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In 2010 PGGM conducted a study to see if it was possible to reduce the number of companies it invested in from 4000 to 400, based on its environmental, social and governance leanings, and still maintain it’s beta risk/return profile.

The idea was that the €133-billion ($174-billion) fund would better know and understand what it owned, and be able to better control those companies.

That experiment failed in that PGGM realised that while the ESG-based reduction in stock investments suited it’s responsible investment and long-term ownership preferences, it altered the beta profile and skewed the long-term cumulative risk.

The strategy persisted in its active responsible equity portfolios, and PGGM has an aggressive active ownership policy for all its equities portfolios.

However, in passive equities, where 90 per cent of the equities investments reside, about $44 billion in market-cap and smart beta strategies, the dual goals of it’s risk/return profile and responsible investment have been more challenging. PGGM is not alone in this problem, with ESG strategies tending to be active.

But now PGGM has developed an index in house, which measures the 2800 companies in the FTSE All World Index for their environmental and social policy and good governance.

The index re-ranks the companies based on these criteria, which also include a minimum threshold. As a consequence of this, about 200 companies that don’t make it into the index have been sold by PGGM, which amounts to about 1 per cent of the portfolio.

The capital is reallocated to companies within that sector, so the index is sector neutral.

There is a slight bias away from small companies, which don’t make it in to the index straight away. About 80 mid-to-large companies are on watch.

Matching profiles

Managing director of responsible investment at PGGM, Marcel Jeucken (pictured below), says the fund has a clear engagement, voting and exclusion policy, and the new index is an extension of its existing responsible investment activities.

“We believe responsible investment is important,” he says.

The threshold is also important and while he adds it could be higher, Jeucken says the approach is not to choose the top 10 or 50 per cent of companies because then it would need an active investment strategy.

“This is an approach that fits passive,” he says. “It meets our risk/return profile. We have the same beta risk/return characteristics as the past but we now also have an ESG selection instrument on top of our existing ownership instruments.”

PGGM believes that screening companies on ESG factors will reveal early warnings of where things go wrong, and engagement and exclusion can take place.

“We have built a system and a database, and we now better know the companies from an ESG perspective,” he says. “This strategy works if you have a strategy to be an active owner and engage, vote and exclude. The index doesn’t work alone. It is not black and white for us. We don’t blindly follow the index from third party providers as we have created our own ESG index and have an increased effort in engagement.”

The way it works

Last year PGGM voted in 3106 shareholder meetings and talked with 746 companies about improving ESG. It excluded 42 companies.

The new ESG index screens companies on 70 factors, varying from labour practices to climate policy and management or carbon dioxide emissions, and weights those factors to various sectors according to that their profiles.

For example, in banks the screens concentrate more on governance, but in mining it is an environmental focus.

The rule-based model uses external data, but the data points and weights have been determined in house.

Jeucken responds to the debate over whether ESG is a risk- or return-generating strategy by saying there is logic to both arguments, but that return fades away quicker.

However, PGGM has particular views on alpha per se. More generally, Jeucken says alpha is to be made but in small parts of the investable universe, which is why PGGM believes in a strategy of index and alternative strategies, not traditional alpha strategies.

ESG, he says, reduces risk over time – whether it be reputational or financial risk.

According to Jeucken, PGGM is willing to discuss the index with its pension fund peers and is open to the idea of sharing information.

Jan Tamerus, actuary director at PGGM, was instrumental in developing the new Dutch pension defined-ambition structure.

Back in 2006, he was involved in looking at the sustainability of the defined benefit system and in concluding it was not in fact sustainable, the idea of defined ambition evolved.

One of the key reasons for not going to a defined contribution structure is the Dutch social predisposition and, in particular, the focus on intergenerational risk sharing.

“There are two areas we don’t like about defined contribution: the risk sharing, especially the intergenerational risk, and no index targets in the system,” he says, describing defined ambition as conditional defined benefit.

“Our next area of study will be to look at ownership rights, the individual defined contribution way is more attractive to people, but we will see whether we can synthesise from defined ambition to defined contribution, and the only way to succeed in that is to have some solidarity elements in defined contribution.”

Intergenerational risk sharing defined

Tamerus concedes that defined contribution could be a more sustainable system because “you can go with the flow for more individual choices”, but he would like to see defined contribution changed in a way that will have more guidance rules about risk sharing and intergenerational risk in particular. It’s his new area of study.

“In The Netherlands we like intergenerational risk sharing, it’s very important. When we decided defined benefit was no longer sustainable, we looked at going to defined contribution, but there is no intergenerational risk sharing and no target, especially an indexed target, in the contract,” he says. “Those are the two elements why we didn’t want to go to defined contribution, so made defined ambition.

“The defined ambition structure is the same as defined benefit, but we have conditional indexed rights instead of unconditional nominal rights in combination with a policy of indexation. The focus is an indexed pension outcome instead of nominal guarantee.

“By skipping the nominal guarantee, we bring in premium stability and make the contracts shockproof – both elements of defined contribution.

“On the other hand we maintain the intergenerational risk sharing and the income-related target – both elements of defined benefit. Moreover, we make it an indexed target.

“I am very proud of the work but anxious to see it evolve. There is a struggle because some people have commented that we move the risks from the employer to the participants and at the same time take more risks, but that is not the way we will do it,” he says. “In defined ambition, the focus in the investment policy is on stable pension income in real terms,” he says. “Due to the dual focus in the current defined benefit schemes – nominal guarantee as well as an indexation policy – this will not lead to major changes. It is more the liability hedge that should be reconsiderd. Because of skipping the nominal guarantee, the nominal interest rate is less important.”

Managing the transition

The new pension legislation will be implemented in 2015 in The Netherlands, but the Pension Act needs to be ready this year. The first version of that will come out in the summer and put on the internet for consultation.

The details of the structure are such that the defined ambition target is calculated as the risk-free rate plus a risk add, which tries to measure the uncertainty associated with defined ambition compared to defined benefit, minus the indexation target.

The risk-free rate includes the ultimate forward rate, which is an estimate of what the short-term interest rate will be in, for example, 60 years from now. It is currently set at 4.2 per cent.

The indexation target means the benefits in a defined ambition structure will be indexed each year.

This factors in wage growth, so the promise is in real terms rather than nominal terms.

Dirk Broeders, senior strategy adviser at the Netherlands Bank (pictured below), which supervises pensions, says there are two things that are differentiate about defined ambition from defined benefit: it is indexed each year, and it is adjusted up and down based on realised investment returns.

The retirement benefit in the defined ambition system is still linked to the performance of pension investments; it comes out as an income stream annually adjusted to the performance of the investments.

Broeders, who is leading the project on defined ambition advice to government and the project on the communication to the public, says in the future funds can use the nominal contract (defined benefit) or choose the real contract (defined ambition).

“Maintaining a defined benefit system is unsustainable in the future. In an ageing society where people live longer, it is too difficult to promise certain benefit,” he says.

“This is a huge transition, a huge commitment and will put pressure on administration systems to keep track of each individual. It is very complicated and costly but maybe that is the price you have to pay to update your system for the future.”

Japan’s Government Pension Investment Fund (GPIF) has $1.4 trillion in assets and is the world’s largest pension fund. The institutional structure and the investment style of GPIF differ from those of other public pension reserve funds. This article describes how GPIF is structured and how it works,then compares it with Canadian and American public pension reserve fund approaches. Perspectives include the discretion exercised in investment decisions, information asymmetry, and accompanying agency and governance problems.

Read Managing Public Pension Reserve Funds from the Rotman International Journal of Pension Management.

The author, Nobusuke Tamaki, teaches at Otsuma Women’s University in Tokyo and is the former director general of the planning department at Japan’s Government Pension Investment Fund.

Sobering new figures in the latest report to highlight climate risk should resonate with trustees more than usual. According to the second study from Carbon Tracker and the Grantham Research Institute on Climate Change and the Environment, part of the London School of Economics Unburnable carbon 2013: Wasted capital and stranded assets, between 60 and 80 per cent of current fossil fuel reserves listed on world markets can never be used if global warming is capped at the 2-degree-Celsius increase targeted by policy makers. It means pension funds, renowned for their high allocations to oil and gas majors, are in danger of holding stranded assets, investments that have plummeted in value because of regulations to tackle climate change coming into play. Current values placed on many of these companies are based on the future development of reserves – coal, oil and gas groups spent $647 billion on exploitation last year alone, according to the report – yet when governments take action to limit carbon emissions, the exploitation on which these values depend may never be realised.

Lack of political will

Campaigners say galvanising pension funds to put strategies in place to tackle climate risk when many are in deficit or still reeling from the financial crisis is an uphill struggle. Funds have also been slow to respond because the long-term threat to returns still isn’t priced into high-carbon assets. Markets still believe that governments won’t put in place the policies needed to tackle climate change. “Market valuations are discounting policy action by governments,” says Nick Robins, head of the Climate Change Centre of Excellence at HSBC, although he does believe policy confidence is coming back. If so, the market could begin to react to long-term signals.

Other barriers to overcome include a dearth of high quality managers specialising in these asset classes. Passive investment strategies or strategies indexed against benchmarks also make climate risk difficult to mitigate, with current benchmarks coming under particular scrutiny in the report. “More forward-looking financial indicators are required if investors are to translate climate change risk into investment decisions,” argues James Leaton, research director at Carbon Tacker.

Who cares?

Yet amid the increasingly shrill calls for pension funds to wake up to climate risk, a handful of the most high-profile schemes have been leading on the issue for a while. Strategies include introducing climate-risk assessments into reviews, increasing allocations to climate-sensitive assets, using sustainability-themed indices or encouraging managers to proactively manage climate risk. In the United Kingdom these include the £34-billion ($54.7-billion) Universities Superannuation Scheme (USS) and Railpen, inhouse manager of the $30.4-billion pension scheme for Britain’s rail industry. The $3.29-billion Environment Agency Pension Fund, admittedly a fund drawn from employees working to reduce climate change and its consequences, is pushing a strategy targeting a 25-per-cent allocation to the green economy by 2015. “We take climate change into account in our investment strategy, asset allocation and via the fund managers we use – they have to understand climate change risks and opportunities,” says Howard Pearce. As head of the scheme, he urges “CIOs of every pension fund” to read the latest Unburnable carbon report. “Our pension fund seeks to avoid climate change risks and we monitor annually the carbon footprint of our investments,” he says. “Also, we have invested over $380 million in clean technology investments.” Investment strategies at the fund to hedge against climate change include exposure to sustainably managed forestry, farmland and infrastructure, says Pearce.

Others well aware of the issues around climate change and the threat it poses to their investments include Norway’s $582.7-billion Government Pension Fund Global, PGGM and APG of the Netherlands, Australia’s Local Government Super and California Public Employees Retirement System, recently ranked fifteenth out of the 1000 biggest asset owners for its disclosure and best practice around climate change risk. In South Africa, the Government Employees Pension Fund has said it believes its investments are vulnerable after calculating its exposure to fossil fuels.

Where to now?

For schemes only beginning to acknowledge climate risk, a first step is to find out how exposed they are and then to tell people about it. It’s a process that Catherine Howarth, chief executive of campaign group ShareAction, believes is starting to happen through ShareAction’s grass-root activism. It is encouraging pension scheme members to lobby their pension funds on climate risk and Howarth says the debate is starting to get louder. “Awareness is growing, although it is from a very low base. Most trustees haven’t had this bought to their attention by their asset managers, but they are starting to take climate change more seriously.”

Read the report here: Unburnable carbon

This paper from Matt Dobra and Bruce Lubich, of the Methodist University in North Carolina and the University of Maryland University College, respectively, analyses the relationship between governance, asset allocation, and risk among state and local government-operated pension systems in the United States of America. It is argued that governance influences investment decisions and risk profiles of public sector pension systems, creating the potential for agency problems to exist between decision makers, plan members and taxpayers.

Read Public pension governance and asset allocation here.

Namibia maybe one of the youngest countries in Africa but it has nurtured one of the continent’s biggest pension funds into life since gaining independence from South Africa in 1990.

The Windhoek-based N$61-billion ($6.8-billion) Government Institutions Pension Fund, GIPF, accounts for over three quarters of Namibia’s entire pension assets and is the only defined benefit pension fund in the country.

The GIPF draws on a 98,000-strong membership from employees across Namibia’s public sector and, reflective of Africa’s youthful population, its average member is only 41 years old. Currently only 37,000 GIPF members draw a pension.

“Our funding levels are 103 per cent, but would have been 129 per cent if we hadn’t had to provide for reserves,” says Conville Britz, general manager of investments at the fund, which has just concluded an actuarial evaluation for the last three years.

The fund reported a total return of 23 per cent for the year to the end of February 2013 and since 2009 has returned a total of 17.5 per cent. The secret of its success, says Britz, is holding fast with a bold 68-per-cent equity allocation and the fund’s continued ability to invest a third its total assets outside Africa. Switching from balanced mandates to using specialist managers has also helped, he says.

Homeward bound

It’s a set of results that are all the more remarkable given that the scheme has to invest 35 per cent of its assets inside Namibia’s small economy in a strategy set out in Regulation 28 of the nation’s Pension Fund’s Act.

It’s designed to boost the local economy, but is now limiting the growing fund’s investment universe. Namibia’s buoyant but illiquid equity market is a case in point. The GIPF’s active strategy is almost impossible to pursue since most investors buy and hold the 35-odd traded companies on the index. In another example, the government has pushed for pension funds to invest in local private equity to help businesses access finance.

Last year the GIPF agreed to hike its allocation to unlisted equities, but only a fraction of the 10 per cent allocation has been dispersed because of the lack of opportunity and the GIPF’s own inexperience with the asset class, explains Britz.

“The fund lost money investing in early ventures and Namibia’s regulator has now ruled that the scheme must understand the asset class better before investing here again.”

Finding a balance between using its investment clout to nurture Namibia’s own economy but also push for returns in more dynamic markets is common to most of Africa’s other big pension funds. Rules of one sort or another restrict investment strategies, particularly pushing funds to finance government deficits via large government debt holdings.

“The current situation suits us fine, but we could run into problems in the future if the government wants us to invest more locally. We realise that there are developmental needs in Namibia and that as the biggest pension fund we have to lead the way, but we also want to invest more offshore to cover our liabilities,” says Conville.

The offshore allocation is particularly helpful offsetting the effects of any depreciation in the local currency, he says.

The mentor next door

Britz holds South Africa’s R1.17-trillion ($127-billion) Public Investment Corporation, PIC, up as “beacon” for other African funds seeking to get domestic investment right. Referring to strategy at the asset managers of South Africa’s biggest pension fund, the Government Employees Pension Fund, GEPF, Britz says: “The PIC has successfully invested for the development of the South African economy and for returns, but we haven’t aligned our investment strategy with national developmental objectives yet.”

The PIC’s 5-per-cent allocation to Isibaya, a return-seeking fund that seeks a developmental impact is one example. Investments range from $220,000 to $430,000 and include affordable housing, transport and lending to small businesses via private equity.

Despite the pull of investing at home, the South African fund is also investing more overseas. It recently decided to portion 5 per cent of its assets in the wider African context and 5 per cent outside Africa altogether.

Britz says the GIPF uses 25 managers, mostly South African, in active strategies. Investment consultancy RisCura advises on strategy. The fund, which targets returns of 3 per cent above inflation, allocates 26 per cent to bonds to hedge against inflation with allocations locally, in South Africa and to global bond markets in line with its global allocation.

The remaining 6 per cent of its portfolio is in cash. Investing at home sheltered the fund from the ravages of the financial crisis but now the GIPF wants to spread its wings. “We need to make sure our investments make a return,” says Britz.