An increasing number of plan members are uncomfortable with the idea of profiting from corporate practices that offend their personal values, such as the destruction of old-growth forests, the development of destructive weapons and cigarette manufacturing. Many members are asking pension plan sponsors and trustees to invest plan assets in a socially responsible manner. Some plan sponsors already state that social responsibility is an organizational value. This makes socially responsible investing (SRI) a logical consideration for these organizations.

SRI assets in the U.S. amounted to over US$2 trillion by the end of 1999, representing 13% of all investment assets under management. While the amounts invested in SRI are much smaller in Canada, SRI mutual fund assets have grown at more than three times the rate of overall mutual fund assets from 1989 to 1999, according to Michael Jantzi Research Associates Inc. of Toronto.

SRI brings an ethical element to bear on investing. The intent of the strategy is to earn a reasonable rate of return while achieving certain goals of social responsibility. Although there are as many types of social responsibility as there are socially responsible investors, there is much common ground in the SRI arena. SRI goals typically include improving corporate environmental practices, discouraging sin products such as alcohol and, in some cases, supporting the local economy.

There are two main approaches to SRI: screening and shareholder advocacy. Screening involves examining a company's characteristics and practices and eliminating those organizations that do not clear an established SRI bar. Shareholder advocacy, on the other hand, does not prohibit investment in any specific firm. It is the process of trying to change corporate behaviour through submitting and voting on proxy resolutions and holding discussions with a corporation's senior management.

There are other SRI approaches such as community or targeted investing and social venture capital. However, these approaches are rarely adopted by pension plans. In the U.S., research conducted in 1999 shows that screening accounts for 57% of all SRI assets, shareholder advocacy accounts for 30%, while 12% of all SRI assets were invested using a combination of these two approaches. Other SRI approaches account for 1% of assets.

A FIT FOR YOUR PLAN?
It is helpful to use the following steps to assess whether SRI is a good fit for your pension plan:

1. Define the social issues. The most common issues targeted by SRI are smoking, gambling, weapons production, alcohol and companies that are not environmentally friendly, according to a report by the Social Investment Forum in the U.S. Human rights, labour practices, birth control and abortion are also frequent targets. However, the issues that are most important to your plan and to your members may be quite different. Feedback is important to consider.

2. Determine the preferred SRI approach. Shareholder advocacy is the less invasive approach to SRI as it does not restrict the selection of securities that the plan can hold. However, plan members demanding SRI may not feel that it is a strong enough stance. On the other hand, screening means 'putting your money where your mouth is' and refusing to hold securities in companies that do not meet your SRI criteria, regardless of the return you expect them to generate.

Pension plans can screen in either of two ways: on an absolute basis--by screening out all companies that do not meet minimum standards--or on a best-in-class basis, which evaluates the performance of companies relative to others in their industry and screens out only the worst offenders. The best-in-class approach allows you to keep the plan's portfolio diversified across all industries. However, the absolute approach is considered to be a purer form of SRI.

3. Investigate risk/return and cost implications. Shareholder advocacy does not explicitly affect security selection and it is presumed to have no risk and return implications for a portfolio. But there may be additional costs. The plan has to pay an external manager to research, submit and vote social proxy resolutions, or do the work itself.

Screening can have a significant impact on a portfolio's risk and return characteristics. Plan sponsors and trustees should review the historical and expected performance and volatility of screened portfolios and compare it to unscreened ones. Due to the wide variety of screening criteria that can be applied, it is important that the historical data be representative of the specific screens under consideration. If actual historical data is not available, review the historical performance of hypothetical portfolios. There are many historical studies showing that, over various time periods, screened portfolios have equaled or outperformed regular portfolios, so you need to review the data cautiously.

Historical comparisons can be end-point sensitive, that is, the same conclusions may not hold over different time periods. This is especially true where outperformance is due to sector, style or capitalization biases in the screened portfolio. For example, many screened funds performed well in 1999 and early 2000 because technology stocks were overweighted. Many of these funds have underperformed traditional indexes over the past year.

It is important to understand the expected, as well as the historical, impact of your screening process on future portfolio performance and volatility. Extensive screens (especially absolute ones) can significantly reduce the universe of stocks available to the plan's fund manager, resulting in a less diversified and more volatile portfolio. By reducing the range of security choices available, extensive screening can diminish an active manager's ability to add value. Also, screened funds can be more costly than unscreened ones due to the additional administration involved in the screening process. Any increase should be considered at this stage.

4. Review legislation and plan documents. One of the biggest considerations in introducing SRI is whether it conflicts with fiduciary responsibilities. There is little concern with a shareholder advocacy approach since the expected return and risk characteristics of the portfolio are not believed to be affected. However, the legality of screening is an area of debate in Canada.

Plan sponsors should review their pension plan documents--plan text, trust agreements and the statement of investment policies and procedures (SIPP)--to determine whether SRI is expressly permitted or prohibited. Relevant legislation for the plan's jurisdiction must also be considered. In Canada, this legislation will include provincial trust law and pension benefits standards acts.

Unfortunately, most legislation does not directly address SRI. To date, there have been few relevant legal cases to guide plan sponsors. Frequently, the decision comes down to a judgment call as to whether the benefit of introducing SRI outweighs any liability. In some cases plan sponsors may be able to significantly reduce liability through what is known as a variation of trust procedure involving member consent to authorize SRI.

5. Assess the risk factors for your plan type. The introduction of SRI in a defined benefit (DB) pension plan is far more controversial than in a defined contribution (DC) plan where members make their own investment decisions. In a DC plan, as long as members who do not want to pursue SRI are able to select similar unscreened funds, adding an SRI fund option--with member education and appropriate warnings about potential loss of return--is unlikely to result in much, if any, additional fiduciary risk.

In a DB plan there are three key risk factors to consider: risk-sharing arrangements, member demand and surplus ownership. With risk-sharing arrangements, if members share the consequences of poor investment results through increased member contribution rates or reduced benefits, they will be more sensitive to any loss of return due to SRI screening, especially if the screens are unilaterally imposed by the plan sponsor. Conversely, members may view risk sharing as giving them the right to demand SRI.

If a large percentage of plan members have requested that the plan pursue SRI, there is less risk of future lawsuits. In instances of surplus ownership, the imposition of social screens by the plan sponsor is less problematic where members have no ownership interest in surplus. In general, the higher the risk that plan members may suffer adverse financial consequences from the introduction of SRI, the higher the fiduciary risk in implementing it. Due to the uncertainty of the legal environment surrounding SRI, especially in DB plans, and the rapid evolution of the SRI marketplace, it is best to seek legal and consulting advice on whether the approach being considered is appropriate for the plan.

IMPLEMENTING SRI
If you wish to go ahead with SRI, it is important to follow a proper implementation process. Identify managers who can follow the SRI approach selected and, if necessary, implement the selected screens. If the plan's SRI portfolio is large enough to use segregated management, then your choice of managers is almost unlimited. However, if your plan's portfolio is smaller, you will have to use existing SRI pooled or mutual funds (see "SRI and manager selection").

The selection process for an SRI manager is the same as the selection process for a regular manager, but with additional considerations related to screening and/or shareholder advocacy. It is helpful to find out:

> If the manager has experience in working with SRI screens and/or shareholder advocacy.
> If the manager has the necessary resources to effectively research, submit and vote SRI proxy resolutions.
> If selected social screens interfere significantly with the manager's investment decision-making process. For example, do the screens eliminate a significant percentage of the securities the manager would hold if unconstrained?

Prudent implementation also involves modifying the SIPP to describe the SRI approach and criteria adopted, as well as the reasons for including SRI considerations in the plan's investment strategy. Once the SRI strategy and managers have been selected, communicate the investment changes to plan members. At minimum you should inform plan members of:

> The reasons for the decision to introduce SRI.
> The SRI approach selected.
> The screening criteria to be followed (if applicable).
> The cost and risk/return implications of SRI.

Member communication is especially important in DC plans where the individual bears the full impact of any investment underperformance.

As with any plan investments, performance monitoring on a regular basis is essential. The monitoring of SRI portfolios is the same as that of the plan's other portfolios, but it should include attribution analysis to show the performance impact of any SRI screens.

It is also important to re-assess the strategy periodically. You must keep up with changes in legislation, legal decisions, plan risk factors and the risk/return/cost trade-off relating to SRI. A regular assessment of these factors will ensure your SRI strategy remains appropriate as the environment changes. BC

Damon Williams is vice-president and Brendan George is a senior consultant with Aon Consulting in Vancouver. damon_williams@aonconsulting.aon.com.