The public response to the February 14, 2018, mass shooting at Marjory Stoneman Douglas High School in Parkland, Florida, which left 17 students and teachers dead, has been swift, passionate and widespread. For many retirement plan participants and advocacy groups, the appropriate response to dealing with firearms-related investments has been to pressure their pensions and other institutional investors to divest; however, for the fiduciaries charged with making prudent financial decisions on behalf of beneficiaries, the issue is not so straightforward.

Many institutional and retail investors have responded to this tragedy by scrutinising their portfolios to assess whether they are invested in firearms manufacturers or other elements of the firearms supply chain, and to what extent. Identifying the owned securities of firearms and ammunition manufacturers is a fairly simple exercise, as these companies typically make up small portions of portfolios. However, there is the related consideration of whether a client believes firearms distributors, such as sporting goods stores, should be considered part of this analysis and what appropriate screening thresholds should be used.

Divestment as a strategy has been much discussed in recent years, particularly in relation to climate-change risk. Investors controlling more than $6 trillion in assets have divested from some form of fossil fuels to date. Investors looking to address divestment pressure or develop a proactive strategy should undertake a full-spectrum assessment of the impact of the relevant issue on the “three Rs” — risk, return and reputation.

For example, assessing risks and returns by backtesting a portfolio’s performance against various divestment scenarios can provide useful quantitative guidance regarding historical under- or outperformance trends for a given industry. However, the backtest tells only part of the risk-and-return story.

Questions to ask include whether the organisation believes an investment’s historical return patterns will continue based on current trends, and whether there are long-term systemic risks an industry might be facing that markets are not pricing into valuations. If so, divestment could serve to insulate the portfolio from abrupt policy or market shifts with potentially severe consequences and unpredictable timing. On the other hand, if the investor believes markets are efficient and unlikely to misprice systemic risks, or that these systemic risks are overstated, divestment may not be palatable.

In addition, investors may face material reputational concerns around continuing to hold an investment and may be under pressure from internal or external stakeholders to act. Such reputational risks can be significant and may warrant divestment – regardless of the potential performance impact – depending on the investor’s type, mission or strategy. For instance, foundations or endowments may determine that their future donor base or student engagement will be negatively affected if they continue to invest in sensitive industries.

If, after thorough consideration, the decision is made to divest or not divest from a sensitive investment area, a range of other questions may well arise:

If divesting

Will investment managers support a divestment request for a specific range of securities, or will such a request impede their ability to meet their investment objectives?

Large investors with custom separate account mandates should be able to implement exclusions relatively easily.

However, investors taking part in commingled investment options will first need to engage with the manager to encourage it to divest from the investments in question. The manager will have to balance that request against other considerations across the strategy and investor base.

If an investment manager is unwilling or unable to accommodate a divestment request, then seeking a new manager that excludes the investments in question may be the best approach.

In the wake of Parkland, both State Streetand BlackRockhave announced gun investment and engagement strategies in response to growing client interest in this topic.

Mercer’s long history of ESG investment strategy ratings, and access to holdings-level ESG data to support portfolio screening, can be leveraged to support any changes investors may consider. After divestment has been achieved, subsequent consideration of a broader strategy to address the sensitive issue may be warranted.

 

If not divesting

If divestment is not deemed prudent, decision-makers should consider whether other means of addressing the issue should be pursued, including:

The development of an engagement strategy that uses the investor’s access and rights as a shareholder (or debt provider) to influence the management practices of select companies or the regulations policymakers set

A program of positive investments in solution providers looking to address the issue with technology or novel business models

A hedging strategy that may result in lessening (but not eliminating) exposure to the sensitive sector

Additional approaches; for example, US-based foundations may decide to use program-related investments or grants to address the issue

Post-Parkland policy shifts by Kroger, Dick’s Sporting Goods and Walmart show that companies are listening to a range of stakeholder voices when it comes to sensitive topics – certainly including those of shareholders.

With our experience helping investors of all types and sizes develop voting and engagement policies to affect investment solutions, Mercer can assist with the design and implementation of a more holistic strategy to address the long-term management of sensitive issues[1].

 

Although firearms may be the current topic in the spotlight, a variety of stakeholders can be expected to continue to raise questions around divestment from sensitive industries. Heightened awareness, driven by social media, a rising generation of socially engaged Millennial investors and beneficiaries, and civil society’s increasing sophistication in engaging the financial services industry on ESG topics, allow scrutiny and pressure to arise more quickly than ever before.

There is no panacea for these challenges, but taking a thorough approach to analysing and debating the relevant issue can help facilitate productive and positive resolution. Even if no action is ultimately taken, thoughtful consideration of the risk, return and reputation effects of various courses of action aids fiduciaries in both making sound financial choices and proactively communicating those choices to key stakeholders.

Max Messervy is senior responsible investment consultant at Mercer.

No matter which particular legislative backdrop you happen to operate in, the fiduciary role is a demanding one. Those who are responsible for managing other people’s money are in an unenviable position. In the widely quoted language of a 1928 New York Court of Appeals judgement: “A trustee is held to something stricter than the morals of the marketplace. Not honesty alone but the punctilio of an honor the most sensitive, is then the standard of behavior.”

A natural reaction to this heavy responsibility is to become risk-averse. And, in particular, to stick with the crowd. But this is not always in the best interests of the plan participant.

The faint-hearted fiduciary

It’s largely a question of incentives. The payoff pattern for the fiduciary is frequently different from that of the beneficiary. Consider this simplified example: an opportunity to take an investment position that has a 50 per cent chance of producing an extra dollar of gain and a 50 per cent chance of producing 50 cents of loss.

From the beneficiary’s point of view, that would generally be seen as an opportunity worth pursuing: there’s more upside than downside. But for the fiduciary, there’s more to it than that. The fallout from a loss that arises from a non-traditional approach can attract unfavourable scrutiny. Criticism can be spiced up with the benefits of hindsight. So the downside for the fiduciary is not just the 50 cents of potential loss but also the fallout that would accompany it. That fallout does not have a corresponding benefit on the upside. This can be a deterrent for the fiduciary.

For defined-contribution (DC) fiduciaries around the world who want to do the right thing by their plan participants, this is not just a hypothetical discussion. The DC system worldwide is too focused on the pre-retirement (accumulation) phase, and not paying enough attention to how to turn assets into the income retirees need to live on after they retire. This challenge is described in the Thinking Ahead Institute’s paper Proposing a stronger DC purpose. That paper argues that most DC plans around the world are trying to solve the wrong problem: instead of focusing on income provision throughout the whole post-work period, too many plans are operating as if their purpose is the maximisation of savings at the point of retirement, which is a much narrower goal.

There’s a need for change; the DC world is crying out for fiduciaries to stand up and change the focus of the industry. It’s the right thing to do. But, as in our example above, the fiduciary who takes action is exposed to potential fallout if the changes lead to lower returns in the short term. The easy thing to do is to wait for others to take a lead. The faint-hearted fiduciary will hide in the crowd.

I have bad news for the faint-hearted fiduciary. As the old saying goes: sometimes the biggest risk in life is not taking one. Sometimes keeping your head down means that you aren’t doing your job. Fiduciaries are expected to make their own interests secondary. They shouldn’t be setting their course according to their own payoffs, but according to those of the beneficiary. Failing to take action in those interests is failing to live up to the fiduciary standard.

Brave, but not foolhardy

So the truly wise fiduciary realises that there comes a time to step away from the (apparently) safe position of sticking with the conventional approach. Clearly, this is not to be done lightly. So it’s important to be clear that changing the focus of the DC system from savings to lifetime income provision really is in the interests of plan participants. The reason this is difficult is because the incentives acting on the various actors in the system discourage change. If we recognise this, then doing what needs to be done to create change is what the fiduciary is there for.

Let’s be clear, too, that fiduciaries who depart from the conventional approach need to take care to document their rationales. Documentation that is made at the point of the decision can be a powerful counter to accusations based on hindsight. Good fiduciaries know they need to ensure not only that their actions are prudent, but also that they can be shown to be so. That’s doubly true in a situation such as this.

Incidentally, the need for good documentation also applies to those who choose to stick with the current approach. Some DC plan fiduciaries may reach the conclusion that, in their particular circumstances, participants’ interests really are best served by a focus on asset accumulation rather than lifetime income. They, too, would be well-advised to capture their rationales for why that is the case.

Is regulation the answer?

One way to shortcut the issues described above could be a regulatory push. For example, in the early 2000s, DC fiduciaries in the US faced a thorny situation regarding what to do with the savings of those who had been defaulted into the plan and had not selected an investment strategy – a situation with close parallels to the situation we’ve described in this article. In an aggressively litigious environment, fiduciaries were reluctant to expose assets to any risk of capital loss, and frequently made choices that were demonstrably ineffective as long-term investment strategies as a result. It took a legislative safe harbour from The Pension Protection Act of 2006 to resolve that particular dilemma.

Perhaps it’s going to take a similar intervention from outside the industry to resolve the current situation and re-align the focus of the system. If so, shame on the faint-hearted fiduciaries who left it to others to do their job.

Bob Collie is head of research at the Thinking Ahead Group, an independent research team at Willis Towers Watson, and executive to the Thinking Ahead Institute.

When the NOW: Pensions Trust was launched in 2011, many employee benefit consultants and financial advisers were of the opinion that investment choice was essential within defined-contribution pension schemes. Employers simply wouldn’t want to provide their workforce a scheme that didn’t offer a range of funds.

But as auto enrolment has progressed, this opinion has been proven wrong, partly because employers and advisers have focused more on operational ease, and partly because experience has shown that members do not exercise investment choice when offered it. It’s fair to say that many people are simply frightened by choice.

Government-backed scheme NEST is the UK’s largest auto enrolment provider. NEST offers a range of funds, including a lifestyled ethical option, higher-risk and lower growth options, a pre-retirement option and a sharia option. In total, less than 1 per cent of members have actively chosen to use any of these options. Across other auto enrolment providers, the picture is remarkably similar.

Despite this, many schemes offer multiple funds with multiple managers for each asset class. As members are provided with more funds to invest in, the cost of running the scheme increases. The extra costs incurred from marketing as funds compete for investors’ attention and the added operational complexity all eventually hit investors’ returns.

Those savers who do self-select are normally guided by the risk classifications of the funds available; however, regardless of the tools at their disposal, members continue to struggle to determine their own attitude towards risk.

Those who do self-select rarely revisit their investment decision. Research shows that about 80 per cent of self-selecting members change their selection less than once every five years, and more than half of them never make a change. An initial choice of a cash fund can remain in place for 40 years or more and lead to significantly lower retirement fund values.

The few members who do switch their investment funds will often chase the market. The buy high/sell low behaviour of even the most experienced investors continues to be well documented.

As a result, the vast majority of savers are better served by the default fund than by making their own investment decisions.

The message is clear – auto-enrolled savers don’t want to be burdened with investment choice. With auto enrolment, these savers are, by their very nature, passive. They haven’t elected to join a pension scheme, their employer has enrolled them. They haven’t chosen the pension scheme their money will be paid into, their employer has decided. In most cases, they haven’t decided how much to pay in, the government has decided that.

With fund sizes for auto enrolled savers still small, it’s perhaps unsurprising that they aren’t paying too much attention to how their money is invested. In the NOW: Pensions Trust, the average fund size is about £400 ($530) with members paying in just £35 ($46) a month, on average.

Evidence suggests that savers don’t begin to engage with their pension savings until they have the equivalent of one year’s salary saved. For our members, this could take a decade.

Focus on risk allocation

We don’t think offering investment choice in this market is the right approach.

At NOW: Pensions, the trustees take full responsibility for the investment journey. All NOW: Pensions members have their funds invested in the Diversified Growth Fund (DGF). It uses a diversified investment strategy, balancing the risk of the different investments the fund holds. We believe this is the right approach if we are to deliver strong and stable returns over the long term.

We focus on risk allocation, rather than asset allocation. This is different to more traditional investment approaches that focus on asset allocation and tend to have a much higher proportion of their overall risk exposed to stock markets. By focusing principally on the risk characteristics of each investment, we are able to construct a balanced portfolio without subjecting our members to inappropriate risk.

As members approach retirement, we gradually switch their funds from the Diversified Growth Fund into the Retirement Countdown Fund (RCF). The RCF is designed to generate returns similar to those available from cash holdings, by investing predominantly in cash deposits and money market funds.

The effect of switching into this safer environment is that the nearer each member gets to retirement, the less impact any sudden market movements will have on the value of their money invested with NOW: Pensions. We cannot predict how and when our members will draw their pension fund, and we do not believe many members are in a good position to do so until they are close to their retirement. Our strategy addresses this need for flexibility.

The DGF returned 11 per cent for our members in 2017 – we are pleased with that performance. Due to the way the fund is structured, we don’t expect performance to lead the pack during periods of strong stock market growth, such as we have seen in the recent past. During stormy weather, however, we think we have better protection against the elements. The proof will only become clear over time, when we expect to see strong returns without the levels of volatility that equity-heavy investment approaches experience.

With an uninterrupted focus on a single investment solution, we can ensure a strong approach to governance, allowing members to concentrate on the things they can influence – fundamentally, when they plan to retire, what they plan to do when they do retire, and how much they should be saving to turn their dreams into reality. Governance is a major priority for us at NOW. All our trustees are wholly independent, which means their only priority is the welfare of the members. Also, we have recently taken steps to strengthen our trustee board, including recruiting Joanne Segars, a much-respected figure in UK pensions and former head of the Pensions and Lifetime Savings Association.

 

Nigel Waterson is chair of trustees at NOW: Pensions.

Twelve years’ tenure – maximum. That’s how long the regulator decided was enough for most board members of superannuation funds.

“[The Australian Prudential Regulation Authority’s] view is that long periods of tenure can affect a person’s capacity to exercise independent judgement,” the regulator’s SPG 510 – Governance reads.

The guidance, issued in late 2016, suggested it was important for superannuation funds to have a board renewal policy that documented the maximum tenure period for each director and the circumstances under which the board member may deviate from the tenure policy. The figure of 12 years was decided after broad industry consultation.

“APRA expects that the length of each director’s tenure would be examined shortly before the end of each term served and that there would be limited circumstances in which maximum tenure limits exceeding 12 years would be appropriate,” SPG 510 states.

The Australian Institute of Superannuation Trustees notes that the majority (81 per cent) of directors of AIST member funds were appointed to their positions after 2010. The average length of tenure is 6.3 years, and the median length of tenure is 4.4 years. Further, 40 per cent of directors were appointed after Jan 1, 2015.

AIST notes, however, that 19 per cent of trustee directors have been on their board for longer than 10 years. Research has turned up examples of trustees who have served longer than 12 years – sometimes stretching into decades. The explanation boards and trustees have offered for this centres around the balance between board experience, corporate knowledge and skills and the need for board renewal, fresh perspectives and further broadening of experience and skills.

AIST chief executive Eva Scheerlinck says: “We think, for the most part, 12 years would be appropriate for most circumstances, because we value board renewal, particularly if that is managed properly alongside a skills matrix and a need for maintaining some corporate knowledge within the board through the time. We recognise that there are some exceptions and nobody should have a use-by date on their value, if you like.

Some of us can do it for two or three years, some for 15. Boards need to know how things are working, how the dynamics are, what the level of knowledge and experience is – and that is a matter for them to decide. There is plenty of regulation of how boards work, including the need for an annual assessment of the board’s performance.”

Several board chairs and board members spoke on the record for this story. Some of them have served for longer than 12 years, some of whom are stepping down from their positions, and some of whom have less than 12 years’ tenure.

David Buley has been an employer director of NGS Super since December 2005, appointed as a representative of Association of Independent Schools NSW, where he is chief financial officer. He says he has no plans to step down from the board.

“We have a skills matrix self-assessment to determine whether the board as a whole has the requisite skills,” Buley says. “I have, obviously, 30 years in finance and a CFA, as well as a master’s in applied finance investment. I sit on the investment committee. I do the 20 hours of personal development needed every year, and most of the boxes in that skills matrix I tick as advanced…From my point of view, I think I bring considerable value to the board, notwithstanding that it’s an employer/employee representative board. There is an expectation that those directors offered up have the requisite skills. No one is sitting on the board as a passenger.”

NGS Super has a second board member who has served longer than 12 years – Peter Fogarty, the deputy chair, who has served since December 1995 as the representative from Catholic Hierarchy NSW. Fogarty was contacted by phone and declined to speak. He did not respond to a follow-up email.

“We certainly chat from time to time about what skills the board needs, in terms of marketing and legal – you outsource what you need; however, what you really need on a board is the business acumen,” Buley says. “You’re advising on running a business, you have to have diversity, agreed, which is why the representative model works OK. But you can’t be oblivious to how you run a $10 billion fund. While I think that setting any number is arbitrary, [APRA] had to choose a number and we all tend to think in terms of threes – four terms of three, that’s quite generous.”

The big trade-off That trade off of renewal versus skill and experience is at the heart of the questions chairs must pose to the board, said Peter Kronborg, a governance adviser to the Australian Institute of Company Directors (AICD).

“This is clearly a part of the art form of sound governance – where the wisdom of leaders has to come through,” Kronborg says. “There is no perfect answer. It’s not able to be done by a formula; it has to be done by human judgements and the particular judgement here is around wisdom. We do need a board that is populated by the relevant skills, diversity of viewpoints through age, gender, ethnic, and organisational experiences. We can’t just live with having passion alone, or years of service, as the key attribute that people are making the judgements/membership decisions on.”

“It’s jarring [when you see a bad board], a board that has just too many long-serving members or is too engaged in group-think and group-support. Again, this is one of the challenges; we’re looking for cohesive boards, but not a same-think board, and not an ‘I’ll scratch your back if you’ll scratch mine’ board. It’s obvious that the whole expectation of boards has risen progressively over the last 20 years, and significantly over the last two years.”

One long-serving board chair who has made the decision to step down is AvSuper chair George Fishlock. He joined the board of AvSuper in 1999 and became chair in January 2013.

“The reality is I’ve been on the board for a long period of time, and from a business planning perspective, you have to recognise at some point in your tenure that you need to be looking at who’s replacing you and getting the right people on board for the right period of time,” Fishlock says. “[Part of this is] being able to train incoming board members up to a suitable standard. All of those factors lead you to a point where you have to pick the right time to leave both the board and, in my case, the chairman’s position, leaving the board in the best possible position, given knowledge and experience. You don’t want to lose all that corporate knowledge/experience at the same time.”

Fishlock notes that in some cases, it might be challenging for superannuation funds that have member-based nominees on boards to find new trustees with the requisite financial or investment skills, meaning that those trustees who do have those skills might need to remain in place longer.

“Some funds are limited by the skill set they can attract with direct nominees, so when you finish up in the situation with the right people, you don’t want to lose them,” Fishlock says. “That needs to be addressed. I believe superannuation board positions require a lot more understanding of the business and the regulatory environment that you operate in, than perhaps [board positions] in a broader organisation [require]. It takes longer for directors to get their feet under the table and then to be able to provide good input on the whole board process and the operation of the business. You need a few more years than the normal situation. Getting someone up to speed and getting value add from people takes longer than on other sorts of boards.

“Most superannuation funds are about investment, and directors have to have a good strong understanding of that.

It is not sufficient to be able to delegate those authorities to people with more knowledge, because at the end of the day, the board director is the one who bears the obligations and the responsibilities.”

Renewal and diversity

As borne out by the AIST statistics mentioned earlier, superannuation funds in general are focusing on board renewal and on placing people with the diverse set of skills required for managing billions of dollars for member retirement outcomes. Also, funds that have long-serving directors are taking steps towards succession planning.

A representative of LGIAsuper said Fiona Connor, a member-representative director since July 2001, will be stepping down from the board as of June 30.

Cbus Super has two directors who have served longer than the organisation’s policy of three, four-year terms: Glenn Thompson, chair of the remuneration committee, who has served since December 2001, and Peter Kennedy, who has served since March 2004.

“Cbus currently has two directors who, whilst exceeding the maximum tenure period, meet the exceptional circumstances prescribed in the policy,” Cbus writes in a statement. “Both directors are up for review in 2018 and Cbus has already commenced this process. Directors who fall outside of the maximum tenure period are reviewed annually by the board (or more frequently as required). Regular reporting on tenure and director appointments is submitted to the board throughout the year.”

Hostplus also has two directors that have served longer than 12 years: Mark Robertson, serving since June 2003 and Robyn Buckler, who has served since May 2003.

“Hostplus is governed by three independent directors including an independent chair, three employer directors and three employee directors,” a Hostplus spokesperson writes in a statement. “Our representation model ensures sound decision-making processes, and diversity of skill and experience, which contributes towards strong member interests.

“We believe well-functioning boards have a mixture of experience and new blood. All Hostplus directors are within the fund’s Board Renewal and Performance Assessment Policy. And, in accordance with APRA’s prudential standards and guidance, we undertake regular assessment of director performance.”

Angela Emslie, chair of HESTA, is also a long-serving board member, joining in 1999 and becoming chair in 2013. She has announced she will step down at the end of her term.

REST Industry Super has two particularly long-serving trustees: Joe de Bruyn, who has served since December 1988 and is sponsored by the Shop, Distributive and Allied Employees Association; and Rohan Jeffs, who has served since July 1990 and is sponsored by Woolworths. De Bruyn was contacted by email and he declined to comment, as he was overseas at a trade union congress at the time of publication. Jeffs did not directly respond to an email. REST chair Kenneth Marshman declined to comment on the record.

Rare circumstances

AIST’s Scheerlinck points out other exceptional circumstances under which a trustee could stay on beyond the 12-year limit, such as in the case of a fund merger.

“Bringing together separate organisations and separate cultures might require a transition phase [in which] people stick around and exceed tenure limit; it’s very important to bring across the values of the transitioning fund in those circumstances,” she says. “There are also boards that have experienced a lot of renewal that might be out of their control because events happen. People get sick, people resign. You could be planning for someone to come off the board and then have a whole bunch of people leave in a short period of time, and you need that corporate knowledge to stay on the board for longer. I understand that we need guidelines; a number like 12 years is a useful guide, but it’s not necessarily reflecting the reality.”

With superannuation facing political scrutiny, calls for mandatory independent directors, and the overarching backdrop of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, there is a stronger focus on superannuation governance. Even so, in the event that a long-serving trustee does not step down voluntarily, or the board chair does not press for a trustee to step down, there is no direct provision under the Superannuation Industry (Supervision) Act for APRA to remove that trustee for long tenure alone.

Governance adviser Kronborg suggests boards must focus on improvement, rather than ad hoc decisions made to fit the specified tenure.

“The important thing now, with this greatly heightened focus on governance, is that we ensure our governance processes are enhanced even further, but that we don’t slip into risk aversion governance, which we’ve seen sometimes before – in fact, just about always after a crisis period,” Kronborg says. “So now the challenge for boards is to look at what they can do to improve but not throw out innovation, progression and even risk-taking decisions that advance the company, rather than just being focused on risk aversion [in] decisions.”

The £8.4 billion ($11.2 billion) Centrica pension fund for employees of one of the UK’s largest energy suppliers is steadily increasing the level of innate defensiveness within its equity and credit portfolios. Recent strategies include a put spread collar to add downside equity protection, switching some equities into convertible bonds that have a floor and don’t sell off as sharply as stocks, and swapping some equity into cash for dry powder.

Within the credit portfolio, chief investment officer Chetan Ghosh has taken down the high yield exposure and reduced the embedded duration in a couple of the mandates to better reflect where government bond yields now sit. It is all based on capital preservation, in case markets fall steeply, he says in an interview from the fund’s headquarters in Windsor, a town on the outskirts of London.

The put spread collar was structured around a zero-premium outlay at the outset. Centrica achieved downside protection but sold off some of the upside to enable this zero premium.

“It was a three-year structure and we only participate in the first 20 per cent of equity returns. By selling off the upside, we could finance the purchase of the protection,” Ghosh explains.

He likes the structure because it is contractual up front and can’t throw up any surprises. He says he will consider a similar strategy at maturity if the equity market still hasn’t gone through a downturn.

“At maturity, the need for protection may have gone away, so we will judge it as and when,” says Ghosh, who joined Centrica in 2009 after working for more than a decade as a pension actuary and investment adviser to UK pension schemes.

He is also spotting opportunities where the fund could deploy its dry powder. He doesn’t expect the same kind of opportunities to appear that manifested in the wake of the financial crisis in the loan market, where the high number of leveraged holders of this type of paper made for rich pickings. Nor does he believe corporate credit will give the same opportunities it did in 2009. This time, he expects more buying opportunities in equity than in fixed income and is shaping a more granular approach. This could include allocating to junk stocks in anticipation of a rally or topping up the emerging-market allocation. He is also looking at special ways to play the high yield market, which could include partnering with managers specialising in recovery plays, given the tail wind to the asset class.

“Being prepared is the main project on our table,” Ghosh says. “If something is expensive, we sell it; if it is cheap we will increase our weightings to it. This is what we do all the time.”

Bold allocation to emerging and frontier equities

Big on the frontier markets

Assets are divided between a 50 per cent allocation to equity and asset classes with equity-like returns, a 25 per cent allocation to a liability matching solution, which includes government bonds alongside assets with long-term contractual cash flows like ground rents and social housing debt. An additional 5 per cent of the portfolio is in UK property and the remaining 20 per cent is in investment-grade and sub investment-grade corporate bond exposure.

Centrica stands out from peers for its bold allocation to a well-constructed and diverse portfolio of emerging and frontier equities that accounts for 25 per cent of the total equity portfolio. The pension fund doesn’t copy the market cap allocation to these markets because it doesn’t want disproportionate exposures to any one country, sector or factor, Ghosh explains.

The allocation rests on his belief in the link between nominal growth and returns on shares from these markets, and the fact that emerging-market growth will come with a demographic tail wind that isn’t present in developed markets and countries. Frontier strategies focus particularly on favourable macro landscapes in emerging economies, he explains.

“We are with one manager who was one of the first to invest in Africa but when the macro landscape moved against Africa, investment shifted to the Middle East,” Ghosh says. “This has worked its way through and we are now putting money back into Africa.”

It’s a regional approach that also focuses on idiosyncratic opportunities in individual countries, which have recently included Vietnam and Argentina. Frontier investments focus on listed equity but, in Africa, steer clear of subsidiaries of large multinationals, where much of the hot money in frontier markets collect.

“If you stick with these well-researched names, you are at the mercy of hot money flows and can buy into overvalued assets.”

Leave active managers to it

All the pension fund’s assets are managed externally, and Ghosh makes no attempt to modify or influence selected manager strategies because he believes it leads to bad investment results.

“We have a distinct philosophy to hire our managers because of the process and approach they have developed over a number of years of experience. We feel if we try to modify or change them it goes against their natural DNA, so we wholly buy into their process.”

About two-thirds of the portfolio is invested in active strategies, where managers are chosen as much for their outperformance skills as their ability to manage risk. Centrica has a different definition of alpha, whereby the pension fund recognises recognises risk savings as much as it does excess returns, Ghosh explains.

“The risk savings piece is materially important because we experience most pain in sharp equity downturns, so if we have managers curtailing that downside, that is materially valuable to us. If a manager can match the index in terms of return but do so with only two-thirds of the volatility, we classify that as alpha as well. We have a large amount of equity capital with fund managers who we expect to do materially better on the downside.”

The fund posted a five-year return of 10.3 per cent.

These kinds of strategies, which combine outperformance with lower volatility and a bias to capital preservation, include allocations to gold or investing in corporate and government bonds to conserve capital when the market is elevated. The pension fund also invests in big blue-chip names that can compound earnings.

“When markets fall off, people stick with these names because they feel they will survive a downturn,” he says. Similarly, the smart-beta portion of the passive equity allocation focuses on material savings on the downside via maximum diversification.

“It means we are getting equity risk premia in the most diverse way and get two-thirds of the volatility of the equity market.”

Go for cash flow

Over the last seven years, Centrica has also steadily boosted its allocation to assets that provide cash flows to match its long-term liabilities. It’s a strategy that views liability management as a cash-generating activity rather than a hedging activity, and assets include ground rents and social housing in a portfolio that now accounts for 11 per cent of assets under management, well in excess of the average among pension schemes.

“We will need more of these types of assets and will take our time in selecting and picking up well-priced assets over next 30 years on our journey.

As for other uncertainties on the horizon, the pension fund isn’t planning any strategy changes around Brexit. After the UK’s vote to leave the European Union, gilt yields moved lower, hitting Centrica’s funding level, and the pension fund was also affected by sterling’s depreciation. It left the fund having to find money to post as collateral against currency hedges for a short time.

“The situation reversed and we got that money back,” Ghosh says. “It was more short-term noise rather than long-term investors. Today, we default to our long-term asset allocation and rest assured that we are properly diversified.”

Jim Craig has been the chair of the A$103 billion AustralianSuper investment committee since April 2017. He has been an independent member of the board since 2016 and brings a wealth of financial services knowledge from his many years at Macquarie Group. He talks to Amanda White about principles and strategy for Australia’s largest superannuation fund.

Amanda White: Let’s start by looking at the AustralianSuper investment committee and its structure and decision-making. Can you tell us a bit about how you make decisions, and how you delegate decisions to the investment team?

Jim Craig: AustralianSuper’s investment governance framework provides a clear set of delegations, from the board to the investment committee, and down to [chief investment officer] Mark Delaney and members of the investment team.

The delegations were restructured in 2017 into the form of mandates, both for each investment option the members invest in and each asset class. These are formal mandates and look like they would for an external provider.

Under this structure, the investment committee retains oversight of key investment decisions, such as key strategies in the portfolio, key parameters such as investment return objectives, risk appetite, liquidity limits and large strategic investments.

This is an evolution in our governance to be as clear as possible, which is appropriate, given our size.

Given the continued low-yield and low-return environment, are you looking at your strategic asset allocation in a different way and making any changes?

During 2017, the fund did a number of things. We reduced the portfolio’s exposure to unlisted assets – particularly property and credit – given valuations. We were close to our limit in unlisted, at about 33 per cent of our asset allocation. We are now at about 25 per cent.

The fund rotated these proceeds to equities, to take advantage of the improved earnings outlook and improvement in global growth. We also increased our exposure to cash to maintain flexibility.

Looking forward, our asset allocation is driven by our view on economic growth,
which we see as slightly positive, the impact of risk factors such as rising interest rates, and the valuations and return outlook.

It is now a well-versed story that your fund is aiming to have about 50 per cent of equities managed internally by 2021. What is the role of the investment committee in holding those internal teams to account and how are you doing that in practice?

The investment committee has a key role in ensuring that the performance is as good, or preferably better, than using external managers for the same strategy. Pleasingly, although it’s early days, to date this has largely been the case.

The investment committee is responsible for reviewing and approving any new internal strategies, and in initial phases we had a subcommittee providing greater oversight and advice on the establishment of the program.

For example, for the last two years, we have been looking at an internal quant strategy. The strategy was reviewed by the sub-committee, and they had two or three meetings looking at it. Once they were comfortable, it went to the investment committee for approval, before we allocated a small portion to it. It then went back to the subcommittee to review and monitor, to make sure it was doing what we wanted. Then we made a larger allocation.

Can you tell us a bit about what is strategically important to the investment committee at the moment and what in particular you are spending time on?

At the moment, our focus is around key medium-term strategic issues, the oversight of the investment program and the internal management program. For example, we are putting a lot of work into a set of ownership principles that clarify our approach to governance of assets.

These will be AustralianSuper specific, and will guide us and the investment team in our governance of the investments we make.

We have a separate set of investment beliefs, but the ownership principles will deal specifically with being an owner of assets.

So let’s explore that a bit more, can you tell us about how you conduct your engagement, what processes and practices you have put in place to monitor listed companies, how you effect change and what impact that is having?

AustralianSuper uses an extensive engagement program that works on two levels. The fund’s equity team meets with the management and directors of a range of the companies in which we invest. This is often either part of an ongoing dialogue about future strategy, or we meet to discuss specific issues that might arise from time to time.

The other level of engagement is through the investment governance team that manages our active owner program. Last financial year, the team attended or supported 272 meetings with ASX-listed companies, on material ESG issues, directly or via our engagement partner, the Australian Council of Superannuation Investors (ACSI).

In relation to directors of listed companies, we maintain a database of each director of ASX 300 companies, evaluated against shareholder returns and our assessment of ESG performance.

In the Australian market, your largest positions are with the big four banks, BHP, Telstra and Wesfarmers – with the largest position being Commonwealth Bank. How are you reacting to the royal commission and are you making any changes to your holdings, given what is coming out of it?

I can’t comment on individual stocks, but in broad terms, AustralianSuper is a long-term shareholder and wants to see boards act in the best interests of staff, customers and shareholders, as this is the only way to build long-term value. For too long, boards have put short-term targets above other key strategic interests.

AustralianSuper is the largest, and fastest-growing, fund in Australia. Clearly that size can be an advantage, but it can also be a disadvantage. Can you talk a little bit about how you are overcoming those obstacles?

Our growth has been carefully managed over the last few years. A key factor is that we have an ethos of wanting to be bigger to be better, we are not interested in growth for its own sake. Another key is the fund’s culture. Every decision and action we take is through the prism of whether it is in members’ best interests.

For example, we had a debate for years about divestment from tobacco. The whole discussion was about what was the right thing to do for the members.

Can you talk a bit about how you are working with external managers and how you will work with them? What you expect from them and how you negotiate fees and alignment of interests?

Our medium-term goal is to move towards having 40-50 per cent of members’ assets managed internally.

Given this is only half of members’ assets, external managers will continue to play an important role in the remainder of the portfolio, particularly in the context of a global portfolio. However, what external managers do for us will continue to evolve.

Our position on fees is largely unchanged as we grow. We want to see value for money in the net returns our members get from fees spent. Further alignment of key investment decision-makers within external managers is critical.

What is your advice for how to chair an effective investment committee meeting?

It is important that the committee respects a diversity of views from the internal team, external advisers, sponsors and independent committee members.

Good governance is achieved only by debating genuinely diverse opinions with respect.
Who are your most important mentors? who do you turn to for advice now?

I have been lucky enough to have worked with many great investors and inspiring business people. It wouldn’t be appropriate to pick one or two, as it is a network of mentors that has guided me.