Feature – In depth: Ethical benefit options

Ethical business practices are a little more than fashionable, they can often represent sound financial sense, says Peter White

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Case Studies – Universities Superannuation Scheme (USS), Environment Agency

When Reverend John Vaughan, financial administrator for the Archdiocese of Miami, was asked why the Catholic church held shares in condom companies, he explained: "Obviously, something slipped through there."

Investment arrangements can be a particularly sore source of embarrassment. Pension funds are prime targets, making up around 18% of the total value of the FTSE with about 70% of pension scheme assets invested in firms, mainly through equities.

Ethical investment was previously not considered a serious trend to affect the investment of pension funds. But ethical business practices are booming; Cafedirect is one of Britain’s biggest coffee manufacturers, ethical chocolatier Green & Black’s was bought out by Cadbury Schweppes and even Tesco has launched its own fair trade brand.

This shift has coincided with an increase in environmental concerns on issues such as the USA’s refusal to accept the Kyoto agreement on climate change, stretching to cover holdings where regimes with human rights issues may benefit.

As a result, the number of pension scheme members and trustees seriously opting for ethical and socially responsible investment choices is rising.

But it should be pointed out that ethical investment is different to socially responsible investment. Ethical arrangements are reactive, whereby organisations actively ask their pension fund managers to negatively screen out investing in any companies that do not share the same moral objectives.

Paul Palmer, professor of voluntary sector management at Cass Business School and author of Socially responsible investment: A guide for pension schemes and charities, says: "For instance, the Salvation Army is against alcohol, gambling, the sex industry and drugs. On this basis, it would instruct its fund managers to avoid having any holdings in those areas."

Socially responsible investment is more of a proactive process and rewards firms that are known for being good employers with healthy corporate responsibility programmes and environmental records.

The differences between pension funds are marked with different shades of green. Light green schemes can include oil, pharmaceutical and financial services firms in their investment choices, but not firms that deal in tobacco, arms, animal testing, that have a poor human rights record or exploit the environment. These funds also have limited exposure to emerging markets and the Far East. On the other hand, dark green funds will avoid investing in firms involved in any of the above.

The Trades Union Congress (TUC), which published the Fund Manager Voting 2005 survey showing how trustees are coping as institutional investors, has seen a shift in attitudes towards social responsibility.

Tom Powdrill, pensions investment officer at the TUC, says: "The mood has changed dramatically over the past five or six years, with the government actively encouraging pension schemes to think about their responsibilities as shareowners and about socially responsible investment as an option. This is a dramatic change from the situation in the past when many trustees were wrongly led to believe that any form of investor activism was in conflict with their fiduciary duty."

But with the ongoing shift from defined benefit (DB) to defined contribution (DC) pensions, more staff in occupational plans are choosing their own investment options.

Money purchase schemes, group personal pensions and stakeholder arrangements all require an employee to choose which fund they invest in. The Ethical Investment Research Service’s How Responsible is your Pension? report shows that 40% of such schemes also offer an ethical additional voluntary contribution (AVC) option.

Some employers have found that by introducing such investment options, take-up increases. Consultancy firm Enviros saw the number of staff joining its pension soar when it harmonised a number of schemes into one ethical plan. And the firm was careful to ensure those that invested in the ethical element did not suffer financially.

However, in DB schemes, a group of trustees is responsible for the investment arrangements. And, since 2000, trustees must include any policy of ethical investment in a Statement of Investment Principles.

Patrick Connolly, research and investment manager at John Scott & Partners, says there are more guarantees required in DB plans. "The trustees have carte blanche over what criteria, including ethical criteria, they adhere to. The reality is that very few people with this responsibility will choose to take the ethical route because if the funds under-perform they may be held culpable and the ethical stance could be one of the reasons given for the performance."

Another danger with ethically invested DB plans is that it may force non-ethical investment on somebody with ethical views or ethical investment on someone with no such views. And when it comes to pension performance, most members are more interested in moolah than morals. As yet, no definitive data is available to suggest which funds perform better.

There can, however, be a conflict of interests where pension scheme members find investment options contradict their role as an employee. If a pension scheme decides to invest in an organisation with a rising share price, for example, this may have been caused by laying off a large number of staff.

"[While] all of this is being carried out ultimately in the interests of pension scheme members, these members are also employees. So we face a situation where employees’ retirement savings can encourage firms to undertake activity that damages their own interests," says TUC’s Powdrill.

And legislation now exists that means trustees are not allowed to favour workers’ rights over investment gains. In 1985, National Union of Mineworkers’ boss Arthur Scargill tried to force trustees from the Mineworkers’ Pension Scheme to invest only in local mining communities, avoiding all other competing industries, such as oil or gas, as well as foreign firms. But a ruling, Cowan v Scargill, made this illegal, suggesting that trustees have to act in the best financial, not personal, interests of the fund.

An interesting example of a pension fund acting alone of its sponsoring employer occurred when the British Airways (BA) Pension Fund voted against a resolution by the British Airports Authority (BAA) to approve political donations and to continue to provide MPs with free airport parking spaces. Despite BA working closely with BAA at many of the UK’s airports, its institutional investors (the pension scheme trustees) felt it was not in the best interests of BA pension scheme members to allow BAA to continue to operate in such a way.

A recent attendee at the UK Social Investment Forum 2005, agrees. Christine Farnish, chief executive of the National Association of Pension Funds (NAPF), says: "Our main concern is the performance of pension fund investments so as many people as possible can continue to benefit from well-managed, well-funded pension schemes when they retire. A desire to change the world [does] not sit easily with [these] duties. But a long-term view in successful businesses does."

Case Study: Universities Superannuation Scheme (USS)

The Universities Superannuation Scheme (USS) strengthened its stance on socially responsible investment in 2000 following pressure from a student body.

The pension scheme for university staff and academics, which is one of the largest schemes in the UK, appointed a specialist in-house team to focus on engaging with companies it invested in, rather than negatively screening which stocks to choose.

The change came as Ethics For USS, part of national student campaign network People & Planet, lobbied the fund to actively interact with the firms it invested in and to put social audits and environmental best practice at the top of its agenda.

USS now uses its role as an institutional investor to discuss practices at oil and gas companies, pharmaceutical firms’ plans for drug prices as well as monitoring wider corporate projects on issues such as climate change.

Case Study: Environment Agency

In April, the Environment Agency revamped the investment strategy for its final salary pension scheme.

The government body has reduced its allocation of assets in UK equities and increased the amount it puts into environmental mandates, as well as global equities and property.

Howard Pearce, head of environmental finance and pension fund management, says the change was financially motivated following a period of poor investment returns and the reduction of the solvency of the fund. "It is based on a sound investment thinking to protect our financial returns from financially material environmental risks like climate change and returns boosts from best in class firms."