Pensions World

Will Oulton, Mercer, on how the finance industry’s focus needs to be on long term sustainable growth rather than simply the next quarter’s earnings

The financial crisis and global recession have left champions of free market capitalism facing an increasingly sceptical global audience. The current debate regarding “fair” or “responsible” capitalism often highlights the finance industry as having a transaction based, short termist culture focused on the next quarter’s earnings, rather than an ownership culture focused on long term sustainable growth, underpinned by a system of strong corporate governance. In June, Professor John Kay will issue the final report of his review of short termism commissioned by UK Secretary of State for Business, Innovation and Skills, Vince Cable. The report will include his recommendations on addressing systemic problems in shareholder ownership, including whether the investment chain and its participants are impeding better oversight of companies by their owners.

The issue of ownership and the practices of shareholders in overseeing corporate boards and their activities is a key part of the UK and European focus on stewardship, a term thrust into the spotlight in 2010 when the Financial Reporting Council published the UK Stewardship Code. The code was launched as a result of the Walker Review into the UK banking crisis and is designed to enhance the quality of engagement between shareholders and companies to help improve long term returns to shareholders and the efficient exercise of governance responsibilities.

Executive pay

Fanning the flames of interest in the role and activities of shareholders is the politically topical issue of executive remuneration. Executive remuneration typically generates some newspaper headlines in the build up to the UK voting season, as companies publish their annual general meeting notices and remuneration reports. However, this year is different. The issue has rarely been out of the press since another of Vince Cable’s consultations, on executive compensation, was launched in September last year.

This consultation set out to address four main areas in relation to the setting and monitoring of executive pay which included once again the role of shareholders as well as the role of remuneration committees, the structure of remuneration and promoting good practice.

This consistent focus on the responsibilities and role of shareholders and their stewardship activities is beginning to be recognised by increasing numbers of pension scheme trustees who, when reviewing and updating their Statements of Investment Principles, are adding language referencing the code with the more advanced committing to monitoring whether their asset managers comply with it.

One of the key challenges for trustees is not how to develop a stewardship policy  but how to monitor that the policy is being implemented. The success of a stronger approach to stewardship will not lie in the code per se, but how it influences a change in behaviour from investors to act like owners of enterprises and take a greater interest in the performance of that enterprise.

Lord Myners, the former financial services secretary to the UK Treasury, once noted that “fund managers should be questioned more rigorously on stewardship issues at trustee meetings instead of being left to talk about short term issues like quarterly performance updates”. Although many proponents of corporate governance would applaud this, the reality is that many trustees feel overburdened by the governance challenges of addressing underfunding and managing liabilities and risks. Mercer, however, is actively promoting support of the code with its UK clients to ensure that trustees understand what it is and what it means to them. Our view is that higher standards of stewardship practices by asset managers are consistent with  the long term interests of a scheme’s beneficiaries and to assist them we have also developed a stewardship service with a focus on the assessment and monitoring of investment managers with the code.

Short termism

The topical issue of executive remuneration provides a useful case study of how engaged shareholders may be with the boards of companies. In the summer of 2011, Mercer asked investment managers to explain how they integrated corporate governance considerations into their analysis of a specific UK bank that was proposing to award its senior staff an amount which was greater than its total dividend payable to all shareholders in 2010.

The findings of this survey highlighted that:

• investment managers, with few exceptions, follow the recommendations of proxy voting research providers
• remuneration was not seen as a major consideration in the analysis and views of the bank in question
• the remuneration levels were not seen as overly excessive.

These responses were not completely surprising. Firstly, we know from experience that the majority of investment managers will often follow, without challenge, the advice they receive from proxy voting firms – “intelligent voting” (ie, informed, pragmatic and based on upholding key governance principles) is too often lacking. Secondly, many asset owners, in delegating the investment activities to third party managers, also delegate the execution of corporate governance activities and, by default, adopt the managers’ own policies as their own. This diluted level of engagement, intervention and oversight is arguably part of the reason why, as one example, executive remuneration has been allowed to reflect a bias towards short term actions and inflate to the levels currently in evidence, despite the lack of similar inflation in average pay or shareholder returns.  

However, another factor may be found in the average holding period of equities. As Andrew Haldane of the Bank of England noted in a speech last year, “there is evidence of the balance of shareholding having become increasingly short term over recent years. Average holding periods for [shares in] US and UK banks fell from around three years in 1998 to around three months by 2008. Banking became, quite literally, quarterly capitalism. Today, the average bank is owned by an investor with a time horizon of considerably less than a year.” 

The last time any major changes were made to the way that shareholders oversee executive pay was in 2002. From this point onwards, listed companies were required to publish a separate directors’ remuneration report in the annual report and accounts. In addition, shareholders were for the first time given the right to vote on these reports on an advisory (ie, non-binding) basis.

The objective of the reforms was to encourage shareholders to be more engaged in corporate governance issues in the companies they owned. In some notable cases the reforms were successful, with shareholders opposing proposed payouts to such an extent that the companies proposing them had to return to shareholders with amended remuneration reports. However, the level of dissent against remuneration reports was never above 6% on average in the period 2002 to 2008. 

Responsible investment

The government’s objective throughout this process has been to encourage better stewardship – ie, more active oversight of companies by their shareholders – and address what it has called a market failure in the setting and oversight of executive pay. The challenge for shareholders is to ensure that their interests are protected and factored into the setting of executive pay and to maintain interest as pay policies are designed and implemented. However, executive pay is only one, currently high profile, symptom of a wider systemic industry issue in how investors successfully integrate longer term environmental, social and governance (ESG) factors into their investment processes, analysis and decision making. This process is often described as “responsible investment”; however, it may be that the term “sensible investment” better reflects reality, as it would be hard to argue against the notion that better informed investors should make better investment decisions.

As Mercer analysis shows, less than 10% of some 5,000 investment strategies reviewed exhibit what could be described as good practice in ESG integration.

Crisis of ownership

The financial crisis has in part been a crisis of ownership. The Western system of capitalism is facing serious challenges from civil society and questions are being raised as to whether investors should continue to enjoy the rights of ownership without clearly exhibiting the obligations that come with them. Investors have regularly demanded, in the form of regulations and codes, higher standards of transparency, disclosure and accountability from the companies they invest in. However, stronger regulation is only part of the answer. What is really needed is a move from a culture of entitlement to a culture of responsible ownership which the trustees of pension schemes and other institutional investors cannot achieve alone.

As Bob Monks, the US based activist investor, noted recently, “shareholding institutions must take the initiative to protect their relevance as a wealth preserving energy in a free society. They cannot wait for others, nor can they decline to act. Institutions must take the lead, because all other courses have failed.”

Those shareholding institutions include long term holders of equities (pension schemes, charities and insurance companies) who also have a role to play in strengthening the integrity of our capital markets. This includes lobbying regulators to address the bias towards “quarterly capitalism”, but also showing leadership themselves by exhibiting good practice in adopting higher standards of stewardship and demanding the same of their agents. 

Supporting the UK Stewardship Code is a good place to start.

Footnotes
www.efinancialnews.com/story/2011-10-11/myners-doubts-u-n-investment-principles
www.bankofengland.co.uk/publications/speeches/2011/speech525.pdf
For examples of these, see p7 in PIRC and Railpen Investments (2009) Say on Pay: Six years on at: www.pirc.co.uk/sites/default/files/documents/SayonPay.pdf
BIS (2011) Executive remuneration discussion paper at: www.bis.gov.uk/assets/biscore/business-law/docs/e/11-1287-executive-remuneration-discussion-paper.pdf
www.ragm.com/libraryFiles/113.pdf