Ministers’ Deputies

CM Documents

CM(2014)135                           16 October 2014[1]

 

1213 meeting, 26 November 2014

11 Programme, Budget and Administration

11.5 Pension Reserve Fund – Investment strategy

Response from the Management Board to the Committee of Ministers on the comments of the Budget Committee as regards the second three-year review

Item to be considered by the GR-PBA on 6 November 2014

 

BACKGROUND

4 February 2014 - The Management Board of the Pension Reserve Fund (PRF) presented to the Committee of Ministers the results of the Second Three-Year Review of the Fund [CM(2014)4] with the following main proposal that would allow the sustainability of the PRF with reasonable investment risk and without increasing member States contributions:

Diversification into global and emerging markets equity, which requires a new Socially Responsible Investment (SRI) strategy – Engagement – for that part of the portfolio.

The Committee of Ministers showed concern for the impact of the change of SRI strategy on the reputation of the Council of Europe and asked the Budget Committee to assess the proposal.

2 July 2014 - The Budget Committee presented its recommendation to the Committee of Ministers [CM(2014)86] with five options to be considered.

The Committee of Ministers decided to forward these options to the Management Board “for further consideration with a view to resuming consideration of this matter at a later stage” (CM/Del/Dec(2014)1204/11.1).

MANAGEMENT BOARD’S CONSIDERATION OF THE BUDGET COMMITTEE’S OPTIONS

The Management Board of the PRF considered at its meeting of 29 September 2014 the five options presented by the Budget Committee:

Option 1: Approve the proposal from the Management Board, allowing the SRI strategy to be less stringent, the targeted rated of annual return is kept at 5.0% and the contributions to the PRF remain the same.

The Management Board considers that this option should be considered as optimal as it allows keeping the 5.0% long-term target of return with a reasonable risk; the Fund could therefore be sustainable without increasing member States’ contributions.

The Management Board is aware of the concern of the Organisation as regards the partial change of SRI strategy and presents in attachment a detailed description of the Engagement strategy and a comparison with the current SRI strategy. This analysis shows that the implementation of the proposed Engagement overlay for a part of the PRF portfolio would imply that the Council of Europe has the objective of improving the social responsibility of companies, while with the current strategy - Best in Class and Exclusions - the implicit objective is that the Council of Europe wishes to invest (only) in the most socially responsible companies and avoid the reputation of being invested in companies with poor SRI practices. Both objectives are perfectly valid for an SRI investor; the Council of Europe must decide which approach better fits with its principles. The Committee of Ministers could also decide to use Engagement on a temporary basis i.e. until the offer of products compliant with the current SRI strategy of the Council of Europe in these two asset classes becomes suitable for the PRF.

Option 2: Keep the present SRI strategy and reduce the targeted rate of return to 4.5% or 4.0%. The contributions to the PRF would then need to be increased by €2.5M or €5.0M respectively. It could be feasible to introduce such changes from the biennium 2016-2017. If the Committee of Ministers chooses this option, the Management Board of the PRF might be requested to consider whether a revision of the strategic asset allocation is required.

The Management Board considers that if the target of return is reduced to 4.0%, there is no need to change the current strategic asset allocation (SAA), while if it is reduced to 4.5%, the SAA should be changed to a too risky strategy (67% euro area equity + 33% euro corporate bonds).

Option 2 implies an increase of the member States’ contributions, which is decided by the Committee of Ministers. The Management Board notes that the increase of contributions should be done as soon as possible since the estimation of increased contributions has been done for the period starting in 2013.

Option 3: Keep the present SRI strategy and leave the targeted rate of return at 5.0%. This would also leave the contributions unaffected. Nothing dramatic would happen in respect of the PRF over the course of the next few years and the matter could be revisited in connection with the next actuarial review, which is scheduled to take place in 2017. It should be noted that the historic trend information of the PRF is limited and the performance has been influenced by financial crises. However, if the performance turns out to be lower than the target for a longer period, sooner or later the contributions to the PRF must be increased. Within this option, marginal adjustments to the strategic asset allocation could be considered, such as an increase of the weight of Euro area equity and Euro area corporate bonds and a decrease in the weight of the EMU government bonds.

The Management Board considers that if 5.0% is kept as the target until 2017, in order to attain it, there will be a need to significantly modify the current SAA to an overly risky strategy: equities should go up from 60% to 83%, government bonds would disappear and corporate bonds would represent 17% of the portfolio.

If the SAA does not change until 2017, the expected return can be assumed to be 4.02% which would cause a loss of EUR 8 million of investment return, to be compensated by the member States’ contributions in order to maintain the sustainability of the Fund.

Option 4: Keep the present SRI strategy but adjust the strategic asset allocation to allow investments in global and emerging market equities with a view to achieving a higher rate of return of 5.0% or more. This would make an active investment management essential. If this option is chosen, the costs of such management must be explored in relation to the real rate of return.

The Management Board considers that this option is not feasible as for the time being there is not an appropriate offer of SRI products compliant with the current SRI strategy of the Council of Europe in these two asset classes.

Option 5: Finally, in respect of the administrative costs and management fees, the Committee noted that the expected rate of return is net of these costs. In the long term, even small reductions of these costs will have an effect on the rate of return and therefore attention should be paid to all possibilities to reduce the absolute and relative administrative costs and management fees. One possibility to reduce these costs would be to place investments with index tracking funds in Europe which comply with the current SRI strategy.

The Management Board considers that this option is not feasible as for the time being there is not an appropriate offer of SRI products compliant with the current SRI strategy of the Council of Europe in these two asset classes.

SUMMARY OF THE BUDGET COMMITTEE’S FEASIBLE OPTIONS

The Management Board summarised the feasible options presented by the Budget Committee in the scheme below:

CONCLUSION

The conclusion of the Management Board after reviewing the different options presented by the Budget Committee is that Option 1 (the proposal of the Second Three-Year Review) is optimal in the sense that it is the solution that meets the most of the Council of Europe objectives for the PRF: it allows the sustainability of the Fund with reasonable investment risk, without increasing member States’ contributions and keeps the SRI character of the portfolio. The Management Board recommends that the Committee of Ministers use Engagement on a temporary basis, i.e. until the offer of SRI products compliant with the current SRI strategy of the Council of Europe in Global and Emerging markets equity becomes suitable for the PRF.

If the Committee of Ministers does not want to change the SRI strategy, then the Management Board recommends Option 2.A: to reduce the target of return to 4.0% (and the Council of Europe should decide to either renounce having a sustainable Fund or to increase the member States’ contributions by EUR 5 million per year) as keeping 5.0% as the target requires too risky a strategy.

 

APPENDIX

ENGAGEMENT OVERLAY

INTRODUCTION

1.         As part of the second Three-Year Review of the Pension Reserve Fund (PRF) of the Council of Europe (CoE), and in order to respond to the request of the Committee of Ministers to enhance the performance of the PRF, the Management Board proposed to the Committee of Ministers a Strategic Asset Allocation (SAA) composed of: investments in global, emerging markets and euro area equity; euro-denominated corporate bonds; and Economic and Monetary Union (EMU) government bonds. Given the difficulty of finding mutual funds in global and emerging markets equity that respect the PRF’s Socially Responsible Investment (SRI) and implementation criteria, and considering that the Council of Europe may be ready to accept certain flexibility in the application of the SRI policy , the Board proposed a modification to the SRI policy: investments in global and emerging market equity would be made using index-tracking mutual funds while in parallel, companies in those portfolios would be contacted by an engagement overlay provider with the aim of influencing their management to respect the SRI criteria of the Council of Europe . This strategy would allow higher diversification (and therefore less market risk), the reduction of asset manager risk and an eventual decrease of costs. It would keep the SRI character of the PRF portfolio, thus showing the compromise of the Council of Europe with regard to SRI.

2.         Following the questions raised by the Committee of Ministers on the proposed SRI strategy, this document first presents engagement overlay practices and the differences with the current approach of the PRF to SRI. It then introduces the process of implementing an engagement overlay. The third part contains examples of pension funds using engagement. Finally, a cost comparison is made between asset management fees under the current and proposed strategy, before a conclusion is reached.

I.          DEFINITION

3.         Engagement is the process by which investors contact companies where they invest to build the business case for better management of (in most cases) Environmental, Social and Governance (ESG) issues. Engagement is often combined with the strategy called ”shareholder activism”, where investors undertake the engagement process around general shareholder meetings, contacting companies individually to explain their voting intentions or votes cast.

4.         The process of engaging with a company can start at any time, although investors generally launch it either after the publication of the annual report or following the detection of breaches of good ESG practices. This often consists of investors sending a letter to the company explaining concerns and requesting to be informed of actions the company proposes to mitigate the raised issues. Depending on the company response, this phase is followed by a more in-depth process of further communication and meetings with company representatives, which may even reach the Board level. If investors do not receive answers in line with their expectations, next steps may include making their request for improvement public and in extreme cases, excluding the company from the investment portfolio. Engagement activities typically take between two and three years to arrive to an outcome.

5.         Engagement becomes more effective when the investor disinvests from those companies with which the process has failed, especially if the exclusion is made public. Even if the direct financial impact derived from the sale may not be relevant for the company, disinvestment sends a clear message that the company’s behaviour is not acceptable. Moreover, publication of the decision to disinvest can provoke serious damage to the company’s reputation, motivating them to take steps to avoid this.

6.         Most SRI investors active in engagement state that they do so with the double objective of improving the ESG behaviour of the investees and of having better financial returns, as they believe that the engagement process imposes no restrictions to the portfolio and therefore its potential return (apart from most SRI investors’ general belief that companies with better ESG policies should deliver higher returns in the long run).

Examples of engagement activities

7.         Most engagement activity is linked to the governance of the companies in question. Investors contact companies in order to influence Board mandates, i.e. increasing the number of independent Board members and exerting influence on executive salaries thereby forging a better alignment between long-term company results and the level of variable executive compensation. Stichting Pensioenfonds (ABP), the Dutch pension fund for government and education employees, cites the change it forged in Royal Dutch Shell’s bonus policy as an example. ABP worked to change the policy from being linked only to production increases to being linked to a combination of the production increase against the invested amounts. In ABP’s view, this will result in Shell making better trade-offs between increasing production (hence profit potential) and the financial and reputational risks linked to drilling in areas with potentially high environmental risks.

8.         Following the Rana Plaza factory collapse in April 2013 which killed over 1 100 people working in the clothing industry in Bangladesh, F&C Investments and 16 institutional investors representing USD 1.3 trillion of assets worked together to influence companies to adopt stronger supply chain risk management. This joint effort led to a number of improvements on building and work safety regulations in the country.

9.         Nordea Bank, a Swedish bank and counterparty for the PRF treasury investments, started engaging with 41 companies in 2011, including Unilever, McDonald’s and Nestlé. They addressed topics linked to sustainable fishing practices, in particular overfishing which can cause irreversible decline in fish populations and disrupt supply chains therefore increasing financial risk for investors.

10.        An example of engagement producing multiple effects from various angles can be found in the discussions between investors and palm oil producers. Palm oil is often produced on land recovered after large scale deforestation, often in combination with bush fires. This process negatively impacts local communities and biodiversity in countries such as Malaysia and Indonesia. Engagement service provider Hermes had long negotiations with palm oil producers in order to push them towards certification of their plantations by the Round Table of Sustainable Palm Oil (RTSPO). At the same time, Hermes engaged with palm oil buyers in order to attract their attention to the ESG risks in their supply chains. The Belgian retail group, Delhaize, announced in January 2014 that by the end of 2015 it would be the first retailer worldwide to use RTSPO-certified sources for 100% of the palm oil used in its home brand products and that by 2020, 100% of this palm oil will be from traceable no-deforestation sources. In doing so, they improved their ESG score and put pressure on their supply chain, which includes companies like Unilever, Henkel and Procter & Gamble, to improve ESG practices.

Differences with the current SRI strategy

11.        Within the context of the PRF investments, engagement means that a specialist firm would, on behalf of the Council of Europe and according to its SRI criteria, screen the companies within the global and emerging markets equity universe and engage with those showing the highest ESG risks and/or worst ESG conduct in a negotiation and dialogue process aimed at improving their practices and policies.

12.        Engagement shall be carried out without shareholder activism as investments are part of mutual funds for which only the fund manager has the right to vote in shareholder meetings. Disinvestment from companies with which the engagement fails would not be possible as it would be implemented through index-linked mutual funds replicating a market index and without the possibility to exclude any company in the index.

13.        The main difference between an engagement overlay on an index-linked portfolio (the proposed strategy) and investing with the current SRI strategy lies in the fact that under the proposed strategy, the Council of Europe would try to improve the social responsibility (SR) of its portfolio without removing any individual company, as the portfolio should follow the composition of the index. Under the current SRI strategy, the companies with the lowest SR in each economic sector are not included in the SRI portfolio and the sectors of tobacco, alcohol, weapons, pornography and gambling are excluded when possible.

14.        The implementation of the proposed engagement overlay within part of the PRF portfolio would imply that the Council of Europe has the objective of improving the SR of companies, while with the current strategy - Best in Class + Exclusions - the implicit objective is that the Council of Europe only invests in the most socially responsible companies and avoid the bad reputation of being invested in companies with bad SR. Both objectives are perfectly valid for an SRI investor; the Organisation must decide which approach better fits with its principles.

II.         IMPLEMENTATION OF AN ENGAGEMENT OVERLAY

15.        Given the high amount of resources required to implement an engagement process, the Council of Europe should contract an external provider to act on their behalf. Engagement overlay service providers are specialised companies (sometimes linked to asset managers) that engage with companies in their clients’ portfolios with the aim of encouraging the company management to improve their ESG practices. Engagement overlay providers usually act on behalf of several SRI investors, increasing their negotiation power and decreasing costs for the investor. Some examples of such companies are given below.

F&C Investments is a UK based asset manager and part of the Bank of Montreal group. Since 2000, F&C offers a Responsible Engagement Overlay (REO) service to investors. At 31 December 2013, this service covered GBP 83.4 billion (EUR 104.3 billion) combining F&C’s own assets under management and the assets of 23 external clients, including large Dutch and German pension funds, the European Bank for Reconstruction and Development and PensionDenmark. In 2013, F&C engaged with 716 companies in 47 countries, and noted 293 instances of positive outcomes where the contacted companies improved their ESG standards.

·                     Hermes Equity Ownership Services is part of Hermes Fund Managers which is owned by the Pension Scheme of British Telecom. They offer engagement overlay services to 32 investors covering around EUR 119 billion at 31 December 2013. In 2013 they engaged with 627 companies discussing 1 433 topics related to ESG and business strategy.

·                     Global Engagement Services (GES) is an independent Swedish company offering engagement services. At 30 June 2014, they had EUR 750 billion assets under advisory, and analyse and follow approximately 18 000 companies worldwide. Their business model is primarily based upon a reactive policy in which they engage with a company when it breaches internationally recognised ESG codes or conventions. GES states that they follow companies based on 60 international conventions.

16.        In practice, the Council of Europe would give a mandate to one of these engagement providers with a list of specifications:

III.        PENSION FUNDS USING ENGAGEMENT

17.        Engagement strategies are widely used by SRI investors such as:

Engagement is usually combined with other SRI strategies and in some cases is applied as an overlay to an index-linked portfolio. Below are examples of the practices of pension funds with an active engagement policy as part of their SRI policy.

·                     CPPIB

CPPIB is the investment management arm of the Canada Pension Plan, Canada’s largest pension fund with CAD 219.1 billion (EUR 150 billion) of assets at 31 March 2014. They consider engagement as the most effective means to improve the SR of companies and the least harmful for returns since it does not impose any restriction to the portfolio and hence to its potential returns. Their main points of attention for engagement are linked to climate change (mostly influencing companies to reduce green-house gas emissions), water (influencing companies to diminish the use of water and to better manage water recycling/treatment), extractive industries and executive compensation. In 2013 they mainly engaged - individually or in cooperation with other investors - with Canadian companies in their portfolio on these topics and voted as an active shareholder on 37 814 agenda items, of which 8.5% were votes against management proposals.

·                     TIAA-CREF

TIAA-CREF, a US pension fund with USD 569 billion (EUR 417 billion) of assets at 31 December 2013. Their engagement policy is pointed towards environmental impact by promoting better energy use and environmentally friendly buildings, and the social and cultural impact of investments made by companies in their portfolio. As an example, they introduced the Farmland Principles within the United Nations Principles on Responsible Investments (UNPRI) with engagement service provider Hermes and five other institutional investors from the Netherlands, Sweden and Denmark. They put special emphasis on respecting certain SRI principles in companies located in those countries where best practices related to SRI are less developed. Like CPPIB, they consider that negotiation and dialogue are a more effective means to change a company’s SR than the non-inclusion of company shares in their portfolio. They only sell or avoid investment in companies when the reputational or financial impact derived from their SRI behaviour is too great.

·                     CalPERS

CalPERS held USD 288.7 billion (EUR 211 billion) in assets at 31 March 2014. Their engagement policy is built around three major pillars: financial capital covering governance issues, physical capital covering environmental issues and human capital covering social issues. In 2013 they actively engaged with 1 903 companies within their portfolio.

·                     EAPF

The EAPF had total assets of GBP 2.3 billion (EUR 2.9 billion) at 31 March 2014. Its engagement activities are turned towards environmental issues and corporate governance, and they are widely applied in their index-linked portfolio. In 2011 they engaged with companies on 868 ESG issues, voted 78 environmental resolutions in shareholder meetings, measured the carbon efficiency of their corporate bond portfolio against that of the index (+6.7% carbon efficiency) as well as the amount by which companies in their equity portfolio reduced their carbon footprint (-16% over five years).

IV.        COST COMPARISON

18.        The current PRF SRI investments are made in actively managed SRI mutual funds investing in euro area equity and euro corporate bonds. The fund fees are taken directly from their Net Asset Value (NAV) and cover the financial asset management costs and the extra costs linked to the SRI specifications. These costs are linked to active management and are higher than those of funds managed with an index-linked strategy. Under the proposed engagement approach and SAA, the financial costs would be withdrawn from traditional global and emerging markets equity index-linked mutual funds while the SRI costs would be paid separately to an engagement provider. Following the Secretariat’s inquiries to a number of engagement companies, services are estimated to cost approximately EUR 110 000 per year.

19.        Table I below compares the annual costs of the current investment strategy with those under the engagement approach and new SAA as proposed by the Board to the Committee of Ministers [see document PRF/MB(2013)23/REV1][2], based upon the value of the PRF at 30 June 2014 (EUR 233.2 million), and the following assumptions:

·                     under the new strategy, the euro area equity and euro corporate bond allocations continue to be managed by the same asset managers applying the current fees;

·                     for global and emerging markets equity, management fee estimates are based on proposals made by asset managers to other pension funds under the administration of the International Service for Remunerations and Pensions;

·                     annual cost of EUR 110 000 charged by the engagement service provider.

TABLE I: COST COMPARISON CURRENT STRATEGY VS PROPOSAL

 

Source: Asset managers, Engagement Overlay Service providers

20.        As shown in Table I above, the annual costs under the proposed SRI policy and SAA are €302 776 (0.13% of the PRF value) lower than the fees under the current SAA (0.38%). As the Fund is set to grow in the foreseeable future, and the cost for the engagement overlay is a fixed annual amount, these cost benefits are also set to grow, both in terms of money and in percentage of the Fund’s value. From a budgetary point of view, the main difference between the current and proposed SRI policy is that under active SRI management, the engagement cost is deducted from the fund’s NAV while under passive management with an engagement overlay, the engagement cost is invoiced separately.

V.         CONCLUSION

21.        Under an engagement overlay, companies in the investment portfolio showing high ESG risks are contacted in order to influence their management with a view of improving their ESG practices.

22.        This alternative SRI strategy, to be applied to global and emerging markets equity only, would allow the diversification of the PRF, as there is not an appropriate offer of SRI products compliant with the current SRI strategy of the Council of Europe in these two asset classes. The higher diversification would reduce market risk while the investment in index-linked mutual funds would reduce relative risk and costs. The financial advantages of this alternative SRI proposal for part of the PRF portfolio therefore seem evident.

23.        From the SRI perspective, the implementation of the proposed engagement overlay within part of the PRF portfolio would imply that the Council of Europe has the objective of improving the SR of companies, while with the current strategy - Best in Class and Exclusions - the implicit objective is that the Council of Europe wishes to invest (only) in the most socially responsible companies and avoid the reputation of being invested in companies with poor SRI practices. Both objectives are perfectly valid for an SRI investor: the Council of Europe must decide which approach better fits with its principles.


[1] This document has been classified restricted until examination by the Committee of Ministers.

[2] See document CM(2014)4.