PFZW, the €180bn Dutch pension fund for the health care industry, has created a new investment framework, the result of an 18-month, soul-searching journey called: “The White Sheet of Paper”. This will translate into policy and implementation steps starting this year. Long-term investing, efficient markets, societal trust in pensions, and sustainability are at its core. Jaap van Dam, Chief Strategist at PGGM, the wholly-owned asset manager for PFZW, explains.
Responsible Investor: Can you outline briefly what PGGM is and who it serves?
Jaap van Dam: PGGM manages pension assets worth approximately €180bn for pension funds. We provide services in the field of pension management, asset management and executive advice to pension funds, affiliated employers and their employees. In addition, we are developing supplementary services in the fields of pensions, healthcare, living and working for employers and the more than 675,000 members we have in the health and social sector, notably for our largest client PFZW, the compulsory defined benefit (DB) plan for the workers in the Dutch health care industry, with more than 2.4 million, predominantly female, participants.
Responsible Investor: What is the White Sheet of Paper Project and what was its motivation?
Jaap van Dam: The White Sheet of Paper Project was an 18-month process that started with one fundamental question: “What if we could start investing from scratch?” So we were starting with a white sheet of paper! Its outcome is a set of investment principles that followed the review. In addition, until 2008 PFZW and PGGM were one organization (called PGGM), when – for several reasons, including regulatory ones – they became separate entities. PFZW has a very lean structure, consisting of the board and several committees, including an Investment Committee.
That board is supported by a staff of 20. In contrast, PGGM has more than 1,000 employees, of whom approximately 400 have some involvement in formulating investment policy or managing assets. As part of the process, PFZW’s board members interviewed more than 30 industry experts from all over the world. PGGM and PFZW realised that since the separation we have run the risk of not speaking the same language in terms of what we want to achieve.
“PFZW cannot afford to see a sustainable world as an externality”
We used to be one company sitting more or less in one room with very short lines of reporting. Now the two entities have become much more different in their roles and the chain of decision-making has lengthened considerably. In a sense you start to introduce your own agency issues, when what you need is to align the motivations and speak the same language everywhere. The global financial crisis (GFC) and its aftermath also led PFZW’s board to reflect on the following major questions:
• Is the“efficient markets hypothesis” relevant for us?
• Looking ahead, it appears that both the long-term risk capital we provide and the returns we need to earn on it have become scarcer. How do we cope with this problem?
• The implied license to operate traditional defined benefit (DB) pension plans can no longer be taken for granted. Societal trust in pension arrangements is at a very low level. How do we cope with this?
• Although we are recognized as one of the most sustainable pension plans in the world, movement toward sustainability in the real economy seems to be much more pronounced and salient.
The project had broad support within the PFZW board: members were willing to devote considerable time to the project over the course of its several phases. Six board members, predominantly members of the Investment Committee, spent one day per week or more on the project.
There have been three major outcomes. First, the PFZW Board has taken full ownership of the resulting investment principles. Second, the project created a powerful common language, both inside PFZW and with the investment organization PGGM. Third, it produced a fresh set of investment principles that combines lessons from the global financial crisis with a desire for strong integration of sustainability factors in investment decisions, and to use what the organization calls “the steering power of money” to achieve those sustainability objectives.
Responsible Investor: Was the project inspired by other pension funds/asset managers?
Jaap van Dam: It wasn’t the case at the time. However, looking back, for example, to when we started presenting the results at the Rotman International Centre for Pensions Management (ICPM) in Toronto, Canada in late 2013 it was notable that thinking about cost issues – which is one of the areas we looked at – seemed to be high on the agenda of other pension funds such as the California Public Employees’ Retirement System (CalPERS). In parallel we have been thinking about the same things without necessarily being aware of that fact during the process. I’ve seen similar projects come out of the New Zealand Superannuation Fund also and some of the large Australian superannuation funds also, so there’s a lot of potential for information sharing. We are working alone at present, but co-operation could be a strong model to achieve some of these changes, and where it makes sense we will definitely do that.
Responsible Investor: Can you talk more about how the project tested the validity of some of the holy cows of the investment world such as the efficient market hypothesis in light of the global financial crisis?
Jaap van Dam: The efficient market hypothesis (EMH) asserts that financial markets are “informationally efficient” and this was a big part of our review and re-think. It’s a very difficult subject, and in a certain sense we didn’t look at the fundamental question of how things are valued and whether we needed a policy change as a consequence of how expected returns vary.
However, on the issue of investment correlation (the measure of how two securities move in relation to each other) we were naïve regarding how this would happen in the event of a major financial crisis. Part of the lesson of the financial crisis is that this matters a lot and you need to think about working on mechanisms and policies in the events of extreme market conditions. We are working on that now to look at issues of company and market valuations and the expected risk premia of both. In essence, it’s the topic of active versus non-active investing. The objective of a pension fund is to translate current pension premium streams into long-term returns that will be high enough to fulfil the promise that you make to your policyholders. So, if you see that your expected returns will not be high enough to realise this promise then you need to change your policy! This required a conscious decision to deviate from the efficient markets thinking that formerly prevailed at PFZW. The new framework accepts dynamic changes in asset allocation over time and emphasizes bottom-up investing rather than the strong benchmark orientation that remains common practice in the institutional investment world.
Responsible Investor: Long-termism and sustainability are strong features in the project: why?
Jaap van Dam: We take our responsibility for society at large very seriously. Our role as a fund in the economic well-being of society is also very beneficial for long-term returns. For example, does our asset portfolio include investments or investment categories that are harmful to the economy in general, or to parts of the financial sector in particular?
The PFZW investment beliefs and principles are based on the idea that it assumes a responsibility for contributing to a sustainable world and that, at the same time, a sustainable world is a necessary condition for generating adequate returns over long investment horizons. In other words, taking the long view, PFZW cannot afford to see a sustainable world as an externality. Moreover, given its size, PFZW can make a serious impact, the phenomenon known as “the steering power of money.” Contributing to a sustainable, viable world requires a decisive approach, with carefully considered, relevant and sometimes daring choices when it comes to making investment decisions. That means we deliberately make certain investments while avoiding others. By targeting the assets entrusted to us and the influence they give us, we can make a positive contribution and minimise the negative aspects of our footprint.
This is a movement which is becoming larger by the day. For example, there is the initiative organised by McKinsey, called ‘Focusing Capital on the Long Term’, which is coming from the idea that there is a limited number of institutions that together provide a large part of the productive financial capital to this world. In a certain sense – and partly stemming from the efficient markets movement – we have neglected the fact that we have an important part in the allocation of that capital, which in turn has profound consequences for economic growth and society at large. This gives reponsibilities. From a negative angle, I think that if you neglect that role then your licence-to-operate will be limited over the long term. You can make the comparison to what happened happened in other industries: until the 1970s you could largely ignore the side effects – the externalities such as environmental pollution – of being a chemical or industrial company. Then came the moment when the environment became an important part of a company’s concerns and so the costs of that had to be internalised. I think that’s what’s happening now with large asset owners.
Responsible Investor: How does this relate to your individual saver members?
Jaap van Dam: Given our role in the healthcare sector and the general ‘do no harm’ principle that applies in it, there is an expectation amongst PGGM’s members that these kinds of issues should be articulated. However, we can never forget that for most of our clients a secure pension fund is the primary concern.
Responsible Investor: What does the project mean practically for your internal investment strategy as well as your use of external asset managers?
Jaap van Dam: The idea was to review how we look at strategic asset allocation within our role as a pension fund manager, and concentrate on this rather than micro management of the external asset managers that work for us. You should really focus on the large decisions because you can delegate a lot of smaller decisions. Also, there is only a limited amount of hours and focus that you can bring to the table, and in that limited amount of time you should concentrate on the big picture. If you can fix the ‘agency’ problem with your managers then you can let them get on and manage, because you look after the strategy. This is part of what we would like to achieve. However, in everyday life agency issues are not small and so we will try and address and improve these in the coming years. Also, with some other pension funds I’ve seen a move towards longer horizon relationships with a smaller number of fund managers, which might be a good way to reduce agency issues.
We already have something like this in our Responsible Equity Portfolio, which takes large stakes in a small number of companies and seeks to drive change and values through long-term ownership support. We also already have a number of evolved sustainability strategies. For example, we developed an index in house that measures the 2800 companies in the FTSE All World Index for their environmental, social and governance policies. The index re-ranks the companies based on these criteria, which also include a minimum threshold. As a consequence of this, about 200 companies that don’t make it into the index and have been sold, which amounts to about 1 per cent of the portfolio. We’ve just completed the second year managing passively to this ESG customised benchmark, which accounts for about 90% of equities exposure, or about €44 billion in market-cap and smart beta strategies.
Responsible Investor: What is the next stage of the project?
Jaap van Dam: The research phase has been done but it is quite philosophical in nature. The translation of the philosophical to the practical still has to be done to a large extent and this will be the work of the next three years and beyond. The next phase is called Investment Strategy 2014-2020. We have identified ten work-streams that will slowly, year by year translate the framework into policy and implementation. It will be a gradual, evolutionary process. There are a number of principles that stand behind this process. One is that to achieve our ambition we must issue clear mandates to our asset managers that require them to adopt a critical attitude with regard to their investments.
Another is that to efficiently fulfil our pension ambition will require customized benchmarks that differ from those of the investable universe as a whole. We do not see “beating” benchmarks in the short term as an efficient means of achieving the ambition. We need to recognise that a benchmark is a means rather than an end: the benchmark should be geared toward the end, which is fulfilling both financial and sustainability goals. The resulting question – “Why is this benchmark an efficient means to solve our problem?” – should lead to better benchmarks, in both financial and sustainability senses: “Does this benchmark reflect our thinking?”
Furthermore, focused portfolios of investments of which we have a thorough knowledge can also contribute effectively to achieving that sustainable finance ambition. Making sustainability an integral part of our investment policy also requires us to invest in ways that are not always in line with current thinking on investment. Costs are also an important component of the investment return and therefore need to be controlled. In short, we are looking for direct links between ambition and investment management.