Pension fund activism: the legislative and policy background
Introduction
At a meeting of the Trade Union Investor Group in January 2004 it was suggested that it would be useful for the TUC to produce a short paper explaining the legislative and policy framework for shareholder activism. This would be intended to address questions and concerns about pension funds becoming more involved in activism and socially responsible investment.
This briefing is intended as a short run-through of the relevant legislative and policy developments.
Government initiatives
There have been several recent developments to the framework covering pension funds and other institutional investors that clearly point to a desire on the part of government for more active and engaged shareholders.
In July 2000 a new duty for pension schemes came into force which required them to introduce, within the schemes' Statements of Investment Principles, a statement on the fund's position on socially responsible investment and the exercise of shareholder voting rights. The requirement reads as follows:
The matters prescribed for the purposes of section 35(3)(f) of the 1995 Pensions Act (other matters on which trustees must state their policy in their statement of investment principles) are -
(a) the extent (if at all) to which social, environmental or ethical considerations are taken into account in the selection, retention and realisation of investments; and
(b) their policy (if any) in relation to the exercise of rights (including voting rights) attaching to investments.
Although this only requires disclosure from pension funds it can clearly be read from the government's decision to implement the regulation that it wants pension funds to think about such issues. Going further it can be interpreted as a requirement to have an activist policy.
Yve Newbold, who chaired the NAPF Committee of Enquiry into Voting Execution argued that pension funds were wise to consider social issues when making investments:
'The requirement to state in the SIP the extent to which social, environmental or ethical consideration are taken into account in investment decisions means that for all but the smallest trust funds a position of having no such policy would or could be called into question as being unsound in the climate of today's heightened awareness of the influence of such issues on corporate reputation and value.' [1]
Looking more widely at shareholder activism in 2001 the Myners review of institutional investment reported its recommendations. The review included a section on shareholder activism and suggested that pension fund mandates should be much more explicit in their support for activism. The final revised Myners principles produced by the government included the following:
'The mandate and trust deed should incorporate the principle of the US Department of Labor Interpretative Bulletin on activism. Managers should have an explicit strategy, elucidating the circumstances in which they will intervene in a company; the approach they will use in doing so; and how they measure the effectiveness of this strategy.'
Following Myners, although the government has not (as the review recommended) legislated to make it a requirement for institutional investors to intervene in companies where there are issues of concerns the Institutional Shareholders Committee issued a set of principles that set out what clients (ie trustees) can expect from fund managers [2] . The government has said that it will review the impact of this voluntary code after two years (which will be October 2004). Trustees are encouraged to familiarise themselves with the ISC principles.
It has also become clear that in the government's own review of the impact of the Myners principles that one of the areas where there are concerns that pension funds are not doing enough is shareholder activism. Treasury Secretary Ruth Kelly has raised this issue in numerous speeches. In short there is definite political pressure for funds to be more active this area.
Finally, more recently since the beginning of 2003 all UK publicly-listed companies have been required to produce a report on executive remuneration and put it to an approval vote by shareholders. Although this has led to some high-profile cases oh shareholders challenging companies on pay issues it is clear that the government expects more from pension funds.
Secretary of State for Trade and Industry Patricia Hewitt wrote in 2003: 'At several of this year's AGMs we heard loud and clear the voice of individual shareholders and trade unions. But too little was heard from the pension fund managers.'
Taken together these developments point to a clear desire on the part of government for pension funds to be more activist. What is more the tone of government commentary has shifted of late from encouraging funds to be open about what they do towards challenging funds to be able to demonstrate that they are doing something. There is a compelling case therefore that shareholder activism is not merely an issue that pension funds should consider but actually an area where they must be able to demonstrate they are active.
A quick aside on Labour thinking
It should be noted that there is a developing current within the Labour Party that is interested in issues related to share-ownership and activism. Most recently this was articulated in an essay for the Institute for Public Policy Research written by Patricia Hewitt. The essay, entitled A Labour Economy: Are we nearly there yet? [3] , first covers Labour's approach to economic questions. But in the second half the essay turns to the role of shareholders. It sketched out a view of share-ownership that is very much in tune with the ideas of trade unions. For example:
'B ecause companies' real owners are a majority of the population, and each individual's investments are widely diversified (each pension scheme contributor owns a tiny fraction of most large UK companies), companies must also have a broad understanding of their responsibilities. It does not help the shareholders if one company makes a profit by dumping high costs on society at large, in essence 'robbing Peter to pay Paul'. But much of the interaction between company directors and investors focuses only on the short term - despite the fact that pension fund or insurance liabilities are met out of absolute returns over the long term, not relative ones in the short term. Long-term value creation needs managers who can understand and build real competitive advantage for their companies, and fund managers willing to support long-term investment.'
And indeed the essay specifically mentions the importance of unions.
'T rade unions have a vital role to play here: supporting the election of pension fund trustees, equipping those trustees with the skills they need, and representing their members when management proposes changes to schemes.'
Trustees and trade unionists interested in this area may wish to familiarise themselves with the essay. It is a 'broad brush' piece of thinking, but it demonstrates that there is interest within the Labour Party in this area, and this might suggest further government activity in the future.
Approaches to socially responsible investment
Much of the debate around the practicality of socially responsible investing has suffered from a misunderstanding of the potential approaches available. In terms of individual pension scheme investment portfolios there are two main strategies that trustees can employ - screening and engagement. Many of the preconceptions about SRI and the legality of trustees embracing it are based on the screening approach which, whilst still used, has largely been superseded by engagement as a tool employed by pension funds.
Within screening there exists the use of both negative and positive screens. In a negatively screened portfolio certain stocks would be excluded because they fail to meet certain social or ethical criteria (on say labour standards, or human rights) or because they fall into industry sectors that are deemed to be unethical (tobacco, defence, oil etc). In a positively screened portfolio the fund manager would favour certain stocks because the companies were involved in socially progressive enterprises or were the most highly rated on social or ethical issues in their industry.
It is important to recognise that in most cases today investments are screened out on the basis that their exposure to corporate social responsibility risks will damage share price performance. It is an investment decision. In addition screened portfolios typically seek to replace stocks that are not deemed suitable for investment with other investments with comparable characteristics. This is intended to offset the impact of not holding the stocks screened out. As such there is no reason to assume that screened portfolios are incompatible with fiduciary duty.
There are positive points for consideration in favour of screening. For one it provides a comfort factor. The fund will not invest in stocks that are felt to fail to meet high standards of corporate behaviour, and as such present a potential risk. There will be no danger of the fund being 'exposed' for holding investments in irresponsible companies. In addition a number of companies now actively seek inclusion in the socially responsible investment indices typically used by screened funds.
But there are also a number of criticisms to be made of screening portfolios. The first is strategic. While disinvesting from a company can be useful as a tool for making public a disagreement with its actions, it can clearly only be used as a one-off. Publicity may be gained at the time and the disinvestments may have an adverse effect on the company's share price. But once this action is taken investors have no leverage with the company to encourage better behaviour. In addition the investor has to sell their shares to someone else who is willing to invest in the company. So in real terms the company will be relatively unaffected.
Secondly there is the question of risk. By definition a pension fund investment portfolio that is screened will have a restricted universe. This does mean that the portfolio might experience volatility that would not be expected in an unscreened portfolio (although by seeking replacement stocks this might be mitigated).
Finally there is the question of the types of companies to be screened out. Many socially responsible investment funds screen out certain industries such as defence, tobacco and nuclear power. It is not at all clear that adopting such screens would be in the long-term interest of union members in those industries. As such it might be necessary, if screening was felt to be a useful tool, to develop a screen specific to union interests - either screening out companies in clear conflict with trade union interests, or positively screening to include companies with good workplace practices.
Engagement is almost the reverse approach. Investors retain shares and then 'engage' with those companies to seek to change their behaviour. The form of engagement seems to vary from letter writing to face-to-face meetings to the exercise of voting rights at the AGM.
This strategy has the advantage that it clearly does not affect the underlying investment portfolio of the pension fund as no stocks are being bought or sold on the basis of how the company behaves, and as such there is no change to its risk profile. There is clearly no conflict with trustees' fiduciary duty, indeed if value is created as a result of the engagement then the fund benefits financially. In addition precisely because shares continue to be held the investor still retains some degree of power over the investee company. And engagement can overlay practically any investment portfolio.
Engagement is the approach taken by many fund managers who now offer socially responsible investment products, by some individual pension funds such as the Universities Superannuation Scheme and some local authority funds.
There are criticisms to be made of engagement. It is not proven that this approach has a demonstrable effect on the companies concerned. A piece of work done on behalf of the Just Pensions [4] project suggests that the impact of engagement so far has been limited, and that precisely what impact it has had is difficult to quantify. There are also concerns that as it is currently a rather nebulous concept fund managers are able to claim almost any activity as engagement.
However equally there is building evidence that engagement does deliver results. In its Sustainability Pays report Co-operative Insurance included an analysis of engagement carried out by PIRC. This found that in a number of key cases engagement had led to changes in company behaviour. For example it argued that it was largely shareholder pressure that led GlaxomSmithKline (no stranger to shareholder revolts) to lower the price of AIDS treatment drugs in developing countries.
Similarly many of the fund managers with a socially responsible investment capability assert that they can point to examples where engagement with companies has led to change, although clearly these managers do have a commercial reason for making such claims.
Finally another practical advantage of engagement over screening is that it is a strategy that can be applied across all kinds of portfolios and does not have an impact on either stock selection or asset allocation. This is likely to be more acceptable to trustees who are concerned about being seen as subverting their fund's investment strategy to fulfil a social purpose.
Overall therefore engagement appears to the TUC to be the more desirable strategy for trustees to take, particularly if the fund is looking to assign a major proportion of its assets to SRI. This will be particularly true for funds in the private sector.
Screening might be employed for companies who refuse to respond to pressure - perhaps over an issue such as involvement in Burma - or by funds which have a clear mandate for SRI from their beneficiaries. Charities and faith-based investors will probably continue to use screening for example.
Conclusion
Trustees should not fear shareholder activism. If anything they have more to fear from being seen to have ignored the issue. The clear thrust of government policy has been to encourage institutional investors to have a more active an engaged relationship with investee companies. This trend in government policy is echoed by emerging thinking in the Labour Party.
In addition The development of engagement as an alternative to screening gives trustees who wish to explore socially responsible investment a tool for doing so that avoids the pitfall of previous approaches and sits neatly with fiduciary duty.
Trustees and trade unions pension funds can quite legitimately embrace activism, and the clear steer from government is that they should.
[1] NAPF Committee of Enquiry into Voting Execution, 2000
[2] http://www.investmentuk.org/press/2002/20021021-01.pdf
[3] http://www.ippr.org.uk/publications/files/templhewitt.pdf
[4] Assessing Engagement, Just Pensions, February 2002
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