Socially Responsible Investment In A Changing Pension Landscape
By: Michael Jantzi
While some still think of Socially Responsible Investing as the use of ‘negative screens’ to avoid investment in certain areas, it is evolving and gaining more acceptance among mainstream investors, says Michael Jantzi, of Jantzi Research Inc.
Socially responsible investment (SRI) has evolved in countless ways since it appeared on the Canadian landscape more than 30 years ago. No change has been more dramatic than the growing acceptance by mainstream investors that environmental, social and governance (ESG) factors can be material. This shift is beginning to affect the more than $1 trillion in Canadian pension assets – but Defined Benefit (DB) and Defined Contribution (DC) plans are facing this reality in radically different ways.
Some people still think of SRI as a strategy that just imposes “negative screens” (alcohol, tobacco, etc.) on an investment portfolio, increasing risk and reducing returns.
But what defines SRI today?
More than ever, it’s the growing number of ‘mainstream’ institutions and plan sponsors that integrate sustainability criteria into their investment decisions because it highlights non-traditional risks that traditional sell-side research overlooks or ignores.
Traditional barriers between SRI and the mainstream began crumbling about five years ago in the United Kingdom when amendments were passed to the 1995 Pensions Act. The act now requires trustees to declare: “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 the policy (if any) directing the exercise of the rights (including voting rights) attaching to investments.”
Similar legislation followed in Germany, underpinned by broad public support. In France, SRI is reflected in legislation overseeing retirement savings contributions and retirement fund regulations since 2002, when amendments were introduced to the Code monétaire et financier. In August 2001, the Australian government passed the Financial Services Reform Act, including an amendment that compels providers of investment products to disclose: “the extent, if any, to which labour standards, environmental, social or ethical considerations are taken into account in the selection, retention or realisation of the investment.”
Together, these changing regulatory regimes have helped re-define what being a prudent trustee means. In a report entitled, ‘A legal framework for the integration of environmental, social and governance issues into institutional investment,’ leading international law firm Freshfields Bruckhaus Deringer argues that ESG issues are to be integrated into investment analysis in all jurisdictions globally. Paul Watchman, the senior author of the report, stated upon its release in October 2005 that “far from preventing the integration of ESG considerations, the law clearly permits and, in certain circumstances, requires that this be done.”
SRI – The DB Response
Alongside these regulatory changes, DB plan sponsors and managers globally began to integrate ESG factors into their processes. UK-based plans like the Universities Superannuation Scheme were joined by others across Europe. One example, the Fonds de Réserves pour les Retraites, created in July 2001 to supplement the retirement system of the private sector, is implementing SRI strategies throughout its €17 billion portfolio. The Commonwealth funds, Catholic Super, and the NSW Local Government Superannuation Scheme in Australia have put in place systems for ensuring that the funds use social responsibility criteria as well as traditional methods for selecting investments. In the U.S., CalPERS, CalSTERs, NYCERS, and State of Connecticut lead the way.
An early indication of this trend was the move by global investors to work together on the Carbon Disclosure Project. Launched in 2002, it now involves 155 institutional investors with assets of more than US$21 trillion. Each year the largest 500 companies in the world are asked to disclose how they are addressing the risks or opportunities associated with climate change.
In 2005, traditional barriers between SRI and the mainstream broke down further, when the UN Secretary-General, the United Nations Environment Program Finance Initiative, and the UN Global Compact launched the Responsible Investment Initiative. Nineteen of the largest asset owners in the world have developed a set of guidelines that outline commitments and responsibilities in this area.
Closer to home, the Canada Pension Plan Investment Board (CPPIB) launched its own Responsible Investment Policy in October 2005. Its centrepiece is a commitment to engage with companies to encourage improved ESG performance and disclosure. It is CPPIB’s belief that longterm responsible corporate behaviour with respect to ESG factors can have a “positive influence on long-term corporate financial performance” and is, therefore, consistent with the board’s duty to maximize investment returns without undue risk.
SRI – The DC Environment
The discussion thus far has focused on the DB world. But SRI is an important issue to consider in the context of DC plans as well, because an increasing number of Canadians are covered by these schemes. Unfortunately, the Guidelines for Capital Accumulation Plans, published by the Canadian Association of Pension Supervisory Authorities (CAPSA) in May 2004, is silent on the issue. At the very least, the guidelines should have dealt with the SRI issue in Section 2.2.2 – Selecting Investment Funds.
This gap in the guidelines is understandable. Few Canadian employers include SRI options in their DC plans. This holds true even for Canadian companies that promote themselves as being sustainability leaders, with the exception of some such as Mountain Equipment Co-Op. More perplexing still are Canadian subsidiaries of American parents, such as Ford and General Motors, which offer SRI options to their U.S. workforce but not to Canadian employees.
Nevertheless, the CAP Guidelines are supposed to be forward looking and south of the border we see the trends. TIAACREF, one of the U.S.’s largest plans, offers an SRI option to its retirement annuity participants. SRI options are offered by New York City, Chicago, and San Francisco and by numerous states including California and Massachusetts. A bill was introduced in the U.S. House of Representatives in April 2004 to offer an SRI index fund for federal employees.
Canadians view social and environmental responsibility as high priorities and it seems likely that SRI will find its way onto the DC agenda before long. In a January 2003 study by GlobeScan, more than eight in 10 Canadians said they supported “requiring pension funds to publicly report whether or not they take the social and environmental performance of the companies they invest in into consideration.” In December 2004, GlobeScan asked Canadians, has “a company’s demonstrated social responsibility ever had an influence on your investment decisions – have you either bought or sold its shares as a result?” Twenty-six per cent of respondents answered “yes, it had an influence at least once.”
So what should CAPSA do? Most importantly, it should provide guidance to plan sponsors on the SRI question, clearly stating that SRI funds are permissible in DC plans. There shouldn’t be a fiduciary issue, given that DC plans are about personal choice. Not that Canadian plan sponsors operate under the rules of U.S. regulators, but they might take note of the May 1998 response of the U.S. Department of Labor (DoL) to Calvert Group, a U.S.- based SRI mutual fund company, which had asked for clarification as to whether or not SRI funds were permissible under the fiduciary responsibility rules of the Employee Retirement Income Security Act of 1974 (ERISA). In its letter, the DoL expressed the view that a SRI fund “… would not, in itself, be inconsistent with the fiduciary standards set forth in sections … of ERISA.”
The fiduciary focus should be on the due diligence process used to evaluate possible SRI offerings – not on the permissibility of the funds themselves. As Professor Eileen Gillese, past chair of the FSCO, stated, “prudence is process, not performance.” The guidelines in Section 2.2.2 spell out what this process should include – an evaluation of investment strategies, investment risks, historical performance, and fees. SRI mutual fund offerings in Canada should fare well under this scrutiny, as they provide asset diversification, good riskreturn profiles, and competitive fees.
What’s The Endgame?
The continuing evolution of SRI, combined with the changing landscape in the pension arena, means that these two issues will continue to encircle one other and increasingly interact. DC sponsors, service providers, and regulators have some catching up to do vis-a-vis their DB brethren. How they manage this issue, among the host of other significant challenges, will help determine the future success of DC plans in Canada.
Michael Jantzi is president of Jantzi Research Inc..
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