PensionsNov 22 2013

SRI not the answer to ethics in pensions

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For all the attention it attracted, it was easy to imagine Prince Charles’ address to the National Association of Pension Funds (NAPF) annual conference in October as a dramatic, climactical speech drawing gasps and applause from the audience in equal measure. In reality, the heir to the throne’s appearance came via a five-minute video message – and if you think that is underwhelming, then so is what he had to say.

In part, the Prince had some useful common sense observations for the UK’s pensions industry. Like many laymen who are not desensitised by decades of habit, he found the pensions industry expensive and accused it of being too short-termist, failing to act in the best interests of the nation’s savers. So far so good – costs are without doubt the enemy of the pension investor and responsible for key shortcomings in the pensions industry.

But his point was not that products were not structured appropriately or that too many layers of unnecessary fees often made the process inefficient and, therefore, disappointing. He was arguing that, as inventors, pension funds have a responsibility to encourage businesses to adopt practices that support the environment and wider society. By improving the world around us, we improve our retirement prospects in other ways. Such a long-term outlook is particularly appropriate for the long-term investment industry, he argued.

Ethical pensions

But the ethics of the pensions industry and of investing are two separate points. Prince Charles may be right about the former, but he is wrong about the latter.

Ethics has been a touchy subject in the financial services industry in recent years, thanks largely to the behaviour of large global banks, and is now a popular theme that resonates powerfully with the general public, which tends to tar the whole sector with the same brush. A tightening of regulation in wake of political pressure resulting from this has affected everyone, including IFAs through the RDR, for instance.

For the pensions industry, the regulatory eye has settled on fees and charges – and rightly so. In that matter, Prince Charles is spot on – the process of retirement saving should be cheaper and more efficient (a point made frequently in this column).

But the ethics of investing is a different matter entirely. Financial advisers, whether making investment recommendations to individual or group corporate clients about pensions, have always been understandably wary of this idea. Socially responsible investing (SRI), or whatever you wish to call it – there are many names – is a divisive subject.

When it comes to making investment decisions on behalf of many people, trustees of pension schemes often feel that their responsibility is squarely to achieve the best financial outcome for the scheme members, not try to change society. Although they are required to take account of SRI issues, trustees are not required to adopt any form of ethical or social stance, and few do. The exception tends to be large investment funds allied to an organisation with clear principles, such as the Environment Agency’s staff pension scheme. The difficulty is that, given the relatively weak investment case for SRI, as well as the confusing mass of definitions of what is, typically, a very subjective and personal issue, trustees normally decline to get involved. Individuals are free to make their own decisions, however. Should an IFA support, contradict or remain agnostic?

Reality check

While the idea of environmentally or socially friendly investing may seem appealing to Prince Charles and possibly wealthy clients, the reality of how it is carried out often is not. The argument in favour of SRI is that investors can or should take responsibility for tackling major global problems – warfare, famine, deforestation, climate change, chronic health issues – by getting major corporations to change their behaviour.

There are a number of approaches fund managers take. First, the moral high-ground: often labelled ‘ethical’ funds, these funds simply refuse to invest in any company that fails to live up to a given moral code. Typically that means avoiding companies involved in arms (or ‘defence’), tobacco, mining – a long litany of seemingly unappealing activities. If you can find a fund whose principles meet your client’s own definition of ‘ethical’ then good luck to them. Will such a fund change corporate behaviour? Almost certainly not, but at least your client is not complicit in their nefarious activity, so their karma remains preserved. Will performance be better or worse? Impossible to say.

The second approach is to have a complex investment process that favours well-behaving corporates over badly-behaving ones. Does this change behaviour? No. Does this maintain karma? Partly, but they are still investing in companies whose activities they may not approve of. Does this deliver better performance? Possibly, depending, as ever, on the time period.

The third option involves something called ‘engagement’, which means fund managers use their shareholding to encourage badly-behaving corporates to mend their ways. Does it provide a sense of spiritual wellbeing? Possibly, through its philosophy of redemption rather than punishment. Does it change behaviour? Possibly, although there is remarkably little evidence of successful engagement by individual fund managers on any material scale. Does it improve performance? It has been argued that engagement improves performance in the UK stock market by 1 per cent a year, although this is impossible to verify. And even if it were true, the same would be the case for all investors – those in an engagement fund hold the same stocks and are no better or worse off financially, they simply foot the bill for the corporate counselling.

Better outcomes?

Ethics and business are awkward bedfellows, and that is even more the case for fund management. With little to go on by way of evidence in favour of any of the approaches above delivering better financial outcomes for investors, IFAs are wise to treat the topic with caution.

Morality is subjective. We all have our own views of what is right or wrong, which is what makes running an SRI fund so tricky. If clients have firm convictions on the subject, then IFAs can play a useful role in identifying a fund which best matches those convictions. If it is a question of religion, the answer may be fairly straightforward, thanks to the well-labelled Sharia and Christian ethical funds which are designed to match the broad codes of conduct of either creed. But even here there are almost as many varieties as there are biblical interpretations. An IFA can do the research and sanity-check the investment methodology, but this is a personal matter and the client has to make the choice.

Outside of religious views the field is wide open, and all an IFA can do is explain the categories and highlight the best performers in each class. What the client should understand is that while in theory better-behaving companies should enjoy a more successful future, the stock market may well not reward them for it. Equity markets are narrow-mindedly meritocratic – they reward financial success, not good behaviour. It is quite possible clients will end up paying for their convictions through a drag on performance. And if that is the case, how does this philanthropic act compare to, for instance, tax-efficient charitable donations? Which is the most effective and efficient?

The argument for adopting a long-term sustainable approach to investing in the way briefly outlined by Prince Charles has been waging for a decade. The bottom line is that any behaviour disreputable enough to have a real impact on business prospects, and therefore share price, will be seized upon by all equity analysts, not just those wearing SRI badges.

His Royal Highness is wrong to conflate philanthropy with a desire for investment success. Most trustees of collective long-term pension schemes recognise that their primary duty is to ensure sound financial performance, not impose their own individual moral convictions upon the funds of their members.

And while individual clients are free to let their personal convictions influence their own choice of investments, IFAs should outline how exactly that would work in practice. Even if the IFA and client can find a fund that is a suitable match of principles, that does not mean investing in it will bring the peace of mind, or performance, that the client is looking for.

There is a reason we have politicians: so that if the world does not look as it should, we have someone to complain to. That is their job; the job of a business is to make profits. Clients who are understandably concerned, like Prince Charles, about what the world will look like when they retire may wish to consider other ways of pressing for social change.