communications;
- begin conversations with service providers, both investment consultants and investment managers, on their approaches to ESG integration and responsible investment within their service offerings;
- access resources and training to raise the level of awareness of ESG integration and responsible investment on the plan governing body;
- sign up to the PRI.
How the PRI can help
By joining the PRI, you become part of a leading, global network of more than 1,700 signatories, representing over US$62 trillion in assets under management. You benefit from an internationally-recognised set of Principles and demonstrate your commitment to responsible investment via an independent link to the United Nations.
The PRI supports its signatories to create a more sustainable financial system through:
- numerous asset class-specific guides, toolkits and case studies;
- opportunities to attend and participate in events and workshops with other signatories, providing the chance to network and share knowledge;
- access to the PRI fs Collaboration Platform, a private online resource, which allows signatories to learn, engage and collaborate with companies, policymakers and academics, as well as over 1,700 fellow investors and service providers;
- the PRI’s Academic Network, which offers signatories access to key academic research findings and the opportunity to collaborate with academics;
- the PRI Academy, a CFA-accredited online training system that can be tailored for staff and trustee needs;
- the Reporting Framework, which guides how communication between corporate plans and beneficiaries can be structured;
- dedicated network managers around the world that offer local support.
To get involved or for more information, contact Graeme Griffiths.
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