As the focus on responsible capitalism has grown stronger, Andrew Williams explores the importance of SRI for pension funds

From politicians to protestors, calls for ‘responsible capitalism’ have been growing ever louder. So, how important is SRI to UK pension funds? How do they go about conducting SRI? And are the calls for responsible capitalism really highlighting the need for SRI to pension funds and those who invest on their behalf?

Importance of SRI
For ECPI head of the research department Aldo Bonati, SRI is driven by two forces. Firstly, the nature of long-term investors and their investment profile, aimed at generating enough wealth to sustain expenses upon retirement; and secondly, increasing pressure from regulators and the public to consider sustainability-related elements in decision-making processes. Because of their fiduciary duty towards investors, pension funds are thus required to assess all the risks an investment is exposed to that might negatively affect its performance, including extra-financial risks.

“The integration of intangible value [and] non-traditional risk factors such as environmental risk, social impact and corporate governance structure (ESG) with mainstream quantitative financial analysis will potentially become [the] pension industry’s best practice, as it provides the most comprehensive picture of an investment,” explains Bonati.

Even given these external pressures, some observers argue that SRI still isn’t viewed as important enough. For NOW: Pensions CEO Morten Nilsson in many cases SRI hasn’t been an integrated part of the business, but rather ‘one of those policies you have to have’ - the easy option being to launch an ethical fund and then continue business as usual.

“We are seeing SRI/ESG teams closing - why? I don’t believe that this, or the lack of take-up [of] ethical funds is proof of lack of interest in SRI. I believe the issue is that most members are not very engaged in their pension, but they do expect their pension provider to deliver stable returns following high ethical standards.

“Pension funds are investing on behalf of members and therefore need to focus on the investment objectives and yet at the same time do this in a responsible manner,” he says.

Although relatively few UK pension funds have invested in specific SRI funds, there has been a steady increase in interest in the issues of stewardship and engagement. Mercer head of responsible investment - EMEA Will Oulton believes that this has been driven by the introduction of the UK Stewardship Code and the high profile that corporate governance, in particular executive compensation, has received over the past year or so. Mercer has been working with increasing numbers of its UK clients to help them understand the stewardship code and to help them monitor and assess whether their managers are complying with it.

“Our view is that stewardship should not be difficult or onerous for most pension schemes,” says Oulton.

Elsewhere, First State Investments head of responsible investment Amanda McCluskey points out that responsible investment, rather than specifically SRI, is very important to all pension funds globally. From her perspective, if funds define responsible investment as considering all the ESG issues that are relevant to their investments, and being an active owner of companies, it is clear that all long-term investors should be responsible investors - the main objective being to ‘protect and enhance client wealth’.

Methods of conducting SRI
In Bonati’s view, pension funds should assume a top-down approach and integrate SRI proxies at the beginning of the investment process, generating a clear strategy and applying it along all the asset classes they will eventually invest in - including equity, fixed income, private equity, hedge funds and real assets. In order to reach this goal, they should use a combination of approaches, such as exclusion, integration, best-in-class, engagement, proxy-voting and impact investing, before assessing the asset manager’s ability to provide a ‘complete picture of all the risks the asset under evaluation is exposed to’ and to develop ESG criteria that allow quantification of the impact of non-financial information on performance.

Nilsson is keen to highlight that SRI is already a part of NOW: Pension’s corporate governance, and as such forms an integrated part of its business model and values. For him, SRI is about securing and promoting high ethical standards in investments, the main aim being to secure against the often unrewarded risks associated with investing in unethical business.

Meanwhile, McCluskey explains that First State is an active signatory to the United Nations Principles for Responsible Investment (UNPRI) and that every investment team across its global organisation considers the ESG issues relevant to its investment process. The approach is not to include or exclude companies on moral or ethical grounds, but rather to seek to make the best possible investment decisions by considering all of the factors that can impact company value.

“The best input to our analysis is our own company research. We are typically active managers across our global portfolios so our analysts are out meeting companies every day,” reveals McCluskey.

“It is the insights they get into management quality by asking questions on a company’s ESG performance that is the most useful aspect of our approach to responsible investment,” she adds.

Responsible capitalism
Bonati is very conscious of the fact that people are more aware of the impact that corporations have on society, and that the public increasingly demands that companies should forego higher short-term profits and focus more on the creation of a ‘maintainable’ growth path. Moreover, since pension funds are relevant shareholders in many listed companies, he argues that the adoption of an SRI approach enables them to engage with corporate management on a level beyond pure financial performance. He points out that funds are particularly vulnerable to reputational risk when investments perform negatively if it emerges that non-financial issues had not been taken into consideration - for example if a fund invested in riskier assets to give priority to higher expected profits rather than assessing the long-term sustainability of the investment.

“In order to respond to mounting interest [in] the subject, the pension industry should spread the knowledge of SRI approach[es] and encourage industry players to contribute to the debate and the shaping of legislation,” says Bonati.

For Oulton, the current debate calls for shareholders to become more engaged owners of the companies they own. There is a view, he says, that shareholders do not take enough interest in the activities and practices of companies and their executive management. He also highlights the fact that other issues, such as the short-term approach to investment, are being researched by the Kay Review commissioned by Vince Cable.

“One area which is gaining greater interest is that of ‘impact investment,’ which aligns financial returns with measureable and tangible social or environmental impacts,” he says.

At the global level, McCluskey is pleased to hear the calls for responsible capitalism. For her, the issue is about investing for the long-term, being active owners of the companies we own and communicating to them our expectations on the management of ESG issues.

“It is about being owners rather than traders. It is about engaging with exchanges to ensure they have the highest possible listing standards across markets,” she says.

“The pension industry should respond by closely scrutinising their supply chain and asking which agents are really acting in their best long term interests. Which agents are really engaging investee companies and behaving like owners of businesses rather than traders of stocks? Which agents are really managing the cost base? Which agents are meaningfully participating in the policy debate to ensure we all move closer towards a model of responsible capitalism?”

The evidence here suggests that increasing calls for responsible capitalism are beginning to filter through to the management level at many UK pension funds. However, looking ahead, it is likely that one of the key challenges will lie in ensuring that such pressure results in long-term and meaningful change.

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