There are some fresh lessons to be learnt from the PRI in Person meeting that has just ended.
First of all, and it is a source of great satisfaction for the 10th anniversary of this annual Principles of Responsible Investment conference, 600 people made the trip to attend the conference. Neither the distance nor Zika managed to put off those interested in discussing responsible investment issues and fostering its development.
What a long way we have come in just ten years. On the second day of the conference, David Blood recalled that his Goldman colleagues had told him that his decision in 2003 to leave Goldman and set up a firm that would invest responsibly had simply validated what they had always thought, i.e. that he was mad… Today, the success enjoyed by Generation Investment Management is another sign that things have changed greatly.
This change is also visible in the goal clearly set by most of the attendees, who say that the question is no longer to disseminate the notion of responsible investment but to make every investment responsible. In PRI, the aim should be to do away with the R of Responsible in order to define simply Investment Principles (based on the reasoning that if part of the investment is responsible, does this mean accepting that the rest of the investment can be irresponsible?
In contrast, what has not changed is condemnation of the dictatorship exercised by “short termism”. Condemnation is widespread but when we try to determine what is responsible for this situation we find fairly rapidly that while there is a dictatorship there is not really any dictator that we can simply overthrow in order to solve the problem. Indeed, several factors combine to justify such short-term investment.
First of all, in consistence with and to some extent reflexively to the assumptions underpinning the efficient markets theory, there is a belief that if prices reflect all the information available at a given moment, such information should be communicated as frequently as possible. For this reason, companies now release their results every quarter. This also responds to investor demand and this last point should be looked at more closely.
While it is understandable that retail investors should closely monitor trends in the prices of each line in their portfolios, there is no reason for long-term investors such as a pension funds to concern themselves about price changes over periods that have nothing to do with their liability management horizons. In the case of pension funds, we have come to a paradoxical situation where some of them publish their investment performances on a quarterly basis (and even monthly as one representative of the NY pension fund regretted) even though, in most cases, the duration of their commitments exceeds 20 years. As the information is available, it is wanted, including by administrators who don’t even ask themselves whether it is relevant or not.In fact, it is not relevant and everybody knows that. Although stock prices volatility is a good indicator of the risk of loss of value for some activities, such as proprietary trading, it is meaningless for a pension fund. Pension funds are long-term investors. As the chairman of PRI’s Board of Directors, Martin Skancke, pointed out, pension funds are recognisable by the fact that they can carry their positions over time and ideally by their capacity for contrarian investment. …
A look at what happens when the large pension funds publish their results shows how difficult it will be to change mindsets. Hiromichi Mizuno, CIO of the Government Pension Investment Fund (GPIF) told the conference that the Japanese media (but this phenomenon is by no means limited to Japan) would undoubtedly start ringing warning bells because GPIF has “lost” €50 billion during the year even though this is solely an unrealised capital loss (linked moreover to exogenous shocks such as Brexit) and, above all, the fund has the capacity to carry its securities over the long term.
We can also note the fundamental asymmetry which makes the same media communicate much less when the fund records a strong increase in unrealised capital gains when markets rise. Lastly, €50 billion out of €1,300 billion in managed assets (-3.8%) is hardly the end of the world.
What is the most worrying, with regard to long-term investors’ capacity to drive change, is that the authorities themselves have contributed, and continue to contribute, to maintaining this paradox. It is unnecessary to stress the limits of the Solvency 2 approach. With regard to pension funds and other managers of long-term commitments, it is the pension promise goal that should be more tightly regulated (with regard to insurance regulations, this is a position that France has always defended for insurance companies’ life insurance commitments). The Anglo-Saxon approach justifies not introducing a priori limits on discount rates by the fact that the managers must manage matching in market value. This is accurate except that high discount rates enable funds to post far more favourable levels of coverage of their commitments than is the case in reality. Even in France, some players with very long liabilities and benefiting from substantial cash flows must still at the regulator’s request show that their equities portfolio can absorb a 32% shock. This reveals a very worrying characteristic of a world in which the authorities can be unanimous about the need to promote long term investment while at the same time maintaining regulations that go against this goal.
During the conference, several large investors expressed a desire to meet to draft a document clearly stating their determination to disclose only their performance over periods more consistent with the duration of their liabilities. This could take the form of calculation of the average return over a period of five years or longer.
Going beyond this proposal, we could also question the interest of continuing to communicate based mainly on market values. A pension fund’s prime responsibility is to fulfil the promise given to its subscribers in exchange for the subscriptions they pay to the fund. This capacity is verified if the assets valued at historical carrying amount are enough to cover the commitments (i.e. the mathematical provisions calculated using a realistic discount rate expressed net of inflation). Communication should relate in priority to this coverage in book value. Does this mean that the information relating to coverage in economic value, which takes into account the unrealised gains generated by variable-income assets, is of no interest? The answer is clearly no, but this information should be presented to show the margin available to the pension fund to revalue the rights already distributed.
Although very much to be wished for, this presentation is likely to come up against a major stumbling block, which is the fact that many pension funds are in a position of underfunding even from an economic point of view. This is the result of a blameworthy complacency in terms of pricing.Rather than adjusting their technical parameters, many pension funds have, despite all the evidence, maintained the discount rates they use to calculate their commitments. With the fall in bond yields that has taken place over the past two years, risk pressure could become unbearable.
In these conditions, the switchover to disclosure focused on funding in book value is unlikely to get beyond the wishing stage.
In any case, regardless of the option chosen – continuing to communicate based on market data and on a short-term basis or communicating based on historical value smoothed over a period of several years – the reality is still the same. Many pension funds will need to make significant adjustments.
With this in view, it is time to think about putting in place innovative mechanisms that enable pension funds to invest more in the productive capital of businesses and in infrastructure. A document being prepared in collaboration with State Street Global Advisors (SSGA) will present some of these mechanisms in the near future.
Philippe Desfossés is CEO at ERAFP.