Jury's out on socially-responsible pension funds

Melanie Stern is section editor of Families in Business magazine.

British institutional pension funds are still struggling to marry a growing interest in ethical investments with their perceived fiduciary responsibilities, says Melanie Stern

"What does it mean to say that 'business' has responsibilities? Only people can have responsibilities."

So said economist Milton Friedman back in 1970 when talking about the fledgling world of corporate social responsibility (CSR). Three decades later and companies are forever paying lip service to the concept, publishing glossy reports on labour policies in their Cambodian sweatshops, printed on recyclable paper in bio-degradable ink. But this interest in CSR (and its buy-side name, socially responsible investment, or SRI) has not been fully extended to company employee pension schemes.

Since legislation was brought in five years ago by the British government, obligating pension funds to disclose in their statement of investment principles the extent to which they considered social, environmental and ethical issues, the profile of CSR has improved – but the majority of funds that have enacted SRI products in their investments are those of local authorities, and far less so companies. Research conducted in 2002 by the UK Social Investment Forum (UKSIF) found that of a 20% cross-section from the UK pension fund market – controlling £170bn in assets – poor practice in ethically-minded investment was still the norm. "It is widely accepted in the corporate sector that the poor management of social, environmental and ethical issues is a business risk," say UKSIF's David Coles and Duncan Green. "But if pension funds do not consider these issues properly, they are seriously exposed."

Elsewhere in Europe, France passed a similar law in 2001, and a French state-owned retirement fund is expected to invest some €300m in SRI strategies shortly – but there is little evidence of corporate uptake there either.

"In part, the reason government-affiliated funds are better at SRI than corporate ones is due to many of the member-appointed trustees of pension funds having a vested interest in CSR – they are union leaders with interests in health and safety, equal opportunities or human rights, for example," explains Mairead Hancock, pensions adviser at corporate ethics advisory Ethical Investment Research Service (EIRIS). Current UK regulation stipulates that at least one-third of a pension fund trustee board must be composed of such representatives.
 
Another explanation for the lack of corporate activity among pension funds could be in the way SRI and CSR are defined, and by whom.

Currently it is almost wholly arbitrary, as there are no solid rules set up by any market or government bodies as to what really is ethical and what is not. The UK's Confederation of British Industry (CBI) has said it is against legislation, believing it would inhibit the 'competitive incentive' for companies to be socially responsible. "Legislation in this area would simply constrain business activity and reduce CSR to a lowest common denominator," says Brian Cress, the CBI's senior CSR policy adviser. "Companies must be allowed to define CSR according to their own activities and context."

Therefore, companies and their pension funds are left to decide what constitutes ethical investment as per what suits them, and those selling SRI strategies to companies – a burgeoning market with many leading names from UBS to Jupiter Asset Management, offering strategies from the gung-ho to the decidedly tenuous - will clearly respond to this by tailoring offerings to demand.

So, whereas one company sees investing pension money in arms manufacturers as a no-no, another might think it acceptable so long as the manufacturer can prove it doesn't pollute the local water supply in the process of making its weapons of mass destruction.

At the other end of the scale, Henderson Global Investors, another key player in the SRI fund market, said recently that it saw workplace stress as a "critical issue for responsible investors" (because of the 13.4m sick days it results in for UK business, and resultant loss of profits).

While lack of rules gives pension funds greater flexibility, it also leads to more confusion for a sector that is still trying to educate itself about SRI. A UKSIF survey of 130 trustees conducted last year found that over half actually wanted the government to promote a formal code of best practice and appropriate legislation, to help them see their way through.

Pension funds usually hire the managers offering ethical products, or sometimes independent research firms, to screen stocks and funds and guide them on how to invest ethically. Often though, it is difficult to effectively screen companies if they do not report thoroughly enough, or are not under strict transparency laws governing the disclosure of their pension strategies. But ultimately, any company pension fund will always revert to its mandate to create stable returns over ethical issues, and the market is not yet convinced that SRI can compete with standard stocks on these terms.

For large family businesses, there is a second stalemate between company ethos and pension strategy. The family business world is awash with statements of 'basic belief' and 'family credos', intended to show employees and stakeholders that these companies care about them and work for their needs as well as to make money. Family businesses are known to take better care of their people than non-family businesses; but they still do not see how this involves their pension strategy, and even with a genuine interest in ethical operations they are often still risk-averse, so they do not frequently consider implementing ethical funds because they may not understand them thoroughly.

In that time-honoured tradition, most family businesses do not want to discuss their pension strategy publicly – Families in Business was refused comment by all but one of the family businesses approached for this article, including Arcadia Group and JCB (who say their trustees are bound by rule not to discuss their strategies) – so it is nigh on impossible to analyse this further.

The pension trustees for J Sainsbury, whose founding Sainsbury family controls just under 40% of the shares in the London-listed supermarket giant, are better known for being pro-active in the SRI space. Sainsbury has mandated Hermes Asset Management, a leading fund manager best known for handling the pension fund for its owners British Telecom, to run an 'engagement' investment scheme across its £2.8bn portfolio known as 'overlay'. It is focused on environmental issues like pollution and waste.

The overlay model is probably the most popular across those companies that are involved in SRI. Until this method came about, pension funds had ignored ethical issues because it meant excluding stocks deemed undesirable – exiting lucrative sectors like tobacco, defence or pharmaceuticals.

Pension funds using the overlay method can retain these sorts of holdings but will use their influence to engage with companies and encourage changes in areas they feel are not up to ethical scratch. Pension trustees don't have to do this themselves if they run their engagement model through a fund manager, such as Hermes, mandated to meet with companies and do the shareholder activist bit.
"We do not believe in the model involving either avoiding unethical stocks or exiting stocks when they do something against our principles," Sainsbury's pension manager, Geof Pearson, tells Families in Business. "We believe the most financially sustainable way of investing in SRI is engagement."

An example of this is the ongoing battle between Sovereign Asset Management, a shareholder in Korean family-controlled oil company SK Corp, whose chairman (and son of the founder) Chey Tae-Won recently returned to his post after a stint behind bars for massive corporate accounting fraud. Sovereign believes Chey's return to power after such a conviction is highly unethical.

To ensure ethical procedure is solid across the board – which as a major retailer is an ever-increasing focus – Sainsbury's environmental policy head sits on the company's board and is also a trustee of the pension fund. "As a major retailer we are particularly aware of customer concerns about environmental issues, and employees share these concerns when they ask about the pension fund. Any major disconnection between a company and its pension fund can clearly damage the company's credentials," Pearson explains. "Engagement means working within the system, not voting with your feet; it is a process powerful enough to remove the management of any company which finds itself seriously at odds with its owners – the shareholders."

EIRIS' Hancock adds that another stumbling block for UK companies is that trustees are unsure if the SRI mandate can sit happily with their own. "Some trustees feel their fiduciary responsibilities do not allow them to pick stocks on any other rationale than a financial one, while others take a more open interpretation of the role and examine factors like risk and long-term performance, where there is evidence that companies who perform well in SRI issues will produce better returns."

Conversely, in the US, where around $3trn or one in every nine dollars is invested in SRI products or strategies according to the Social Investment Forum, leading pension funds think the opposite. "I feel strongly that we wouldn't be living up to our fiduciary responsibility if we didn't look at these broader social issues," California Public Employees Retirement System (CalPERS) board member and State Treasurer, Philip Angelides, told Ethical Corporation magazine last January (although by the end of the year, CalPERS' CEO Sean Harrigan had been sacked after a crescendo of criticism from big business of his zealous commitment to that mandate). "I think shareholders need to start stepping up and asserting their rights as owners of corporations."