Encouraging the widespread corporate adoption of a majority-voting standard, promoting diversity on boards and collaborating to improve the way funds report environmental performance are just some of the focuses of the CalSTRS corporate governance team.

Anne Sheehan, CalSTRS’ director of corporate governance, talked exclusively with top1000funds.com about what the key issues are for the self-described “activist investor”.

Sheehan’s team is fresh off the success of its program to encourage more small companies in the Russell 2000 stock market index to adopt a majority-voting standard.

It is a program they plan to continue rolling out in the coming years.

The majority-voting standard requires that a sitting board member receive a majority of the shareholder votes cast in order to continue serving as their representative.

CalSTRS reports that it engaged 95 companies to adopt the standard in the 2012 proxy season. Of these companies, 82 adopted a majority-voting standard.

Sheehan explains that the fund decided to move beyond the typical large-cap companies that make up the S&P 500 to the plethora of smaller companies.

Less than 10 per cent of companies in the S&P 500 index still maintain a strict plurality standard, by which a nominee can be elected with a single affirmative vote.

More than two-thirds of companies in the Russell 2000 maintain a plurality vote standard.

 

Small cap shift
CalSTRS argues alignment of interest is greater between boards of directors and shareholders when elected under a majority, rather than a plurality, vote standard.

“A couple of our colleagues at other public funds were focusing on those remaining S&P companies so we thought, all right, let’s go to the next tier down, where majority voting is not as prevalent as it is in some of these bigger companies,” Sheehan explains.

The fund decided on which companies to target its engagement efforts by looking at where it had the most influence, both in terms of the size of its holdings as a percentage of total shares outstanding and their total dollar size.

The same screening methodology will be used for its next tranche of companies, with letters set to go out to another 100 companies next week, Sheehan says.

“We will march our way down the Russell 2000,” she says.

A spokesperson for the fund says CalSTRS has approximately  92.5 per cent of its US equity market investments in companies in the Russell 1000 index and 7.5 per cent in companies in the Russell 2000.  With CalSTRS having about $55 billion invested in US equities, this translates to a roughly $4 billion exposure to companies in the Russell 2000.

 

First-time engagement
More than a third of the 95 Russell 2000 companies contacted in the 2012 proxy season adopted majority voting without a proposal being filed.

Sheehan explains that for many companies it is the first time they have had direct engagement with a large active owner like CalSTRS.

“Many of these companies have never received a shareholder proposal, some may have not have heard from a big institutional investor like us, an activist fund,” she says.

“They may have a fund that is a large institutional investor, but it may be a fund that has a different focus.”

As part of its majority voting engagement this proxy season, CalSTRS submitted 61 proposals related to majority voting on corporate boards, with 48 withdrawn after the companies made significant progress towards implementing a majority voting standard.

Of the remaining 13 proposals, nine were passed with more than 75-per-cent average shareholder support, CalSTRS reports.

“If you put this stuff on the proxy, the shareholders are going to support it,” she says.

 

A say on pay
Reflecting on the recent voting season, Sheehan says that the fund is seeing a lot more focus on the directors of companies, with their election no longer the rubber stamp it once was.

“I see much more focus on director votes over the past couple of years than we have in the past,” she says. “I think directors are beginning to understand that they are getting much more of the focus and attention.”

Sheehan observes that companies have become much more responsive to investors, especially in dealing with compensation issues.

The new Say on Pay regulations are one reason Sheehan cites, with companies keen to avoid a failed vote.

CalSTRS sent letters to about 120 companies whose shareholders voted no on compensation and received a 100-per-cent response.

“We have a lot of discussion with companies, including board and compensation-committee members, about their compensation structure. So I have to compliment the companies on being responsive to that because they believe that a failed say-on-pay vote, or even poor showing on their compensation, does not bode well for them in the future.”

“We have seen changes – more can be done – but acknowledgement is the first step.”

Sheehan says that the focus on compensation has generally moved beyond the typical perks and gross-ups that used to be what she describes as “shareholder irritants” to honing in on aligning pay with long-term performance.

 

Duelling with dual-class shares
Corporate board members are also having to turn their minds to who is sitting next to them, with investors such as CalSTRS pushing for more diversity on boards.

In keeping with a broader strategy of collaboration, CalSTRS has teamed up with fellow giant Californian public pension, CalPERS, to take on a leadership role in pushing for greater diversity.

This involved the launch of the 3D database of pre-approved board candidates that emphasises people with fresh ideas and new perspectives. 3D stands for Diverse Director DataSource.

The database project is conducted in partnership with GMI Ratings – an independent provider of global corporate-governance ratings and research – and is, according to the funds, an attempt to provide a market-based solution to the supply and demand issues concerning suitable board candidates.

Sheehan says that as the fund starts to evaluate its most recent proxy-voting season and turn its mind to its strategy leading up to the round of voting next year, the key concerns of majority voting, diversity and the performance of corporations on environmental and sustainability factors remain a priority.

After vocal opposition to News Corp’s dual shareholding, Sheehan says the question of equal shareholder rights for all owners in a company also remains a concern.

The fund has observed that tech companies in particular are favouring dual-class shares, and Sheehan says that has spurred the fund into action.

“We have a concern with dual-class shares, where not all the voting rights are equalised. Some of the companies in Silicon Valley have gone down that path and it is a concern to us,” she says.

“Media and tech companies seem to like this strategy and we continue to have discussions around that because we do believe that in the long run, the market does discount that [dual-class share structures].”

Florida’s State Board of Administration (SBA) has appointed Mercer to conduct a broad-ranging review of staff compensation that was initiated and will be overseen by the organisation’s independent investment advisory council.

As part of this review, the investment advisory council (IAC) passed a motion at its recent quarterly meeting to provide annual recommendations to trustees on the executive compensation of about 15 top investment staff.

This includes the heads of various asset classes, as well as Ash Williams, the former hedge-fund executive who holds the powerful dual roles of executive director and chief investment officer at the SBA.

Williams, who advised the council at its meeting last week, voiced his objection to recent moves by some public pension funds in the US to cut back bonuses when funds lost money during market downturns.

 

What Williams said
CalPERS is one such fund that provides discretion to trustees to reduce or eliminate investment-staff performance pay in years of negative performance.

This process came about through a similar review of staff compensation also conducted by Mercer.

Responding to questions from the council, Williams noted that to retain staff it was vital that any bonus structure was maintained, regardless of whether the fund lost money in absolute terms.

“The broad history of compensation at public pension funds, more in the US than anywhere else, has been, unfortunately, one where when times are tough and markets are down, for example, [incentive] programs may be abridged,” he said.

“The argument is that – notwithstanding that your relative performance may be statistically and demonstratively excellent and that you added value by protecting capital in an adverse market – if the absolute return was flat or negative, then there have been situations in other jurisdictions where public funds’ leadership has chosen to simply abridge whatever the agreement has been with the affected employees.”

Williams noted that the IAC would be limited to recommending executive pay, with the final decision resting with trustees.

“I think what we would need to do here is create something with enough institutional dignity and have the communication process be thorough enough on the front end of this so that it is understood in order for this to be a credible and effective program at recruiting and retaining the talent you want. But it has to be honoured, however, at the end of the day the trustees can do what they want.”

Williams has been a long-time advocate for increased pay levels for staff at the SBA, the organisation that as of the end of last year ran more than $149 billion in assets over 30 funds.

His pay packet is reported to be $325,000 a year, with the capacity to earn an additional 8 per cent of this salary – or $26,000 – as a performance bonus.

Williams complained to the council that his pay was one of the reasons why he left the fund after a six-year stint in the early 1990s.

“In the six years I was here in the 1990s, I had one raise and, to be honest with you, that was one of the reasons why I wasn’t here for 12 years,” he told the committee.

Williams says the current arrangements in which the trustees decide on pay of executive staff put them in a “tough spot”.

The pay of executives at the SBA has been the focus of politicians in the state’s legislature, which has been particularly vocal during periods when the funds managed have lost money.

The State Board of Administration’s most recent operating budget reported that the fund spent about $18.3 million on staff salaries and benefits.

 

Managing potential conflicts
The Mercer review will examine the compensation of about 100 staff.

The consultancy will look at comparative pay rates in similar public and private sector organisations as well as whether pay and incentives align with the objectives of the SBA and its stakeholders.

Members of the IAC stressed the need for the 9-person council to take an active oversight role in the review, noting that it should be at arm’s length from staff.

Mercer already acts as a consultant on manager selection and oversight in public markets for the SBA and also recently conducted a review of the effectiveness of the fund’s foreign-exchange-trading processes

While Mercer has conducted similar compensation reviews at the Georgia Division of Investment Services and CalPERS, IAC chair David Grain said the council was looking for a tailored outcome.

“I don’t think one size fits all, the fact that they were successful and had good references from CalPERS and Georgia doesn’t mean that we want the same product that was produced for them,” Grain said.

“Ours is going to end up being unique in my view.”

In its review of compensation at CalPERS, Mercer recommended a simplified system of incentives for investment staff that would increase transparency.

The SBA reports that it last updated its pay grades and ranges in 2006. In 2009, the SBA engaged consultancy McLagan Partners to conduct a review of salary and compensation levels across the organisation.

The New York-based consultant found that the average salary of SBA investment staff was 40 per cent below that of staff at other comparable state pension funds.

In a request-for-quote document sent to potential candidates for the compensation review, the SBA details that “a modest incentive program for certain investment staff has been in place for much of the last decade, but payouts under the program have not been budgeted for several years”.

Institutional investors are turning their attention to Asia, with CalPERS the latest large pension fund to announce a new foray into the region.

America’s biggest public pension fund this week announced it would invest $530 million in two new real-estate funds targeting investments in China.

Despite concerns about a residential property bubble in China, CalPERS’ chief investment officer Joe Dear says that the $238.2-billion fund sees the urbanisation and income-growth trends in the country underpinning the strength of its real estate.

“Income growth and urbanisation remain the key themes for growth in China,” Dear says.

“China’s office and retail sectors offer stable rental income and potential for capital value growth.”

 

Heading east
Faced with a laggard US economy and Europe slipping into a grinding recession, large institutional investors are increasingly looking to the Asian region for returns.

The Canadian Pension Plan Investment Board has a long-term relationship with specialist listed-property fund manager, Goodman Group.

Investments include industrial and logistically focused investment in China, Australia and Hong Kong. The ongoing partnership has recently been expanded to investments in greenfield sites in North America.

The $43-billion industry super fund AustralianSuper has also set its sights on Asia and, in particular, China.

The fund’s chief investment officer, Mark Delaney, says the fund now has 45 per cent of its international equities in emerging markets and more than half of this exposure is in Asia.

The fund has also looked to build on-the-ground expertise in the region, hiring a specialist local investment analyst in China.

This year it also launched an Asian Advisory Committee to look at investment opportunities in the region. The committee is chaired by former reserve bank governor Bernie Fraser.

CalPERS’ latest investment continues to build on its exposure to the Chinese property market.

The Californian fund will invest $480 million in the ARA Long Term Hold Fund sponsored by ARA Asset Management, a member of the Cheung Kong Group.

The pension fund will also invest $50 million in ARA’s Dragon Fund II. CalPERS previously invested $500 million in the ARA Dragon Fund I in 2007.

The ARA Long Term Hold Fund will target investments in high quality office buildings in central business districts and retail malls in well located, densely populated suburbs in first and second-tier cities in China and Hong Kong.

The Dragon Fund will primarily focus on retail, office and residential property investment in key cities of China, Hong Kong, Malaysia and Singapore.

CalPERS’ initial investment in ARA’s Dragon Fund I earned the pension fund a 19.2-per-cent return for the one year period ended March 31, 2012, and an annual 8.4-per-cent return over the last three years through March 31, 2012.

CalPERS aims to increase its total-portfolio risk oversight, as well as move towards more dynamic asset allocation as the fund attempts to overhaul its investment decision-making processes.

This week the fund released a two-year business plan that aims to implement a risk-based dynamic asset-allocation approach by June 2014.

It is the first time the $238.2-billion fund has drawn up a business plan over a two-year time frame, with other such plans typically setting out the fund’s objectives on a year-by-year basis.

The 2012–2014 business plan forms part of the implementation of its five-year strategic plan and also details a push to establish a comprehensive portfolio-risk-management system and practices to measure, manage and communicate investment risks.

Stretching out to 2017, this strategic plan sets out broadly ranging goals for the fund, which covers not only investment objectives but the culture of the organisation and its broader societal engagement.

In the plan CalPERS aims:

  • To cultivate a high-performing, risk-intelligent and innovative organisation
  • To engage in state and national policy development to enhance the long-term sustainability and effectiveness of its programs
  • Focus on improving long-term pension and health benefit sustainability.

Hybrid on the horizon
California’s public pension system is under the spotlight after the state’s governor Jerry Brown announced a wide-ranging reform program that would seek to develop a hybrid defined-benefit/defined-contribution system.

CalPERS has engaged in the preliminary policy discussions around this reform program, presenting to the state legislature but is under pressure to ensure a future system does not disadvantage current members and maintains future flows into the fund.

At the end of last year CalPERS reported that it was near a 75-per-cent-funded status, which would result in unfunded liabilities of between $85 billion and $90 billion.

In its latest strategic plan, the fund aims to hone its investment process so that it considers both the asset and liability sides of CalPERS’ balance sheet.

CalPERS outlines 11 objectives in its five-year plan, which include funding the system through an integrated view of pension assets and liabilities, and delivering target risk-adjusted returns.

To achieve these particular objectives it will actively manage and assess funding risk through an asset-liability-management framework, which will guide investment strategy and actuarial policy.

The fund also aims to implement programs and initiatives that improve investment performance and ensure effective systems, operations and controls are in place.

CalPERS will also conduct an asset-liability workshop by June 2013, “leading to potential revisions to the asset allocation by applying a new risk framework”.

 

Stakeholders engaged… to no avail
In January the fund initiated the five-year strategic-planning process. As a key part of this development, an engagement plan was designed to inform and seek input from key stakeholders, including CalPERS leadership, staff, members, employers, member and employer organisations, and government representatives.

A series of meetings with those stakeholders revealed some key themes. For the board and executive staff, the investment themes included continued innovation to balance risk and returns, making an effort to bring down investment operating costs, the importance of considering ESG factors, and that there is a risk of significant drawdown impacting the funding level permanently.

At a pension policy level, it was highlighted that the fund should defend defined-benefit funds and that it should prepare to administer hybrid plans.

It was also noted that CalPERS should defend its stance for a variety of important issues.

However, there was no consensus on what those issues should be. Suggestions ranged from the value of defined-benefit plans to benefit adequacy to policy issues that could impact sustainability.

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