Calling time on unethical investing

Nest has a tough task on its hand in delivering the cynics a national pension scheme that will suit the needs of millions of impoverished Britons.

It is under pressure on all fronts to deliver a scheme that generates acceptable returns in a manner that has not just members’ interests but also their principles at heart.

That is one reason why it has signed up to the UN Principles of Responsible Investment (UNPRI) a move that has been welcomed by the unions.

Upon the announcement late last year, TUC General Secretary Brendan Barber said: “It’s absolutely right that Nest has signed up to these important principles. We need all equity investors to take their responsibilities as company owners seriously, and the UN principles set out a clear minimum standard. Nest is continuing to be a model of good practice for the stewardship of pension assets.”

Few would argue that corporate standards should be as high as possible. But what actually is the significance of UNPRI, and how much influence should these standards have on the way advisers design schemes?

What does UNPRI involve?

Central to the entire concept is ESG (environmental, social and governance), which is a generic term used in capital markets and used by investors to evaluate corporate behaviour and to determine the future financial performance of companies.

ESG factors are a subset of non-financial performance indicators that include sustainable, ethical and corporate governance issues such as managing the company’s carbon footprint and ensuring there are systems in place to ensure accountability

So it’s a form of ethical investing?

No. Managers who follow the UN principles are at pains to point out that signing up does not mean they will exclude stocks they aren’t happy with. So the classic ethical no, no’s, such as armaments, tobacco and gambling stocks are not excluded.

Paul Todd, head of investment policy at Nest says: “This is not about exclusion, it is about understanding the ESG risks associated with your portfolio and about working to create value over the long-term.”

It’s an area that the defined benefit pension arena already embraces readily. For instance, the BT pension fund has also implemented a number of detailed policies for responsible investment and a specific area of concern for the scheme is the issue of climate change.

FTSE Group director of responsible investment David Harris says: “The BT Pension Scheme wanted to look at the climate change aspects of the FTSE All Share Index, which its UK passive fund currently tracks – not that the scheme wanted to divest from companies in that index.

Instead, we tilted the weights, so the portfolio now takes into account the risks of higher costs associated with greenhouse gas in the future.”

Why all the fuss?

Auto-enrolment will see up to an additional eight million people, many of them low paid workers, brought into the pensions market without their formal agreement. Providers believe that it’s vital that the financial wellbeing of those workers is protected. They claim that responsible investment is vital to ensuring that pension savers’ long – term financial best interests are looked after.

A spokesman for Nest says: “For the first time millions of people will invest in the stock market and it is a big change in how they save for their retirement. We have spent an awful lot of time looking at our default proposition and managing its risk in a holistic way over the long-term. We think this is best served by UNPRI.”

Louise Rouse, director of engagement at FairPensions says: “Employers have the power to select an auto – enrolment pension provider for their employees. We would encourage employers to include membership of the UN PRI and adherence to the UK Stewardship Code as selection criteria for any auto-enrolment provider to encourage improved responsible investment.”

What are the benefits?

Nest reckons that it empowers the small shareholder because it can represent them on their behalf and go into battle with other institutions to tackle issues that they feel could be key to a company’s performance.

“We are creating a place where we can discuss issues and where there is an alignment of interests,” says Todd. “It gives small investors a voice.”

He cites the example of tar sands, which has had its fill of governance issues. “It is not about tar sand companies being good or bad. It is about ensuring that the companies are providing the right information so investors can make a judgment on the right risk and return profile,” adds Todd.

So it will make any difference to performance?

Fund managers believe so. They are quite defensive at the suggestion that it is simply a box-ticking exercise. “We haven’t gone into this willy-nilly,” said a spokesman for L&G, which has signed up to UNPRI. “We take corporate governance very seriously.”
Todd says: “We signed up because we firmly believe it will make a difference, we would not have ticked the box unless we did.”
The most high profile case of corporate fiasco in recent years was BP and its dividend cancellation in the wake of the Gulf of Mexico oil spill, something that directly impacted UK pension fund income.

Advocates of UNPRI say that poor corporate governance practices were a crucial element in the financial crisis, the impacts of which on savers and pension holders are still evident.

FairPensions says: “It’s vital that all auto-enrolment providers demonstrate a commitment and ability to address such issues and use their shareholder rights in companies (to vote on certain issues and engage in dialogue with the company) to reduce these risks to pension savers. Becoming a member of UNPRI is an important step in demonstrating this commitment but must be accompanied by swift and full implementation of the UNPRI principles.”

So do we take UNPRI signatories’ word for it that returns are better?

Not every one believes that engagement has positive results. The recently published Kay Review offers a different opinion. The Review was an independent review to examine investment in UK equity markets and its impact on the longterm performance and governance of UK quoted companies.Following its consultation it recognised that it is not always the case that shareholder engagement has the result of encouraging such a perspective.

The report states: “Indeed we received many reports of how shareholder engagement had encouraged companies to engage in financial engineering, to run their businesses to ’make the numbers’, or otherwise to emphasise short-term financial goals at the expense of the development of the business’s capabilities.”

The Review highlighted the thoughts of Sir Terry Leahy, perhaps Britain’s most successful and respected manager of the last two decades. He told the Review he did not feel he had enjoyed such a relationship with analysts and fund managers during his time as chief executive of Tesco, and that he had missed the opportunity for such engagement. He added that he felt that the interaction had deteriorated rather than improved and that analysts and fund managers had become more concerned with quarterly numbers and with earnings guidance, and less with the strategic direction of the business.

Do DC providers have a moral obligation to offer a default fund that embraces ESG principles?

Many already do. John Lawson at Standard Life reckons that schemes should offer funds that conform to ESG principles for members who wish to choose these funds, but not as default funds. He says: “It would also be possible to construct a default fund for the whole scheme, should the employer or trustees wish to, that conformed to their ESG principles – this would probably be a blend of funds already available – the market will construct a blended default according to the specification laid down by employer/ trustees/member governance committee.

“I think excluding investment in certain assets is more difficult to define. Standard Life already offers a choice of ESG funds on its platform but I cannot warrant that every potential member or scheme will be able to find a fund on our platform that conforms to their principles.”

Have many firms signed up to UNPRI?

Worldwide – more than 1,000 in total. This includes 249 asset owners, 593 investment managers and 168 professional service partners.

But according to Fairpensions none of the UK’s top 10 leading contract-based pension providers are signatories to the UNPRI in their capacity as insurance companies and pension product providers (as opposed to in their capacity as an asset manager acting on behalf of other pension funds). It hopes that the other players in the UK auto-enrolment market, including the Danish provider Now Pensions, will follow Nest’s example in becoming a signatory to the UNPRI in their capacity as pension product providers.

Will members care?

Probably not, if the demand for ethical funds is anything to go by. Even Nest admits that members’ priorities are to get a better income in retirement and probably won’t care too much how those returns are delivered. “But we think it is important to help to deliver returns over the long-term,” adds Todd.

Of the £10bn under management on its DC platform, Fidelity says that only £8m is in ethical funds. A spokesperson adds: “Ethical funds do not normally form part of the standard or default range of fund options and tend to be added as a self select option for most plans. As you can see from the amount that we have under management in these types of funds there is not a great demand or take up.”

That said it is assumed that many auto-enrolment providers will offer savers the option of an ’ethical’ fund, as Nest will. FairPensions says that savers should be informed which companies are included within the particular fund so as to be assured that they are in fact investing in the manner that they intended.

“Currently there is a lack of transparency on this issue. Some pension providers may mistake offering an ’ethical’ option as having dealt with responsible investment,” says Rouse. “However, environmental social and governance issues are relevant to mainstream funds, as evidenced by the BP oil spill and the financial crisis, and, accordingly, the provision of an ’ethical’ fund should be in addition to rather than instead of applying responsible investment principles.”