Thought Leadership

Pensions Newsletter - Winter 2015

Events like BP’s Gulf of Mexico oil spill, and Chinese corruption allegations against GlaxoSmithKline, throw into stark relief the risks of ignoring environmental, social and governance issues. Losses to a company’s reputation, profits and, increasingly, its share price, can be immediate – in BP’s case, the shares halved in little more than two months.


Can investors do well while also doing good?

Events like BP’s Gulf of Mexico oil spill, and Chinese corruption allegations against GlaxoSmithKline, throw into stark relief the risks of ignoring environmental, social and governance issues. Losses to a company’s reputation, profits and, increasingly, its share price, can be immediate – in BP’s case, the shares halved in little more than two months. 

Even so, many investors have been reluctant to embrace ‘sustainable’ investing, wary of its possible effect on long-term returns even if it may help avoid prominent disasters. But recent 

research suggests such concerns are unfounded: investors who incorporate environmental, social, governance (ESG) or other sustainable criteria into their investment decisions can enjoy healthy returns and a clear conscience.Last year, a joint ‘study of studies’ conducted by Oxford University and Arabesque Asset Management1 confirmed that, on several measures, companies deemed to be operating sustainably outperformed their more traditional rivals. In one very telling statistic, the researchers found that an overwhelming 90% of previous studies confirmed that adopting good ESG standards lowered a company’s cost of capital. According to one analysis2, well governed firms enjoyed an equity cost advantage of anywhere between 0.88% and 1.36%. Moreover, other research suggested that both the interest rate spread on a firm’s bonds and the ratings given them by agencies tend to be superior if the issuer was seen as having good ESG policies.

It was a similar story when the researchers looked at internal measures. Thus, 88% of the studies reviewed concluded that sustainable companies tended to have better operational performance. ‘Proper corporate environmental policies result in better operational performance’ the authors reported. ‘In particular, higher corporate environmental ratings, the reduction of pollution levels, and the implementation of waste prevention measures, all have a positive effect on corporate performance.’


But perhaps most importantly for investors, this lower cost of capital and better operational performance demonstrably feeds through into superior share price performance. According to the Oxford-Arabesque review, four-fifths of the studies they looked at suggested that share prices
are enhanced for companies with good sustainability practices.

This would be unsurprising if it merely related to improved governance which, other things being equal, one might expect to reflect better management. More interesting were findings that a
group of so-called ‘high sustainability’ companies have produced long-term outperformance against a group of more traditionally managed entities. According to research by academics
at Harvard3, an equally-weighted high-sustainability portfolio would have outperformed by 2.3% a year between 1993 and 2010, a return that would more than double if the portfolio were instead weighted by value.

So, we would argue that sustainable investing should be gaining many more admirers amongst institutional investors. While no professional will claim that they can always avoid disasters like
BP’s, it is becoming increasingly clear that investing with ESG issues in mind doesn’t have to be a drag on performance. Indeed, it may even create outperformance not available from any other source.

The major pension themes for 2015

Like death and taxes, one thing is certain in 2015: the changing policies of governments, regulators and central banks will continue to have a significant impact on pension schemes.

Stormier waters ahead

In 2015, pension schemes face an ever-growing number of risks that could throw their investment strategies off course. Whether it is less optimism about Chinese growth expectations, possible
eurozone deflation, eastern Europe, the Middle East, the falling oil price or a UK general election, there will be plenty to make investors nervous.

With a few notable exceptions, the last few years have seen a relatively benign environment for markets, with unusually low market volatility. It seems likely that markets will become more choppy in future, as political and economic developments cause swings in investor confidence. The Credit Suisse Fear Barometer, which measures the level of fear in markets by using the price
of buying equity protection, has been steadily increasing over the last five years (see chart).

In light of this, many pension schemes are reviewing their exposures to benchmark-relative investment strategies in favour of more outcome-oriented ways of investing. For example, in fixed
income, schemes are investigating strategies with a wider remit to take active positions across currencies, interest rates, and different sectors. In equities and other growth assets, schemes are increasingly seeking ways to protect themselves against large market corrections without sacrificing too much long-term return.

Will gilt yields finally start to rise again?

In recent weeks, UK gilt yields have fallen to all-time lows, causing more pain to pension schemes, which have seen the value of their liabilities rise yet again and their funding levels sink (see our funding level tracker, next page).

Many expect central banks in the UK and US to raise interest rates next year. However, with lower growth expectations in other regions such as Europe and China, the global recovery is an unsteady one at best.

Furthermore, the market already expects short-term interest rates to rise, and this is priced into the yields available from longer-term gilts. Interest rates would need to increase faster than the market expects if schemes are to benefit from falling liability values.

Trustees will need to take all of this into consideration when determining how to manage their liability matching strategies in 2015 and beyond.

The DB implications of new pensions flexibility in DC

Last year’s radical changes to defined contribution (DC) pensions giving members new flexibility in retirement will have ramifications for defined benefit (DB) schemes too. DB members will also be able to take advantage of the reforms by transferring to a DC scheme when they retire and then cashing in their pension entitlements.

1 From the Stockholder to the Stakeholder, Smith School of Enterprise and the Environment, University of Oxford, and Arabesque Asset Management, September 2014.

2 Corporate Governance and the Cost of Equity Capital, University of Wisconsin and University of Iowa

3 The Impact of a Corporate Culture of Sustainability on Corporate Behavior and Performance, Harvard Business School, 4 November 2011.

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