Pension Funds and their Advisers

UK Local Authority Pension Funds and
shareholder Activism

When UK local authority pension funds came under scrutiny seven years ago over their approach to investment decision-making and their role as active shareholders, Paul Myners painted a bleak picture: unrealistic demands were being made of trustees by asking them to take crucial investmen decisions despite a lack of resources or expertise.

• If anything, the environment in which local authority pension funds operate today is even more complex than in 2001, placing even higher demands on their trustees and officers:
• UK pension funds have steadily moved their equity holdings overseas, with only 54% of assets allocated to the UK in 2007, compared to 70% in 2001. UK local authority pension funds are now exposed to varying levels of corporate practice in the different
  markets they invest in, compelling them to adopt a global perspective on activism, whilst at the same time facing the need to take local market variations into account.
• Shareholder activism on extra-financial issues such as climate change or employment practices is no longer the domain of specialised socially Responsible investment sRi) funds. As investors around the globe grapple with their duty to protect the investment interests of their beneficiaries in the long-term, whilst at the same time generating steady returns, the integration of environmental, social and governance (EsG) issues into
  mainstream investment analysis and decision-making has emerged as a major challenge.

More than ever, local authority pension funds need to be equipped to ensure that shareholder activism is conducted in a way that both fulfils their fiduciary responsibility towards their scheme members and safeguards long-term investment returns.

Outsourcing their activism to fund managers does not necessarily provide the solution. around two thirds of local authority pension funds delegate shareholder engagement to fund managers, but claims by fund managers that they fully integrate EsG issues into their mainstream investment
processes are largely unsubstantiated. in a 2006 study the local authority Pension Fund Forum concluded that integration by fund managers remains superficial, and that problems include insufficient training on EsG issues for financial analysts who represent fund managers’ early
warning system, and a focus on value protection at the expense of value enhancement. this is supported by a review by the institutional shareholders committee (isc) which found a continued lack of integration.

When it comes to global activism, fund managers are better placed than local authority pension funds to meet the cost and logistic challenges. however there are doubts about the effectiveness of fund managers’ engagement as a whole, and the extent to which it goes beyond a series of
meetings at which “reservations” are expressed.

Communication between fund managers and their local authority pension fund clients also remains an obstacle, with funds criticising managers for not supplying the kind of information to them that would enable a judgement about the quality and effectiveness of fund managers’ engagement activities. Fund managers, on the other hand, find that local authority pension fund clients rarel ask the sort of questions that would help them develop a better service. the onus therefore continues to be on the local authority pension funds themselves and their trustees and officers, to adopt a cost-effective approach to global shareholder activism that is based on identifying the right issues to raise with companies, in order to achieve sustainable longterm returns.

Global activism – local collaboration

There are many challenges involved for local authority pension funds that consider moving from a UK-centric perspective towards global shareholder activism.

Any institutional investor who makes an activist move into a new market will be the new kid on the block: companies won’t know them yet, and might not be inclined to take them seriously, especially if the investor represents a small holding (which is often the case for UK local authority pension funds).

The style of activism is quite different in other markets, a typical example being the Us, where shareholder resolutions are a common tool for investors to put forward their concerns, whereas they are seen as the ‘nuclear option’ in the UK.

Corporate governance and csR regimes also differ widely between markets, requiring a fair amount of local expertise. in the Us, for example, investors are fighting hard for the right to nominate directors to company boards, something which UK investors are entitled to do, but hardly
ever make use of. Remuneration practices in continental Europe vary from country to country, with some markets having in place binding shareholder votes on remuneration reports, and other markets not requiring any disclosure on remuneration at all. in terms of csR, china poses risks to institutional investors because of the country’s complex web of laws, politics and culture affecting employment practices.

Collaboration with other investors would not necessarily be the first step in a UK engagement campaign, where it would usually be part of an escalation strategy once investors have unsuccessfully explored other routes to affect a change in practices at a company. however, the
move into new markets necessitates collaborative support from local investors – this will give UK local authority pension funds access to local expertise, networks and infrastructure. a meeting with the chairman of a Florida-based company might be tempting, for a resource-strapped pension fund it is unlikely to be a viable option.

Resource limitations faced by individual local authority pension funds cannot be ignored and it is unlikely than any but the biggest funds would be able to engage at such a high level. It is possible that schemes could use their influence as clients to encourage fund managers to engage on their
behalf, but as noted previously this relationship still requires some development.

Increasing numbers of UK local authority pension funds therefore seek other avenues to fulfil their role as active shareowners. Rising awareness and pressure to act is evident in the numbers of local authority pension funds collaborating under the umbrella of the local authority Pension Fund Forum (laPFF). the Forum has 17 years experience of active shareholder engagement in the UK and overseas and is growing rapidly. it currently has 46 members with aggregate investment of over £85 billion.

In 2006, a new force for investor collaboration emerged with the launch of the Un Principles for Responsible investment (Un PRi). the PRi provide a common framework for integrating EsG issues into mainstream investment decision making and ownership practices; signatories to the PRi principles have access to a range of services, including opportunities to collaborate and network with other signatories, reducing research and implementation costs of engagement projects.

Integrating EsG: an exercise in assessing risks and opportunities

A fundamental argument used by responsible investors to convince company boards to consider non-financial issues such as climate change or employment standards, is that good corporate governance and corporate social responsibility practices result in superior financial performance of
companies. this link, despite a plethora of attempts to demonstrate or even prove it, is tenuous at most. one of the reasons for this is that financial markets do not currently reward good corporate performance in areas such as climate change or health and safety with a premium – far from it.

One of many examples for this is the case of BP, where a string of widely publicised and catastrophic safety failures was followed by a much reduced total shareholder Return (tsR), resulting in a reduced payout under the company’s long-term incentive plan to its executive
directors in 2007. Markets had finally taken notice of deficient management of non-financial business performance at BP – after the event.

A study by the world Business council for sustainable development (wBcsd) and the Un’s Environment Programme Finance initiatives (UnEP Fi) sheds some light on the reasons for this. It found that young financial analysts remain unconvinced of the materiality of most EsG issues to
business and are unwilling to depart from business as usual because of conflicts with remuneration, career advancement or culture. Moreover they are unable to consider them because of inadequate information, training or tools.

The need for integration of EsG issues into mainstream investment processes therefore brings two challenges: firstly, what methodology should be employed to achieve this integration, and secondly, how should markets be convinced to adopt this particular methodology? there are efforts
underway to address this. the Enhanced analytics initiative (Eai), a consortium of investors seeking to incentivise sell-side and other analysts to systematically integrate extra-financial factors into their research, is one example. the initiative is based on the belief that were investors to price extrafinancial, mid—to-long-term factors into equity valuations, they would potentially hold that extra bit of information that would enable them to beat the market.

The key is to determine which non-financial factors are likely to influence a company’s performance going forward. a forward-looking perspective and a consideration of sector and business specific factors are main building blocks of this approach. in the UK the companies act 2006 has opened
a route towards this end by making it a requirement for directors to identify, in the company’s Business Review, key performance indicators (KPis) used to measure its non-financial performance in areas such as health and safety, employee relations or environmental management. For
activist investors, the critical appraisal of those KPis, as well as of those omitted from the list, is a formidable tool in their engagement toolkit.

From the viewpoint of local authority pension funds this type of thinking would certainly be better aligned with their fiduciary duty than the current race for quarterly results. Funds should be concerned with the early recognition, management and minimisation of risks, before events
occur that destroy shareholder value. they should also be aware that it is unlikely that their fund managers are going to move towards this new approach to investment without pressure from their clients.

Local authority pension funds are facing a major challenge. as they increasingly globalise their asset allocations, they face the challenges of global shareholder activism. at the same time shareholder activism on extra-financial issues is moving from specialised funds into the mainstream, where the concept of responsible investment quickly goes under in the race for quarterly returns. More than ever, trustees need to be equipped to fulfil their fiduciary duty. the integration of environmental, social and governance issues into mainstream investment decisions, and global collaboration of activist investors will be vital.

Biography of Ebba schmidt M.sc.consultancy services Executive, PiRc ltd.

Ebba schmidt advises the UK local authority Pension Fund Forum (laPFF) on global shareholder engagement and research projects. her current work includes engagement on issues such as M&a, executive remuneration, climate change, employment practices and investment in countries
with weak governance. she began her career as a Geophysicist, researching climate history in the arctic and antarctic, and working in oil and gas exploration. she also managed the training and development programmes for 3000 learners over three continents at a multi-national oilfield
services company. Prior to joining PiRc, Ebba worked on the analysis and quantification of environmental impacts at trucost plc.