Institutional shareholders, including pension funds, have been taken to task by politicians and others over the past year or so for their failure to address effectively the looming financial crisis before the dam burst in 2008. We have long argued that pension funds and their managers played a relatively minor role compared to bank boards and their regulators. But the truth is that no one can carry on as if nothing has happened.
Pension funds currently own about 13 per cent of listed companies, meaning that another 87 per cent is in the hands of other investors in the UK and, increasingly, overseas. Our survey of 2009 shows that pension funds believe that their engagement work is “quite effective” and that material changes to companies’ corporate governance have often resulted from it. So how can that position be used better to benefit pension funds and their members?
The object of good governance practices is to improve corporate performance over the longer term. That is good for pensioners, good for employees and good for the economy. The academic evidence supports this assertion.
The board is responsible for ensuring that the company is managed in the interests of shareholders. The non-executive component of an effective board is formed from individuals who collectively have the skills to assist and critically challenge the executives, but who are also independent and willing to question accepted wisdom. This is quite an ask for any director and is one reason why the Financial Reporting Council is keen on the introduction of more effective board evaluation processes. Shareholders generally support board evaluation as it provides a valuable insight for the outsider as to how the board conducts itself.
The next link in the chain is the fund manager who is responsible for managing the pension fund’s assets day-to-day. Pension funds have for 10 years been required to state how they discharge their responsibilities for environmental, social and governance issues. We believe that it is no longer sufficient for funds to delegate this to their fund managers without acknowledging that responsibility remains with the fund itself. They should hold their managers accountable for the delivery of this element of the mandate in the same way as they assess performance.
Fund managers are a vital link as it is they who select the stocks which go to make up the portfolio and who have discretion over the votes which in reality belong to their clients. They need to exercise that role with care and thought, which begins before the AGM; ideally some time before. In the UK the comply or explain regime can only work well where investors understand the business sufficiently to be able to engage effectively with management.
A robust discussion of the effectiveness of a manager’s engagement policy will provide better insights into his investment abilities than any debate over the latest performance data
It is understandable if management choose to discount the views of an investor who has failed to do his homework. I am not referring here to the heavy duty engagement by an activist shareholder who recognises the need to know as much as possible if he is to persuade the board to change its strategy. It is true also of the fund manager who runs an index-tracking fund and cannot explain why he is opposed to a particular part of a company’s corporate governance policy. Non-compliance with the Combined Code is not a sufficient reason.
The fund manager can only report back to his client in a meaningful way if he has applied the policy intelligently. That report is not a voting report but is a statement of how the manager has sought to protect or enhance the value of his client’s portfolio. Further it should be clear how corporate governance is integrated into investment decision making.
Finally we come to the pension fund – the “owner”. I believe that a robust discussion of the effectiveness of a manager’s engagement policy will provide better insights into his investment abilities than any debate over the latest performance data or his economic overview. The data means little to the trustees and the overview seldom differs much from what is available in any reputable newspaper. In my experience trustees grasp the importance and relevance of company behaviour quickly and will willingly hold fund managers to account for their stewardship of the pension fund assets. This “engagement on engagement” is only just beginning but will gain considerable momentum, I hope, from the publication by the FRC of its version of the ISC Code (of which the NAPF was part author). The benefits to pension funds from building a stronger corporate governance culture and holding managers to account are obvious: better long term returns and a better understanding of their managers’ investment processes.