What’s inside your assets?

July/August 2010

For any trustee who may have been living under a stone or in a cave for the past two years the world has just come through the greatest financial crisis in a generation.

Although the causes of the great financial crisis were many and varied – with an overabundance of cheap credit, an over-reliance on borrowing, and a poor understanding of the risks in the American housing market all playing a part – it is a widely accepted view that actions by banks and a lack of accountability to investors in the years leading up to the crisis were also to blame.

As some of the largest investors in global businesses, pension schemes were singled out for more than their fair share of the blame. Lord Myners, the former treasury minister and author of the Myners’ principles for pension scheme investments, attacked pension schemes as “absentee landlords” in his March 2009 address to delegates at the National Association of Pension Funds (NAPF) investment conference in Edinburgh.

“Disengaged investors lead to ownerless corporations and the risk of unaccountable executives and boards running amok,” he said. “This carries with it very substantial economic risk.”

But attacking pension schemes is both unfair and a misrepresentation of the facts. Adam Steiner, chief executive officer of SVG Investment Managers, says while it is true to say a lack of proper governance caused or exacerbated the crisis, “it’s unfair to accuse pension funds”.

Nevertheless, as a result of the crisis, corporate governance – or holding companies to account and questioning their actions – has become a far higher profile activity. And now a new set of rules has been introduced that will make asset managers and trustees focus more attention on their responsibilities as large shareholders.

A Golden Opportunity

As major, long term shareholders in companies in the UK and the rest of the world, pension schemes are in a unique position to have their voices heard. In general, companies prefer their shares, or equities, to be held by long term investors like pension funds, rather than short term investors such as hedge funds, who are usually motivated by quick turnovers and even quicker profits. As a result, company boards are more likely to heed the opinions of their long term investors on matters such as pay and practices.

Good corporate governance should not just be confined to issues such as executive compensation and other rights, but should also pry into the deeper workings of a company. A good recent example was the fierce opposition to insurer Prudential’s attempts to buy Asian insurer AIA for US$35.5bn. The price was felt by many to be excessive, given the unknown nature of the Asian business and the risks Prudential would have faced.

Harlan Zimmerman, a partner at Cevian Capital, says the current economic environment is a “golden opportunity” for trustees and pension schemes to engage with companies as concerns over corporate governance have been “turbo-charged by the downturn”. “Schemes have the potential to be more influential, but it has got to be a sizeable shareholder and they cannot work alone,” he adds.

But for investors, is there any advantage in engagement? Paul Lee, director of Hermes Equity Ownership Services (Hermes EOS), which deals with corporate governance and engagement on behalf of the £34bn BT pension scheme and 20 other institutional clients, says good corporate governance should add value to a scheme’s investments.

“The opportunities for pension schemes are very substantial. The value you can get from effecting change is vastly in excess of the cost,” he says.

Zimmerman adds the value schemes can add through engaging with already well run companies is “a fraction of the value destroyed by companies with poor boards that are not working in the interest of the company”.

Although there is far more scope for the positive effects of good governance to be felt in companies with relatively poor performance than well governed firms, it is equally difficult to quantify the effects of engagement.

Stephen Birch, head of manager research at Hymans Robertson, admits the “cause and effect” of engagement and added value is “difficult to establish” but sufficient engagement can have a positive effect.

Equally, it is important that there is broad-based support from schemes and other investors for change, as a lone voice can easily be ignored. In his NAPF speech, Myners said that company boards complained they heard conflicting views from shareholders, making it too easy to disregard. Anita Skipper, director of corporate governance at Aviva Investors, agrees: “There needs to be a critical mass to be influential – shareholders can’t be influential in small numbers.”

She adds that engagement is best when it actively targets areas for improvement, rather than reacting to problems as they arise.

How to go about it?

Broadly speaking there are three ways for a pension scheme to go about flexing its corporate governance muscles, each of which has their own advantages and disadvantages. At one end of the scale, schemes can take all the corporate governance activities in house, organising their own voting activities at company annual general meetings (AGMs) and ancillary activities, such as letter writing and lobbying company directors.

Further up the scale, schemes can delegate these activities to their asset managers, either trusting the judgement of the asset manager or issuing instructions. At the other extreme, a scheme can use the services of a specialist engagement manager or join forces with pension-industry lobbying organisations such as FairPensions.

STAYING IN-HOUSE: At its most basic level, engaging in corporate governance can be as simple as turning up to AGMs and exercising the right to vote as a shareholder. However, while it is a key part of holding companies to account – notably the required sign-off for pay and compensation packages – merely voting once a year can be a limited way of making an investor’s voice heard.

Part of the weakness of AGM votes has been a tacit belief that schemes would automatically side with management, acting in many respects as a ‘rubber stamp’ for board decisions. But voting can be an effective way of signalling discontent, as FairPensions’ campaign to highlight the risks of BP and Shell’s controversial plans to exploit the oil reserves in Canada’s vast yet risky tar sands showed. At its recent AGM, Shell was dealt a blow by shareholders, as 11% of voters either supported or abstained on the lobbying group’s resolution to demand greater disclosure and transparency on the risks of the tar sands project.

Many of the shareholders that supported the resolution were pension schemes and asset managers with large numbers of pension scheme clients, including the UK’s Environment Agency scheme and Co-operative Asset Management.

As Steiner of SVG says: “Voting against a company is seen as terribly controversial, but there shouldn’t be any onus on trustees to vote with management.”

Outside of AGM votes, shareholders can also write letters to company management, expressing discontent with corporate practices and demanding changes be made. While this has proven popular in the US, Hermes EOS’ Paul Lee says he is sceptical of the positive effects letter writing can have. He says letter writing is more likely to influence companies more amenable to change – in effect, pushing against an already open door.

“To our minds, letter writing doesn’t amount to much. The biggest opportunity to add value is with companies where they don’t want to change,” he says.

ASSET MANAGERS: The simplest option is often to instruct asset managers to take charge of corporate governance activities, either by issuing direct instructions or delegating the responsibility to the manager and leaving the intricacies of policy to their discretion.

While this was a novel approach in the past, in recent years, it has become a standard and accepted method of dealing with corporate governance issues – the logic being an asset manager should have the best interests of their client at heart. In the case of the Prudential/AIA takeover bid, many of the most outspoken critics of the deal were large asset managers, running money on behalf of institutional investors such as pension schemes.

Aviva’s Skipper says corporate governance activities have “become a normal measure over time. It’s now very much part of the investment process”. “Using fund managers is definitely the most effective route – it’s more closely linked to the investments in your fund,” she says.

Engagement via an investment manager relieves trustees of one burden, freeing up their time to concentrate on more strategic matters, central to the smooth running of their pension scheme. The broad scope of governance polices can be set in advance as part of a scheme’s statement of investment principles, leaving underlying mangers to implement these policies.

It is important for schemes to hold their managers to account. One effective way of doing so can be to ask for evidence of governance activities as proof of their commitment. “Pension schemes should say to asset managers that they want examples of where engagement made a difference – asking for qualitative evidence of how their actions have improved the company,” Zimmerman says.

OVERLAY PROVIDERS: For schemes looking to adopt a more bespoke approach, they can hire the services of dedicated engagement managers. Compared to other methods, appointing an external engagement provider can be expensive, as it represents another layer of fees on top of the asset manager – a service that, by rights, the asset manager should provide in the first place. But schemes may have specific goals with companies that they feel cannot be fulfilled any other way.

Barry Mack, head of governance and plan management at Hymans Robertson says: “An overlay provider can aggregate client assets, so that when they go to speak to a company, the company is more likely to take notice.” Hermes EOS’ Lee adds that when interacting directly with a company, it is far preferable to talk to board members directly: “You can have as many conversations with junior members as you like, but to make change happen, you have to have that dialogue at the board level.”

Even so, there are dangers of directors merely paying lip-service to shareholders “Even face to face, they can ignore what you have to say. In practice, engagement doesn’t work as much as you’d like,” says Zimmerman.

He adds: “There’s a fine line between engagement and interference. Trustees should engage more, but given that they’re unlikely to have the skills to engage directly, they should appoint someone to do that for them.”

DIVESTMENT: A final option exists – divestment, or simply refusing to invest in companies engaged in unpalatable practices or that are unwilling to change. It is common for schemes to have ‘black lists’ of certain areas in which they will not invest – alcohol, tobacco, armaments and pornography, as well as firms with close links to questionable political regimes – but for many trustees, it represents a final option, and one not to be considered lightly.

Hermes’ Lee says: “You risk losing your seat at the table – you need to be a shareholder to have your voice heard. You can’t change companies if you’re not a shareholder.”

One expert, who declined to be named on the record, dismissed divestment on the grounds of its ineffectualness, arguing that for every pension scheme unwilling to invest, there would be sovereign wealth funds and other investors willing to step in as de facto ‘silent partners’, who would be more than happy to accept shady practices and morally dubious activities as long as they generated a return.

Despite this, Aviva’s Skipper says that divestment is a “legitimate practice” for responsible trustees. “There are companies where we’ve looked at them and the risks are too great,” she says.

Having robust corporate governance practices and policies in place – be it handled via an in-house team, delegated to the scheme’s asset manager or through a dedicated corporate governance agency – can no longer be ignored.

The great financial crisis has made good corporate governance an integral part of scheme management, as no trustee wants to see value in their fund destroyed. Whether it is through activities organised by trustees at a scheme level, orders given to asset managers or as part of a wider, co-ordinated effort by the industry, trustees can make a positive difference to the companies they run.