The strategy paper, presented to and endorsed by the board, explains the fiduciary framework the fund has adopted to integrate sustainability across the entire fund and sets out the themes and visions for the future.

Anne Simpson, director of corporate governance at the fund, says one of the interesting questions for a fund as big and complex as CalPERS is “how do you actually get this done?”

“This is a new strategy for a total-fund approach with practical impact. It has been a two-year project, it takes time, so be patient,” she says.

In developing a total-fund approach, it was essential to get buy-in from all aspects of the fund at the outset.

The fund’s corporate-governance program has been overseen by a working group that has representatives from all the key constituents in the business, including the chief executive, the president of the board, the chief operational officer and head of external affairs.

“This allows the fiduciary, investment and all aspects of the business to be across it. This is critical to develop this new strategy,” she says.

“There is a question in the industry about whether the governance people sit in the investment team, legal or in a separate division, the answer is yes, in all of them.”

The outcome of the report is that implementing environmental, social and corporate governance (ESG) is now a strategic goal for the investment office, and it is a board commitment, she says.

“This won’t work if we can’t get the F into ESG,” she says. “It sounds like I’m swearing.”

Until Christmas, Simpson’s corporate-governance group of around 20 people sat within the global equities asset class. That has now changed and they work across asset classes.

“Previously we were in global equities, but that didn’t allow us to connect on issues across other asset classes, such as private equity. This move was made just before Christmas, and it is one of the moves we’ve made internally to implement the sustainability plan.”

At the same time the sustainability plan was being formed, the fund conducted its triennial asset-liability-modelling review.

External matters

It now manages assets in three buckets: growth, which includes public and private assets; income; and inflation hedges. The management of ESG is done within these different buckets and the appropriateness of the strategy assessed on each.

“The working group across asset classes had a representative from each, and the commitment of each asset class and a critique of the vision was done on economic grounds. They assessed the vision and how to link that on to an investment strategy,” she says.

“We have an economic view that wealth creation is through financial, human and physical capital and that became the intellectual framework for ESG.”

Each of these three elements – financial, human and physical capital – was then assessed in each asset class.

CalPERS still faced the enormity of how to prioritise these forms of capital in ESG implementation, and for clarity it benchmarked the fund through an international group of peers.

It communicated directly with 11 funds, all of which had more than $200 billion, including Norges Bank, Government Employees of South Africa, Previ, Ontario, PGGM and BT.

From that process clarity of how to implement a strategy became clearer, it prioritised one mission for each of the different areas.

Climate change became the theme for the environmental consideration. The reasoning was it affects all asset classes and CalPERS believes as a mega-fund with long-term liabilities, it will be impacted by climate change.

For social issues, priorities and human capital, talent management and rewards, human rights and fair labour practices across the entire supply chain will be a focus.

And for governance, alignment of interest is the key focus.

“It’s not everything, but we can’t do everything. We had to do something that speaks to our size, global exposure and the long-term nature of our liabilities,” Simpson says.

“Each asset class developed a couple of specific things before now and the end of the financial year.”

Internal considerations

In addition, another project is underway, a “manager’s expectation” document across the total fund.

“We have a complicated structure with internal management of public assets as well as external managers. If we think ESG has the potential to effect risk then we need to be consistent with expectations of internal and external experts. An expectations document is the next project to start next week.”

“CalPERS is in a leadership role. Rather than small portions of capital to the space, we want managers to look at risks and opportunities,” Simpson says.

CalPERS will also issue a request for proposals next month to review the “evidence” of the effect of ESG on risk and return. This will set the scene to commission new research, which ultimately will identify data and create a matrix to integrate into financials.

The fourth project, in what Simpson describes as a “mighty amount of work to do”, is to review the more than 110 initiatives and statements across the CalPERS portfolio.

This will be developed into a unified statement of principles for the entire portfolio.

“We have been doing a lot of rethinking about the long term, the fear of sustainability of returns, and the fundamental ability to pay pensions,” Simpson says.

Simpson says CalPERS has been proactive in leading by example internally.

It has cut its own greenhouse gases by 30 per cent between 2008 and 2010, more than 90 per cent of its printing and writing paper come from recycled sources, and it has conducted a governance overhaul, which includes in an external-board evaluation this July.

“We are willing to take those things on,” she says. “Asset owners need to act and engage intelligently on market level reforms. We need a broader vision.”

As with any integration process, empowerment is crucial; for integrating environmental, social and corporate governance (ESG) into investment processes it is no different.

Mills is working on the premise that ESG information can be turned into alpha and it rests with empowering the investment decision-makers.

His solution is a labyrinth of players which are involved in a continuous multi-directional loop of information. But the secret, he says, is to leave the responsibility for decision making, with the fund manager.

The Highland Good Steward Global Bond Fund, which uses Pimco as the sub-advisor, has an emphasis on changing the behaviour of borrowers in a long-term sustainable way, but also to remain flexible enough to maximise short-term opportunities.

The key, Mills says, is to provide ESG signalling to the underlying manager in order to guide its long-term decision-making in sustainable companies without limiting its shorter term investment discretion.

The philosophy is that the outcome will be achieved by collaborating with the manager rather than replacing the manager’s judgement.

“Philosophically, we do want a sub-advisory based on traditional asset management with a track record. But we want to stimulate their thinking, not change their thinking, for ESG, but ask them to think deeper,” Mills says.

“What underpins all of this is that you don’t tell managers what to do. You hire the best managers, listen to them and work with them.”

There are a number of differences in this approach that distinguish it from simply overlaying a process with ESG information on a company.

How data signalling and engagement work
Highland Good Steward Management (HSGM) has developed a consortium of research firms that provide company ESG and socially responsible investment (SRI) information. This is fed to the manager as additional information for securities selection, of which the manager retains ownership.

The research consortium includes ECPI, Eco-Frontier, MSCI, CAER, EIRIS, and SocioVestix Labs, and produces a grading on 7000 companies for the individual elements of environment, social and governance, as well as a consolidated ESG rating.

“The data from these providers acts as a signal for the portfolio managers to use, alongside financial and other data used for analysis.”

“Highland will not limit Pimco’s investment choices by negative screening. Instead the aim is to collaborate with the manager in their search for additional alpha by integrating ESG considerations into their investment analysis.”

But it doesn’t stop there. Another element of the process is the use of a service, provided by Hermes EOS, to engage with corporations before and after the investment decision.

Colin Melvin, managing director of Hermes EOS, says engagement is a way of looking at longer term decisions and aligning the client.

“We have an engagement indicator that measures the quality of the company and its responsiveness to engagement. If you are considering it as part of the normal decision-making, then you want fund managers to do it as they do other things. But you can also use it to challenge managers on their decisions,” he says.

“For many, these issues have been taboo for funds managers. They have been overly impressed for too long by short-term decisions.”

Hermes engages this way with about 500 companies globally.

For this relationship, the engagement starts with investors suggesting themes. These currently include climate change, access to and utilisation of water, operations in troubled regions, supply chain, and access to medicines.

Hermes then suggests to HGSM certain companies that may have potential for engagement breakthroughs. This list is then taken to Pimco for the manager to analyse as possible portfolio holdings on the basis of their investment thesis.

If Pimco invests in these companies, which is at their discretion, then Hermes engages in focused impact engagement in order to accelerate the corporate and potential changes in share value.

It also works the other way: if Pimco invests in companies outside the HGSM research-consortium database, then HGSM can request that a research report on the company be performed by one of the research companies, and Hermes may also engage with that company.

“It is incorporating the manager in the process. We can take all the holdings in the fund and download them into research,” he says. “Over time we can see how the portfolio is moving towards E,S,G or not.”

Case studies on the HGSM platform
Mills points to the example of two companies as to how the process may work. On a corporate level, the companies would be analysed on a theme and how they engage with Hermes, and then ranked.

Say, for example, company A has improved its water management, which will be reflected in a good environmental score, but it has a tight yield spread. Compare this to company B, which historically hasn’t taken Hermes seriously on water engagement and has a low environment grade, but its yield spread is higher.

In recent times when Hermes engages with company B, it now wants its senior management to be involved, which is sending a different signal about how it is approaching the issue. HGSM sends the information to Pimco, instructing that it is a signal to be fed into the analyst’s process.

“They love that,” he says. “Everyone wants to prove ESG works. It entirely depends on the time frames, the same way for example value and growth does. We have been attaching the wagon to the wrong thing and setting ourselves up. The ideal way is corporate engagement – it is the only way to determine a company’s DNA.”

“You can be more explicit in engagement than data providers can be on performance. But the engagement partners are selected not with an eye to embarrassment but effective engagement.”

“We would go back to Hermes and say that water engagement is important to my client and Pimco bought 500 bonds on that basis. We will also share with the company we’re engaging with.”

“This is a long-term monitoring process that makes sense, it’s better than trying to prove alpha exists,” he says.

Mills is now transferring all the data from this platform to Microsoft Cloud, which makes it immediately customisable.

Scott, who spent his career managing the balance sheet at Microsoft, Dow Chemical, the Alaska Permanent Fund and now investment consultant Wurts, says institutional investors want to manage returns, which is impossible.

“Returns are a function of animal spirits. They swing between fear and greed. Do companies really change in long-term valuation over the weekend?” he asks.

And while he points to investors such as Warren Buffet who “thinks about risk constantly with his capital”, Scott says many institutions are not thinking about risk.

“There is poor governance, and poor risk management. A lot of losses experienced by funds throughout the financial crisis were a function of missing simple risk-management concepts like custody of collateral and liquidity. You didn’t need fancy mathematical risk models instead of common sense you can get in Omaha.”

Scott says that institutional investors are behind in their risk-management practices.

“Many asset-management firms and hedge funds have far superior approaches to risk management than institutional investors. There are steps to take and it has to start with governance, and then understanding the risks you are taking.

Change of hats
As chief investment officer of Alaska, Scott managed a number of strategic partnerships with service providers, and now has flipped to the other side of the table to be providing those strategic partnerships.

“It is the same hat and we have switched it around,” he says.

Scott says he works with funds at an organisational level discussing a new approach to asset allocation, that is really risk allocation, but before that there needs to be a discussion around knowing the funds’ risk tolerance, which is a lot more than standard deviation.

“Two different funds could have the same investment objective but the exposure for each is different because of what it “means” to them in the overall context.”

“We take the objective and liability of a total enterprise and manage a diversified portfolio relative to that,” he says. “We show them how we manage that, take an active risk budget around that and how we manage that risk budget and how investments change.”

While a few managers may have similar propositions, what Wurts does is have a service agreement alongside the investment-management agreement, whereby that knowledge will be applied at the portfolio level.

In other words, Wurts is transparent about the risk of the discretionary portfolio it manages, but it also communicates that thinking at the organisational level, feeding back advice on organisational and governance change management.

“We have an investment-management agreement and a service-level agreement, which defines in writing what the strategic partnership program is designed to accomplish and how it will operate.”

The key to good governance, Scott says, is a clear delineation between who has authority, responsibility and accountability.

Scott says some concepts applied during his tenure at Alaska were concepts and methods developed in treasury management learnt at Microsoft and Dow Chemical.

Resourcing was an obstacle to applying more than about 60 per cent of the concepts.

The current chair of the Microsoft investment-advisory committee chair is Mohamed El Erian, co-chief investment officer of Pimco, demonstrating the complexity in the portfolio.

A report on the progress that some of the world’s biggest companies are making towards achieving sustainability by 2020 has shown many US companies are failing to embrace sustainability at a pace necessary to meet the 10-year road map.

The 21^st Century Corporation: The Ceres Roadmap to Sustainability measures how companies are responding to environmental and social challenges such as climate change, water scarcity and supply-chain conditions.

Researchers found that some of the 600 companies assessed were showing leadership but overall there was significant need for improvement.

The report, conducted in conjunction with Sustainalytics, was launched at the Ceres annual conference in Boston last week.

President of Ceres, Mindy Lubber, and chief executive of Sustainalytics, Michael Jantzi, say companies are missing a big opportunity by not fully embracing sustainability.

“We see it as a world of opportunity for companies to improve competitiveness, realise large savings through energy efficiency, invest in their workers, strengthen their supply chains and, in many sectors, reap the benefits of the enormous investment opportunities in clean technology and clean energy,” they write in the report.

According to a press release, Anne Stausboll, chief executive of CalPERS, echoes the sentiment, saying: “The future will belong to innovative companies that understand that building long-term shareholder value and being an industry leader requires the integration of sustainability principles at every level, from the C-suite to operations and throughout supply chains.”

Ceres directs the Investor Network on Climate Risk (INCR), which includes more than 100 institutional investors with about $10 trillion in assets.

Andrea Moffat, vice president of corporate programs at Ceres, says there is an opportunity for institutional investors to proactively ask companies about their environmental, social and corporate governance (ESG) risks and opportunities.

“Companies respond when their owners ask questions but they are not hearing from enough investors. The Roadmap to Sustainability analysis indicates that investors have a significant opportunity to engage directly with companies on their sustainability disclosure in financial filings, annual meetings, investor road shows as well as ensuring that boards of directors have clear oversight,” Moffat says.

“If environmental and social performance was raised as part of every investor engagement with business, we would expect to see a much larger number of companies developing sustainable business strategies that account for their full range of risks and opportunities.”

Similarly, the EIRIS Sustainability Report looks at the sustainability performance of the 2063 companies in the FTSE All World Developed Index and applies its newly launched EIRIS’ global sustainability ratings to measure the extent to which those companies are tackling sustainability challenges.

The analysis reveals some significant differences in the extent to which companies are on track to tackle these.

“Investors need to be aware of these differences and also the initiatives, drivers and strategies which are likely to be the most effective in engendering improvements in corporate sustainability performance,” the report states.

For example, ExxonMobil, the world’s largest oil and gas company by market cap, only ranks 41 out of 84 companies in that sector and so does not show the same level of leadership as some of its smaller peers.

Similarly, Apple, ‘one of the world’s largest companies and a financial superpower’ scores D in EIRIS’ analysis, which places it among the worst performers of the technology hardware and equipment sector.

EIRIS works with more than 100 asset owners and asset managers globally to create customised ESG ratings, engaging with companies and creating specific funds for their clients.

Facts and figures

In the Ceres report’s four-tier assessment system, just a quarter of all companies surveyed were in the top two tiers for progress on governance, while 24 per cent achieved some degree of meaningful stakeholder engagement.

On corporate-performance metrics, only 13 per cent of the companies evaluated on human rights policies and programs were ranked in the top two tiers. And just a third of the 600 companies had time-bound targets for reducing greenhouse gas emissions in direct operations.

However, there were some companies that stood out for their leadership.

Alcoa, Xcel and Intel were noted for sustainable corporate governance practices; Baxter and Ford were setting a high standard in stakeholder engagement; and Exelon, Nike and the Coca-Cola Company were ahead of the pack in performance on metrics for reducing environmental impact and improving workers conditions.

Intel is cited specifically for linking executive and employee compensation to company environmental goals such as reducing energy use and greenhouse gas (GHG) emissions; in the two years since it started the program, the company has cut energy use by 8 per cent and GHGs by 23 per cent.

Coca-Cola is credited for being on track to meet its ambitious performance goal of improving water efficiency by 20 per cent by the end of this year (against a 2004 baseline).

Other cutting-edge performance examples: Nike’s new partnership to implement a water-free fabric dyeing process, Kohl’s Department Stores achievement of net-zero greenhouse gas emissions at its stores, Pinnacle West using recycled urban wastewater (about 20 billion gallons a year) to cool its Palo Verde nuclear power plant and EMC building a new energy-efficient “virtual data center” to move data from physical storage to an entirely virtualized IT infrastructure (the shift has already saved the company more than $23 million).

The top 10 global sustainability leaders

EIRIS has applied its sustainability-ratings research methodology to measure the sustainability performance of 2063 companies from the FTSE AWD Index.

It identifies the top 10 leaders and their business categories as:

Puma, personal goods, Germany

FirstGroup, travel and leisure, UK

National Australia Bank, banks, Australia

GlaxoSmithKline, pharmaceuticals, UK

Roche, pharmaceuticals, Switzerland

Novartis, pharmaceuticals, Switzerland

Phillips Electronics, leisure goods, Netherlands

Deutsche Boerse, financial services, Germany

Novo Nordisk, pharmaceuticals, Denmark

The GoAhead Group, travel and leisure, UK

Part of the problem is that conventionally safe assets, such as US Treasuries, are expensive.

“That will take years to work through and investors need to work assets hard in different ways. For example bond investors need to look outside of the core to a broader range such as private markets, anything that produces an income,” Mercer’s global chief investment officer, Andrew Kirton, says. “This requires thinking more creatively to behave more dynamically.”

Kirton believes there is a role for specialist managers in unique asset classes such as high-yield bonds or private markets, and Mercer has invested in boosting its research coverage of alternatives.

A decade ago bond investing was relatively straightforward, Kirton says, now there is a new product or investment strategy every month.

“It’s a very exciting time. While it remains a challenging time, it is not without opportunity.”

Kirton is encouraging clients to think laterally, to get out of their comfort zone.

“I say to investors they need to be prepared to look at assets that are less familiar to them.”

The biggest mistake investors can make is to lose sight of their objectives, Kirton says.

“Keep a careful eye on the risks to not achieving your objectives in a world where there will be more shocks,” he says. “Look at risk-management issues and the journey you’re on.”

Global head of fixed income at Mercer, Paul Cavalier, says the safety of fixed income has been called into question.

This is especially so in credit markets but also sovereign debt, he says, adding while it is a mistake to call the asset class risk-free, it can still be branded least risk.

Beware the benchmark

One of the consequences of the upheaval is investors need to be more cognisant of the benchmark composition.

“Over the past few years benchmarks have come into question, first in credit then in sovereign. In credit, financials represent 40 per cent of the benchmark, which is a large percentage, but financial credit operates differently to industrials. Investors have to understand what they’re getting into.”

The result is that indices are being split, and customised portfolios, such as credit ex-financials, are being built. This happened in equities 20 years ago, he says.

The inherent volatility can be observed by looking at yield levels on indices, Cavalier says.

“In December 2006 the global aggregate index was yielding 4.25 per cent and the US Treasuries 5 per cent; in December 2011 the global aggregate index was yielding 2.25 per cent and the US Treasuries 1 per cent. Is that what people expected?” he says.

“Further, during that period the emerging-market sovereign-debt local-currency index has traded at between 6 and 8 per cent the entire time, so there is a bubble in the risk-free assets.”

Cavalier is a proponent of an emerging-market debt allocation and says there is better value in emerging-market debt than developed-market debt, pointing to better growth, better debt to GDP and ratings upgrades.

“In the developed world the downgrades are outpacing the upgrades, but last year in emerging markets there were 17 upgrades and only 3 downgrades. All indicators favour emerging markets,” he says.

It is Cavalier’s view that fixed-income exposures should not be organised by regional diversification, but different asset classes, with the liquidity premium more important than ever, especially in credit.

“Dynamic asset allocation needs to focus also on illiquid markets – private debt, for example – and giving up liquidity for long-term return. Banks are out, now institutional investors play a role as patient capital.”

Cavalier, who managed money for an asset management firm for 22 years, advises investors to consider specialist managers rather than generalists who can do everything.

Asset management is not a profession he envies in the current environment: “I’m glad I’m a consultant not an asset manager at the moment, I can take a step back.”

The Healthcare of Ontario Pension Plan (HOOPP) has a large derivatives program, amounting to more than 1500 positions worth about $200 billion. The worth of its net assets available for benefits is $40.3 billion.

This unique approach to investing – using its balance sheet as an asset – has enabled the fund to remain fully funded throughout the global financial crisis, an enviable position among its peers.

Chief executive of the fund, Jim Keohane, who was chief investment officer for 10 years before taking up the top job, says HOOPP is clear about its investment strategy and its strategic advantage as a long-term investor.

“We don’t have any strategic advantage in security selection. Where we do have a strategic advantage is we are creditworthy, have a large balance sheet and low liquidity needs. We can find strategies that we can do that others can’t, and that is often non-traditional,” he says.

According to Keohane, the external environment is in the biggest state of flux since he’s been in the pension business.

“There has been high market volatility, low interest rates and changes in government policy. Pensions are on the front page and will be for some time to come.”

Keohane says the fund has been positioned fairly well in this environment, and some of the actions of the past few years to restructure the portfolio have meant it could take advantage of the opportunities as well.

“We have done a lot of long-term option writing. We saw an anomaly had been created, there had been a lot of annuity sold but they hadn’t hedged them. These options provided equity-like returns with nowhere near the risk.”

Clear objectives: split and divide

The HOOPP investment portfolio is divided into two: a liability-hedging portfolio and return-seeking portfolio.

Within the liability-hedging portfolio there is a large weighting to long-term bonds as well as real-return bonds and real estate. The investment strategy is to hedge the liabilities, but it also turned out to be a source of 2011 returns.

The fund entered the international real-estate market last year, closing its first deals in the UK and the Czech Republic.

In the return-seeking portfolio, managed by Jeff Wendling, the fund gains equity and credit exposures through derivatives.

The structure of HOOPP’s investment process is most akin to the Danish ATP, which also divides its portfolio into two separate portfolios.

The difference is that ATP uses derivatives for fixed-income exposures and cash for equities exposures, while HOOPP does the reverse.

“ATP does the reverse of us. They use interest-rate swaps to hedge the liabilities and use cash to fund the return-seeking portfolio. We do the reverse, use derivatives for equities exposure, because there is not a well-developed interest-rate swap market in Canada.”

The fund has a list of approved counter parties, which Keohane says can be up to 15 investment banks, and it has a team to manage the credit and collateral management very tightly around that. It has also been cutting-edge in setting up the systems to support that.

Over the past few years the previous chief executive, John Crocker, oversaw the spending of more than $100 million in technology.

The result is a sleek operating system for both investment and administration that will save costs in the long run.

“We spent the money to get daily price feeds on everything we trade, we mark to market daily,” Keohane.

He sees this technology and the particular in-house expertise necessary, as one of the barriers to other funds investing the same way.

“Developing some core in-house expertise is a barrier to others investing the way we do. For example, [with] cash management and collateral management and managing the balance sheet, we have a treasury function similar to a bank. The fund started using derivatives in 1999, it’s taken about 13 years to get where we are.”

Keohane says having very clear objectives of what it is trying to achieve is a key driver of the fund’s success.

HOOPP’s vision is that all healthcare workers enjoy a financially secure retirement. Its mission is to deliver on the pension promise, and it is driven by the values of professionalism, accountability, collaboration and trustworthiness.

The study examined the organisational design of 19 of the world’s largest funds with average assets of $90 billion and found that these funds spend an average of 46.2 basis points on external management, compared to 8.1 basis points on internal investment capabilities.

Partner at CEM Benchmarking, Mike Heale, said the funds with internal management platforms are better performers after cost, and this is largely driven by lower costs of internal management.

The biggest cost savings were from internal private equity, with the median cost of internal management for private equity 25 basis points, while for external private-equity management the median cost was 165 basis points.

For fixed income the difference was 3 versus 18 basis points, for equities 10 versus 40 and for real estate 21 versus 75 basis points.

Heale says in the past 10 years there hasn’t been a great deal of internal private-equity management, but he believes the industry is on the cusp of change.

According to CEM Benchmarking vice president, Jody McIntosh, the extent of in-house investment management was a driver of many organisational aspects, including the number of staff and the compensation.

“The number of staff at these 19 funds ranged between 20 and 647 full-time investment staff. This is a big variation, and it was interesting to see what was driving that was internal assets under management.”

CEM conducted a regression analysis that revealed 70 per cent of the variation in the number of staff was due to internal management.

McInstosh says most funds plan on increasing the number of staff over the next three to five years, some by as much as 10–20 per cent as they increase internal management.

There was also a clear relationship between the number of front and back-office staff, with 1.7 people required in the back office for every member of front-office investment staff.

“The number of front-office staff is the best predictor of governance, operations and support staff,” he says.

Resource allocation matters

But it is not just the number of staff that distinguishes these funds, it is where the resources are allocated.

Large funds have a substantial number of full-time staff dedicated to asset allocation and risk, with an average of 13 of 135 staff allocated to this area.

A survey of these funds strategic objectives revealed that risk management was the number one priority, followed by organisational leadership, culture, talent and asset allocation.

McIntsosh says the number of internal staff was also a clear indicator of the compensation paid to the senior staff.

“The best predictor of compensation for the highest paid five staff was the number of full-time staff in the organisation. The higher the number of people, the higher the compensation,” she says.

Of the funds surveyed, the highest compensation was in Canada, followed by Europe, US and Australia/New Zealand.

Average salaries at investment departments in Canada was $536,000, in Europe it was $246,000, for the US $148,000, and in Australia and New Zealand $139,000

The average salary of the top five investment staff in Canada was $1.5 million, in Europe $720,000, in the US it was $372,000 and in Australia $297,000.

Heale says the study is part of global leaders program introduced by CEM last year, which looks at understanding the common characteristics of the funds, including big internal operations, sophisticated asset mixes, high need for performance-management information and high allocation to private markets.

The organisation design study is the initial piece of research into which CEM plans to drill deeper.

The internal investment team is targeting a total cost range of between 50 to 54 basis points, down from the total of 58.9 basis points recorded in 2010.

It has asked for an increase of investment administration costs of $6.5 million in the next financial year to help achieve this.

The argument is that it is important to focus on total cost, and that internal management results in lower total costs, even if the internal costs are higher due to more staff.

It argues that if a total basis point cost target is set, and the investment management team is accountable for that target, they should be able to trade-off across external and internal expenses, making decisions about the use of internal versus external resources based on economics instead of budget process.

The $225 billion CalPERS manages 93 per cent of total public assets and 64 per cent of total assets in house.

While the cost reduction is significant, the total target is still a lot more than the 30.9 basis point total cost the fund recorded in 2006. This is due primarily to the amount of private assets in the portfolio, which has increased from 16 to 26 per cent from 2006 to 2010.

Of the total cost of 58.9 basis points in 2010, 47.7 basis points were attributable to private assets including hedge funds. Reducing complexity is also being targeted as a way to reduce costs and, where possible, it is focused on eliminating small non-value-add programs and reducing the number of managers.

According to papers presented to the board, the reduction in total fees will primarily come from a reduction of external management and consulting expenses, with a reduction between $100 million and $200 million over the next three years.

The vast majority of the total costs, $1.15 billion of $1.26 billion, is from external asset management fees. About 87 per cent of the total external assets management fees come from private assets and hedge funds.

The internal team plans to develop a long-term “resource strategy” for the investment office and reinvest some of the external savings in internal capabilities.

The papers say the target operating-model implementation is to move down the complexity spectrum, but selectively adding complexity where significant value can be added, such as co-investment in the alternative investment management program.

The CalPERS investment office believes there is an opportunity to further reduce external management and consulting costs and reinvest some of those savings in missed internal capabilities.

It outlines three cost drivers of investment management organisations: private versus public assets, external versus internal management, and the breadth and nature of the investment strategies and activities.

Kimberly Gladman, director of research and risk analytics at the governance research company GMI, says investors should set the expectations that sustainability metrics are included in executive compensation packages.

“They should ask companies how they integrate those metrics, in a really concrete way, and make it part of the routine of dealing with companies,” she says. “It is a failure of imagination that more companies have not integrated environmental, social and corporate governance (ESG) metrics into executive remuneration.”

She says that companies should be required disclose sustainability measures.

“It would be ideal that every company has a mandate to disclose the top three social or environmental issues material to its business risks or opportunities, why they exist and what the company is doing about them, then they should be built into the executive compensation.”

Similarly Nicolas M0ttis, professor of accounting and business control of ESSEC Business School, says institutional investors can keep pressure on companies at the chief executive officer-level to improve ESG performance.

“They can also do more to publicise the good examples and support good practice,” he says

Linking executive remuneration and sustainability has not been a priority for companies, Gladman says, because they don’t prioritise it as important enough to core business.

“With sustainability in general, you can’t make a consistent case that it will lead to profitability – you can say its neutral or won’t hurt you. But outside of measuring profits, there is an argument it is necessary for company’s survival, its licence to operate, and its reason to exist at all.”

Linking ESG to strategy and compensation

The United Nations Principles of Responsible Investment (UNPRI) is facilitating a project between companies and a group of 11 institutional investors with the aim of creating overarching principles of how ESG metrics are linked to executive remuneration.

As part of the project it is looking for a group of 10 global companies whose boards have experience, or have recently embarked, on integrating sustainability into reward schemes for executives, and want to learn more about peer practices and investors’ expectations.

The investors include PGGM, APG, AustralianSuper and Colonial First State.

Manager of ESG research and engagement at Colonial First State, Nick Edgerton, who is involved in the project, says while it is very early days, the research reveals most companies are “unsophisticated in the main”.

“What we want to do is link ESG to strategy and compensation,” he says. “There are ESG risks to the business and this creates targets around that, for example in the property sector occupational health and safety is an issue, so a good safety performance will be an edge, and so good safety metrics linked with remuneration make sense.”

This would play out in key performance indicators looking at business requirements such as return on equity and sales targets but there would also be a metric on safety record such as the lost time frequency rate, he says.

Data and collaboration get results

The link between executive compensation and sustainability metrics is a topic of much discussion amongst academics. However, as in other areas of sustainability academic study, a lack of data is hampering research.

“Academics can’t do the research because the data is not available,” Gladman, who joined Mottis on a recent UNPRI Academic Network webinar on the topic, says.

Both M0ttis and Gladman believe, instead, that academics should be looking at more in-the-field study.

“There is a research gap,” Mottis says. “I feel there are many papers based on statistical analysis but the marginal output is limited because data is not there yet. Academics need to go into the field to look at detailed examples and the practical challenges. In three to five years there will be a long list of companies looking at how to improve ESG performance.”

Similarly Gladman says there is potential for interviews with corporate committees, designers of compensation packages, and executives inside companies to get their opinions of what would work and what the company has tried.

Conducting his own fieldwork has revealed some interesting examples to Mottis.

He gives the example of a steel industry company that wanted to reduce its water consumption. It examined its existing practices, designs and processes, and decreased water consumption by 40 per cent.

“That is a very impressive figure and they achieved it by working together,” he says. “At first they didn’t change incentives, but it became more institutionalised. Every manager has a clear objective related to a general target of water consumption, and part of the bonus, something like 10–20 per cent is connected to this collective action. The main driver at first was not cash but the belief it was possible to improve things and make changes.”

Mottis believes collective action, and team collaboration, is a sensible way to connect sustainability metrics and executive remuneration.

Greening the long term

The GMI company research looked mainly at large cap-listed firms in developed markets but also those in MSCI emerging markets with more than $1-billion market capitalisation.

While only 26 companies were found to be using a specific sustainability metric in executive compensation, a larger number also “say something vague”, Gladman says.

A paper by the governance analysis and proxy voting firm, Glass Lewis, Greening the Green: linking executive compensation and sustainability 2011, tells a slightly different story.

Of the companies it surveyed, it found that 40 per cent provided a link between executive compensation and sustainability, up from 29 per cent in 2010.

The report shows that “social” links were the most prevalent type of link cited by companies when constructing compensation packages. This is not surprising, the paper says because employee health and safety represents the most visible link to shareholder value.

It measured the link between sustainability and compensation in companies in the US, Canada, Australia, the UK, Norway, the Netherlands, France, Switzerland and Germany, and found that Australia has the largest proportion of companies that link sustainability metrics to compensation.

However, CFS’ Edgerton says for the most part ESG metrics reside in short-term bonuses such as a one-year time frame.

“We haven’t seen them flow through to long-term incentives, even though they are long term issues. It would be good to see the alignment of those time frames,” he says. “It is the responsibility of fiduciaries to understand remuneration, to understand best practice, and the sustainability strategy.”

Gladman agrees that even the companies that are looking at the link between sustainability metrics and remuneration are looking at it as short-term bonus, not a long-term bonus strategy

Another limitation, observed by both Edgerton and Gladman, is that even those companies that do report a sustainability metric, the percentage it makes up of executive remuneration is so small, “it’s almost an afterthought”.

James Gifford, executive director at UNPRI, said the new strategy came out of its board meeting last week in Australia and would include its own internal research function.

“UNPRI is uniquely positioned to contribute to a more sustainable system,” he says.

“We are building on a micro focus of supporting our signatories in implementing principles, but given the problems in the financial system as a whole, UNPRI is uniquely positioned to make a contribution to the solution to a sustainable financial system that delivers returns to members, beneficiaries and customers and also benefits the environment and society.”

He says one of the problems is the misalignment of incentives in the industry.

“You often hear super funds are long term, and most corporations are very long term, but the intermediaries that connect them are very short term,” he says.

“Asset owners are in the driving seat. It is up to them to incentivise managers appropriately.

“We don’t have any answers at this stage, but UNPRI is well positioned to have a look at these issues to create a more sustainable system.”

He says UNPRI will work closely with its signatories, which now number more than 1000, to develop an internal research capability and agenda.
“We want to engage more in public debate around these issues more than in the past. We are canvassing signatories on what they feel we should work on.”

Chair of the UNPRI, Wolfgang Engshuber, said the organisation needs to be more vocal.

“We need to have a public voice, be a thought leader and engage with signatories and policy makers.”

David Atkin, chief executive of the Australian superannuation fund, Cbus, and UNPRI board member, says funds are long-term investors but are driven by short-term incentives.

“We need to understand the issues and collaborate. A lot of focus in the industry is on how we can outperform our peers, but [we] need to see our economies performing well. We don’t focus enough as an industry on the beta, and supporting productive economies.

“We need to collaborate and have a strong voice on these debates. We have been mute in very dramatic times.”