Should beneficiaries decide how pension funds invest?
One episode in the investment world that sticks with me is the resignation of nearly half the investment staff of Cambridge University Endowment in 2018. After being criticised by students and staff for refusing to divest from fossil fuels and other controversial investments, these investors preferred to resign rather than implement an investment portfolio that was not in the best interest of the beneficiaries of the endowment.
I have a long-standing aversion to divestment campaigns and am opposed to such efforts because they are counterproductive. Yet, there is an increasing push to get the beneficiaries of pension funds or endowments involved in the decisions the funds make. In the UK and the United States, this so far has not been an issue and the only example I know of is the NEST pension scheme in the UK which surveyed its members on responsible investments, but without any indication if and how the results of the survey will be incorporated into the investment process.
But in Europe, regulators are increasingly demanding both the integration of ESG risks and members’ preferences in a fund’s investment policies. The EU Pension Directive in 2016 claimed that ESG factors are important for pension funds investment process, but did not explicitly mandate to take into account beneficiaries’ interests and preferences. In the Netherlands, meanwhile, the Dutch Committee on Investment Policy and Risk Management said that ESG risks must be an integral part of a pension funds’ investment policy and that member preferences must be embedded in the pension fund’s policies. In 2018, several large Dutch pension funds signed the Agreement on International Responsible Investment for the Pensions Sector that stipulates that the fund must have member support for the chosen responsible investment policies. The nature of the Agreement is such that the Dutch pension regulator audits pension funds compliance with it.
The problem for pension funds is now that if they have to ask their members for their preferences the results may be detrimental to the financial goals of the fund. Imagine the Cambridge endowment had asked staff and students of the university about their preferences. If the results of such a referendum would be binding for the endowment, it would have ended in an economically much worse outcome because students and staff would have voted for populist measures that may feel good but are economically disastrous.
And if you think that one can educate people in a referendum to make a rational choice, you obviously haven’t paid attention to recent UK history.
But one Dutch Pension fund showed the rest of the world what best practice could be. The pension fund for the retail sector which has more than one million members and about $35bn in assets asked its members in 2018 about their sustainability preferences and their integration into the fund’s investment policy.
Crucially, they didn’t ask about divestment policies or the like. Instead, they turned the problem on its head and asked, which beneficial goals the fund should support with its investments. Essentially, the fund went to the UN Sustainable Development Goals (SDG), prioritised three of the 17 goals (decent work and economic growth, climate action, and peace), and implemented these by creating bespoke benchmarks for each of the SDG in collaboration with FTSE Russell. Then, at the referendum in 2018, the fund asked its members if it should expand its engagement with companies and add a fourth SDG, responsible consumption and production. The members approved both resolutions and the fund created a fourth benchmark for the newly added SDG and increased the number of engagements with companies.
The result was increased buy-in by the members into the fund’s investment policy and objectives without reducing the return opportunities for the fund.
The trick and this is the key lesson for investment managers, is to not frame a decision about sustainability as a win/lose question. Every referendum needs to be broken down into a yes/no answer, but if you ask the question about divestments, for example, you know that one side will lose and think they are worse off than before, while the other side will feel they have won. But if you frame it as a vote on integrating additional objectives, then there is much less downside. If the additional objective is rejected, nothing changes and if it is accepted, the fund’s investment officers can decide how they will achieve that goal in practice. And even if the investment officers think the additional goal may be stupid or detrimental to the fund, they can still implement it in such a way that it doesn’t do too much harm.
Imagine the Brexit referendum in the UK would not have been about staying in the EU or leaving the EU, but whether the UK government should explore options to generate more flexibility in international trade and regain sovereignty? I think the referendum would have achieved a larger majority and the government would have had enough flexibility to explore different options instead of simply triggering article 50. How you ask a question can sometimes be more consequential than what you ask.