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One year on and the job of trustees gathered at the United Kingdom’s National Association of Pension Funds, NAPF, annual investment conference in Edinburgh hasn’t got any easier. As the search for optimism in a low-return world endures, the conference seems to be caught in a time loop. Compared to last year, deciding on the best allocations is just as tricky, liabilities have got worse, the impact of longevity on investment strategies is still worrying and inconclusive, and complex and costly regulation threatens just as tight a stranglehold. Trustees say they face the same old problems. The grim outlook suggests the time has come to start doing things differently, and some funds have responded with an encouraging sense of adventure.

Anyone for an equity ride?

However, any glimmer of hope that the resurgence in equity markets could signal better long-term returns, or the beginnings of a great rotation from bonds to equities, was snuffed out early on by the London Business School’s Professor Paul Marsh. Based on stock-market data gathered over the last 100 years, Marsh and his colleagues don’t expect equities to generate any more than 3-per-cent returns for the next 30 years. He predicts a structural shift in the pension landscape as schemes merge, managers are paid less and contribution rates rise. “You shouldn’t live in denial that equities can bail you out,” he said. “Those managers that are saying they can produce 7-to-10 per cent a year should shade them down. Pension schemes in the US forecasting equity returns of 10 per cent are plain crazy.”

Even without the gloomy historical context, managers trying to drum up enthusiasm among trustees for a bumpy ride with equities have their work cut out. Apart from the biggest pension funds, like the £34-billion ($50.68-billion) University Superannuation Scheme, which has a higher than average 54-per-cent equity allocation, most UK schemes now hold more bonds than equities. A decade ago they owned 20 per cent of the FTSE. Of course schemes that rely on defined contribution by individuals still like equity assets, but defined-benefit schemes will continue to shun stocks, match liabilities and hedge against inflation with UK inflation-linked gilts, says Martin Mannion, chairman of NAPF and director of pensions finance and risk for pharmaceutical group GlaxoSmithKline’s UK pension scheme. In a vicious circle, de-risking defined-benefit schemes’ steady flock from equities to fixed income will have an increasingly profound impact on growth and economic activity for the UK’s biggest companies.

No gilt lily

But gilts aren’t necessarily the answer either. In the words of one delegate, trustees are crossing their fingers and hoping, rather than grasping the nettle. Everyone knows how the price of gilts has been driven up by funds’ searches for safe havens and successive rounds of quantitative easing. It has exacerbated the pressure on prices and yields, with many pension funds seeing their deficits increase as yields plummet. To add to the problem, anticipated rises in UK interest rates – at historic lows for years now – means the bond outlook is growing darker with a forecast fall in prices and the worry for funds of losing money.

The alternative long-term adventure

Alternative investments for closing and maturing defined-benefit schemes after long-dated and illiquid assets could be corporate bonds, real estate and infrastructure with inflation-protection characteristics. The answer for other schemes has to be bigger global allocations and more investment in non-traditional asset classes. Funds should revisit their risk appetite in search of returns and adopt a more flexible approach to their asset allocation. Tilt portfolios towards emerging markets or give up liquidity and invest longer for bigger rewards.

Encouragingly, schemes are getting more adventurous. Non-traditional assets now account for 15 per cent of a typical defined-benefit scheme’s asset allocation and more schemes are investing in new diversified growth funds. Assets managed by diversified growth funds in the UK and Ireland rose form $45 billion to $75 billion last year, according to consultancy Aon Hewitt. Funds are also adapting to changed times, such as the planned merger of London’s local authority schemes into one giant fund to create an economy of scale and pack more investment clout.

In the grand scheme of NAPF’s 90-year life, the current poor returns are just a snapshot on a long roll of film. For all today’s angst, pension funds have been investing and paying pensions through world wars, recessions, tumult and innovation and that’s not going to change. But pension funds, cautious and ponderous by nature, must not be gripped by paralysis. As long as the outlook is unsettled, funds should diversify their risks and spread their bets or we’ll all be back in the same place again next year.

When the European Commission announced plans on February 14 to introduce a Financial Transaction Tax (FTT) by the start of 2014, it planted a bomb under Europe’s pension funds. That is not, of course, the view of Algirdas Šemeta (pictured below right), the EU’s commissioner for taxation. He says the proposed tax is “unquestionably fair and technically sound” and will “temper irresponsible trading”, by imposing a levy of 0.1% of the value of share and bond transactions, and 0.01% for derivatives trades.

Yet the Commission’s opinion has been universally rejected by pension funds across Europe, which argue that the FTT will ultimately punish their members. “If pension schemes’ costs are higher because of the FTT, then sooner or later those costs will be passed on to their members,” says James Walsh, senior policy adviser on EU and international affairs at Britain’s National Association of Pension Funds. “For company schemes, it could be that employees and employers will have to make higher contributions and members will have to accept higher retirement ages.”

That may seem unduly alarmist, given that the FTT under the present proposal is a rather smaller beast than the Commission originally intended. The principle of an EU-wide FTT has only been adopted by 11 member states; they include France and Germany, the euro region’s two largest economies, but not the UK, which has consistently opposed the tax. Another conspicuous member state outside the 11-member FTT zone is Sweden, which in 1991 repealed the last of its various financial transaction taxes.

Objections raised

The first alarm bell for Europe’s pension funds and other institutional investors outside the FTT zone is that the tax will very likely still hit them. This is because the Commission, backed by Germany and France, proposes that “the tax will be due if any party to the transaction is established in a participating member state, regardless of where the transaction takes place.” In other words, if a British-based pension fund buys a share, a bond or a derivative inside the FTT zone, the transaction will automatically incur the tax, even though the UK is not a signatory state.

Under this regime, it is almost impossible to imagine any institutional investor with significant euro exposure escaping the impact of the tax, given that Italy and Spain, as well as Germany and France, are inside the FTT zone. The Commission has also closed the door on transactions being defined as outside the zone if one of the parties is in, say, London or Zurich, by envisaging a so-called “issuance principle” where the tax is levied at source as soon as a company issues a tradeable bond or share or writes a derivatives contract.

Impact on funds

Why, though, are pension funds in particular so exercised about the impact of the proposed FTT? The answer starts with last year’s position paper on the FTT by Pensions Europe, the umbrella organisation for the region’s pension funds. It stated that “pension funds and institutions for occupational retirement provision generally fulfil a social function” as not-for-profit entities with the “sole purpose” of providing workplace pensions for their members. On those grounds, Pensions Europe argued that pension funds should be exempt from the FTT, whose justification is to claw back from banks and other financial investors the costs of bailing them out during the 2008-9 crisis.

So far, the Commission has dismissed this argument, describing pension funds as “important actors on financial markets… in direct competition with other investment funds, such as index funds shadowing stock exchanges or bond markets.” Gert Kloosterboer (pictured below right), a spokesman for the Netherlands’ Pensioen Federatie, says this refusal by the Commission to exempt pension funds justifies the Dutch government’s decision to stay outside the FTT zone “as long as Dutch pension funds are not excluded from the tax”.

The Commission goes on to note that in any case the impact of the FTT could be” extremely limited” for “conservative fully funded pension funds”, of which it clearly approves. According to Brussels, such funds “typically follow low-risk investment strategies that are mainly reflected in buying bonds or shares when they are issued and holding them until maturity”. This glosses over the fact that many conservative pension funds since the 2008-9 financial crisis have adopted more active investment strategies, with a higher volume of transactions, in order to meet mandated return targets.

Disincentivising derivatives?

Pension funds across Europe are also infuriated by the way the Commission has lumped them in the same box as high-frequency traders and hedge funds to justify the proposed FTT on derivatives transactions. The view from Brussels, supported by France and Germany, is that the FTT will discourage speculative trading on Europe’s derivatives exchanges that increases market volatility. Yet as Pensions Europe stated in its 2012 position paper on the FTT, “pension funds use derivatives for risk-mitigating purposes. The FTT will lead to a disincentive to use derivatives, which may imply higher risk for pension funds, IORPs [institutions for occupational retirement provision] and their beneficiaries.” Walsh suggests reluctance by pension funds to use derivatives as insurance against currency risk and other investment hazards may be particularly strong because of the perceived danger of an FTT chain reaction. As Walsh points out, the sheer volume of transactions in futures, swaps and other options is because they are so often hedged by further trades.

Harmonisation an elusive goal

It seems from the EU taxation commissioner’s confident statements about the FTT that pension funds have lost their case for full or partial exemption. On the bleakest outlook, they are now faced with a countdown to next January, when the tax will be introduced. The hope in the pension industry, as with other investors, comes from the curious fact that while only death and taxes are supposed to be certain in life, Brussels sometimes fails to deliver on its tax proposals.

Šemeta’s announcement on February 14 was meant to kick-start a process in which the 11 signatory states would finalise the small print of the FTT so that the new tax could be implemented. But in the EU, where tax harmonisation is an elusive goal, that is easier said than done. “There is not much evidence so far of a collective political will among the 11 member states that want the FTT to develop a coherent tax,” says Peter Sime, head of risk at the International Swaps and Derivatives Association in London.

If the FTT’s introduction is delayed, Šemeta faces another problem. The Commission’s term, including his own, expires in October 2014. Given the snail-like pace of EU processes, that leaves the EU’s tax commissioner with little time to adjust the FTT timetable if he encounters further obstacles. In principle, there is nothing to stop a new Commission taking over the task of pushing through the FTT where its predecessor left off. Yet a host of political uncertainties, from this September’s German federal election to the EU parliament elections in June 2014, could sap the will in Brussels and across the 11 FTT member states to introduce the tax. Pension funds, like all financial investors, thus have a strong motive to carry on lobbying against the tax – if not to win the argument, then at least to drag out the arguing till the Commission runs out of time. For as any EU lobbyist will confirm, once a proposal is kicked into the long grass in Brussels, it very rarely returns.

For many people their most memorable in situ news moment is when man landed on the moon or when John Lennon, Princess Diana or Michael Jackson died. But most Italians will remember where they were when Pope Benedict XVI resigned. A country with record unemployment, no head of state and no head of the church was an interesting location to host a corporate governance conference where issues of leadership and strategy are key.

But politics and religion aside, 280 delegates made up of asset owners, managers, corporates and proxy voting firms from around the globe convened in Milan to attend the International Corporate Governance Network event, to discuss the relationship between investors and corporations, and how to promote best practice in corporate behaviour.

The conference, hosted by Borsa Italiana, centred around the topics front of mind for investors with regard to corporate governance: remuneration, proxy voting and gender diversity on boards.

There was much discussion of the role of regulation and legislation in regard to corporate governance and Ugo Bassi, director general of internal market and services at the European Commission, says in its work on corporate governance the commission will focus on transparency but will not have prescriptive rules.

“A lot can be done through the information a company provides to an investor and vice versa,” he says.

Not surprisingly, long termism was also a key theme and how to counter the short termism in “incentive structures and thinking that is undermining capitalism”.

Bassi says that shareholder engagement is not an objective of the European Commission as such, rather it aims to create the conditions for improvement of shareholder engagement.

“We will fight short termism,” he says. “You can’t oblige a shareholder to engage but when they are willing, we want them to do it easily.”

There is scope for European legislation directing asset owners who issue mandates to service providers in Europe to say that they have “thought through” what they want their asset managers to engage with companies on, ICGN conference delegates heard.

Peter Montagnon, senior investment adviser of corporate governance at the UK Financial Reporting Council, says there needs to be improvement on the integration of investor engagement with corporate governance and corporate decision-making. He says the stewardship code is a vehicle for empowering asset owners to tell their managers what to focus on with regard to corporate governance, but there was scope for European legislation to this effect.

Montagnon was part of a panel discussing whether there is a “return on engagement”.

“Investors need good long-term sustainable returns and there is a better chance of doing that if you engage,” he says. However he did point out the reputation of institutional investors with regard to engagement was hindered by the recent vote in favour by investors of the Royal Bank of Scotland’s takeover of ABN Amro.

Speaking from the floor, chairman of GMI Ratings, Rick Bennett, asked whether the question of a return on engagement should be more on the expense side rather than return side. “The question is not whether there is a return on engagement, but is it a sufficient return for those doing the engagement? The question should be on the expense side, who’s paying for it? The return goes to everyone, so there is a free rider problem.”

Montagnon says this was an excuse that asset managers use and that it “makes me upset”.

“Your duty is to act in your clients’ interest and if that costs you then that’s part of it. Managers spend a fortune on dealing commissions without ever questioning it. When asset owners issue mandates, maybe they should outline how much they are willing to spend on dealing commissions and some of that money could go to corporate engagement.”

Montagnon says generally there is an overemphasis on executive remuneration with regard to corporate governance issues and there should be more time spent on issues of strategy, audit committees and risk.

“Stewardship is not about big rows about remuneration. It’s a pity the focus is so strongly on remuneration. You don’t get good long-term quality relationships with a company if all you talk about is remuneration,” he says.

Neither is stewardship about ESG, according to Montagnon.

“Stewardship is not about opening a door to a social policy. ESG is important but the primary purpose of stewardship is to get a deeper understanding with and between companies about risk management and decision-making, and a relationship with board and management,” he says. “We have loss sight of this, with too much emphasis on deal making, trading and short-term profits.”

Asked to vote on the most important engagement issue between companies and investors, 65 per cent of the audience said strategy, 30 per cent said risk management, and 5 per cent said remuneration.

The European Securities and Markets Authority (ESMA) has developed a set of high level principles with the aim of encouraging the proxy voting industry to develop its own code of conduct.

Speaking at the ICGN conference in Milan, the head of the investment and reporting division at ESMA, Laurent Degabriel, said it will set a deadline of two years for a code of conduct to materialise.

The high level principles are:

Responsibility for voting lies with the investor
Potential conflicts of interest should be dealt with and disclosed
The methodology and information behind voting policies should be disclosed
Local market conditions should be taken into account in voting advice
Investors should be informed of how advice is developed and of any limitations it might have
Engagement with issuers should be disclosed.

“It is a new thing for us to come up with a code of conduct, and it is important that it is drafted and owned by the proxy voting industry. We are at the beginning of the process. If after two years the result is dissatisfactory, ESMA can consider a different regulatory approach or the EC may consider taking action,” Degabriel says.

The proxy voting firms participating in the panel, Glass Lewis and ISS, both agreed with concept of a code of conduct. Katherine Rabin, chief executive of Glass Lewis, which is a fully owned subsidiary of the Ontario Teachers Pension Plan, says she was very supportive of developing a code of conduct. “We think it will facilitate a better understanding of the voting process,” she says. “I’m also excited about the prospect that the code will create a platform for other issues, particularly the ‘plumbing’ issues that effect many participants.”

The panel also discussed the misunderstanding of the role of proxy advisers among the wider community, as well as the use of them by investors. Frank Curtiss, head of corporate governance at RPMI Railpen, says the fund uses many advisers, including Glass Lewis and Manifest, as well as Governance for Owners for engagement in Europe and Japan.

Railpen, which has been an active voter of its UK holdings since 1992, also has a voting and engagement alliance with fellow UK asset owner, USS. If the two investors are to vote no or abstain from a vote, they write to the company beforehand to explain why. “We are invested in 2000 stocks around the world, and we have a team of two people on voting and engagement. We have to have a system of filtering and streamlining that, so we turn to external proxy advisors,” he says.

Curtiss says this activity does not bypass its funds managers – all of its assets are managed externally – and it expects its funds managers to do direct engagement.

He says the work of ESMA, and the focus on full transparency is a good thing and a code would be helpful.

For a pension fund that describes itself as “ponderous”, the $154-billion California State Teachers’ Retirement System, CalSTRS, has moved uncharacteristically swiftly in recent months. The second largest public pension fund in the United States, the plan for teachers and faculty is in the process of divesting its holdings in gun manufacturers following the massacre at Sandy Hook Elementary School in Newtown, Conneticut last December. “CalSTRS is a teachers plan, so for our members it hit home that teachers were killed protecting their students,” said general counsel at CalSTRS, Brian Bartow, during a recent webinar hosted by ESG research and ratings provider, MSCI ESG Research. Adding how the tragedy had extra resonance given California’s own stricter gun laws, he said: “Because the weapon used is illegal in the state of California, we asked ourselves should we own this asset?”

CalSTRS’ initial step, instructing private equity firm Cerberus to sell its 2.4-per-cent stake in Freedom Group, the manufacturer of the Bushmaster rifle used at Sandy Hook, happened quickly. “Cerberus decided to sell the asset. They are finding another buyer for their stake in Freedom Group,” says Bartow. Now the fund is in the more complicated process of trawling its entire portfolio, including a 50-per-cent equity allocation and a 14-per-cent private equity allocation, to locate all exposure to gun makers.

As CalSTRS tracks down its different firearm holdings, it is applying a so-called 21 Risk Factor Policy, adopted in 2008, which seeks to flag social and geopolitical concerns regarding investments. “It is not a divestment list as such, but is there to trigger thoughtful evaluation of our investments,” says Philip Larrieu, senior investment officer at CalSTRS. Stress tests include gauging whether a risk factor is “violated over a sustained period of time”, whether the asset causes the fund to lose revenue or the investment “weakens the trust of members”. The divestment process begins with the fund pursuing “active and direct” engagement with the company “to try and bring about change” – a process that soon hit the buffers when gun makers Sturm, Ruger and Company and Smith and Wesson, identified within CalSTRS roster of investments, declined to meet. “We reached out to two groups publicly but no dialogue ensued. Others have answered questions by email,” says Larrieu, adding that shareholder meetings weren’t a viable alternative approach either. “We couldn’t wait for this,” he said. In a final step towards selling off the assets the fund is currently evaluating input from a cohort of managers, advisors and experts, with the ultimate decision to divest taken by the board investment committee, meeting this April. “We are still in the divestment process, gathering all the information the board needs to make an informed decision. The actual divestment comes at the end of this process,” said Larrieu.

Trigger-happy divestors

CalSTRS’s move has encouraged other funds to flex their financial muscles and push the issue of gun control. New York State Common Retirement Fund has frozen its holdings in firearms makers and the $254-billion CalPERS, the biggest pension fund in the US, has approved divestment of assault weapon makers in its portfolio. Client requests for ESG and screens relating to firearms manufacturers and retailers have also spiked. “We have seen a surge in interest from clients post-Newtown,” says Christopher McKnett, vice president and head of ESG at State Street Global Advisors.

In other examples, New York City, Chicago (where Mayor Rahm Emanuel is urging all city plans to divest from firearms makers), Philadelphia and Los Angeles are all conducting divestment reviews. Funds aren’t just targeting the US firearms industry either. “We’re evaluating foreign companies and have told our managers that we can’t purchase these securities either,” says Larrieu.

Fixing the sights

But defining the firearms sector and gauging where to draw the line on a spectrum that ranges from ammunition manufacturers and retailers to unpicking complicated corporate structures is challenging. “Some clients have their own internal capacity to decide their investment universe or they will rely on managers to provide the information,” said McKnett. Screening out firearms manufacturers in actively managed equity funds also means having to find returns elsewhere. “Active funds are already using screens to select stocks. If you exclude a favoured investment the challenge is replacing that alpha,” he said, adding: “If an active portfolio has an exclusion, we don’t adjust the return budget.”

That said, firearms companies aren’t significant equity weights, with only three firearms companies carrying a market capitalisation above $3 billion. Fewer than half of the 20-odd publicly traded companies worldwide that manufacture firearms and ammunition are large enough to be included in commonly held indices. Total portfolio exposure of firearms companies in the main indices is typically well below 0.50 per cent on a market-capitalisation-weighted basis, according to MSCI. Similarly, most firearms groups issuing bonds would be too small to be captured in fixed income index, Barclays Capital Aggregate Bond Index. However, if funds choose to screen out retailers it will have a bigger impact on the portfolio, explains McKnett. Gun retailers, like supermarket giant Walmart, the largest gun retailer by virtue of its size, can be much larger. The retailers tracked by MSCI say firearms sales account for less than 15 per cent of their total sales – Walmart says less than 1 per cent of its sales come from firearms.

It’s too early to measure the impact of screening out some, or all, of these groups on portfolio performance. But by beginning a divestment process, big institutional investors have made gun control a campaign that could sit alongside the likes of apartheid, terrorist links or tobacco. “Other issues have carried more advanced warning and we have known about them ahead of time,” said Bartow. “This issue has evolved very rapidly, but it really is something that public pension funds can look at.”