August 1, 2014

Pension Funds and Integrated Reporting: A Progress Report

“Australia’s largest super funds have thrown their support behind a new reporting system....The Integrated Reporting Pension Funds Network is being taken around the world....”.

The Australian15 July, 2014

The IR Initiative

The International Integrated Reporting (IR) initiative was the subject of our May 2013 Letter titled “The Integrated Reporting Initiative: What’s In It For Pension Funds?” The initiative was formed in 2010 to build a globally-accepted framework to produce clear, comparable information about how business organizations create value over time. Remarkably, IR has come to be supported by leaders across the international corporate, investment, accounting, regulatory, and academic communities. In just three years, the IR initiative has produced a Discussion Paper on integrated reporting (2011), a Prototype Framework for integrative reporting (2012), a Pilot Program made up of a Business Network and an Investor Network (2012), and a detailed Consultation Draft on the proposed IR Framework in early 2013. All this led to the issuance of the International IR Framework in December 2013.

Our May 2013 Letter encouraged the leadership of the international pension management community to become familiar with the initiative. Not just because it will lead to more useful investor information about how investee corporations are creating value over the short, medium, and longer term, but also because the IR Framework is a useful tool for pension organizations themselves.

In many cases, pension organizations could do a better job informing their own stakeholder groups (i.e., pensioners, workers, employers, investors, regulators, governments) on what they are doing to create value. As their decisions impact future stakeholder groups too, relevant information about these impacts should be conveyed as well.

The above-cited article in the 15 July issue of The Australian indicates pension organizations have indeed begun to embrace the IR message. Under the umbrellas of AIST (Australian Institute of Superannuation Trustees) and ACSI (Australian Council of Superannuation Investors), a new IR Pension Fund Network has been formed by five Australian funds with a vision to become a multi-national body. The two key focus points for the new Network are 1. Integrated Report preparation for pension organizations themselves, and 2. Interacting with the International IR initiative and other relevant bodies (e.g., regulators) in the development and use of Integrated Reports.

This Letter revisits the IR initiative by summarizing the key features of the new International IR Framework released this past December. It also assesses the Integrated Annual Report prepared by the South African Sentinel Mining Industry Retirement Fund in the context of the new Framework. While this Report clearly demonstrates the power of integrated reporting, we point to three areas where, in our view, future versions the Report could be improved.

The New International IR Framework – Guiding Principles

The Framework sets out seven Guiding Principles in the creation of an Integrated Report:

Strategic Focus and Future Orientation: explain how organizational strategies will create stakeholder value in the shorter and long terms and the related use of capital resources.
Connectivity of Information: paint holistic picture of how various factors integrate to create value over time.
Stakeholder Relationships: describe nature of stakeholders, their relationships to the organization, and the organization’s accountability to them.
Materiality: provide information on matters impacting the organization’s ability to create value over time.
Conciseness: use no more words than necessary.
Reliability and Completeness: include all material matters with balance and accuracy.
Consistency and Comparability: present information to enhance comparability over time, and to other organizations to extent possible.

These seven Guiding Principles naturally lead to eight Content Elements.

The New International IR Framework – Content Elements

Integrated Reports should cover the following linked (i.e., not mutually exclusive) elements:

Organizational Overview and External Environment: what does the organization do, and what are its context and circumstances?
Governance: how does the organization’s governance structure support value creation?
Business Model: how does the organization create stakeholder value over time?
Risks and Opportunities: what are the key risks and opportunities and how are they addressed by the organization?
Strategy and Resource Allocation: where does the organization want to go, and how is it going to get there?
Performance: what did the organization achieve over the period in the context of its strategic objectives, and what were the impacts on capital resources?
Outlook: what challenges and uncertainties does the organization face in achieving its strategic objectives? What are the implications for its business model and future performance?
Basis of Presentation: what is the determination process for deciding which matters to include in the Integrated Report?

How could these Guiding Principles and Content Elements translate into an Integrated Report for a Pension Organization? That is the next question this Letter addresses.

South Africa’s Sentinel Mining Industry Retirement Fund

Sentinel is a multi-employer pension plan in South Africa that completed a major merger on July 1, 2013. It now involves 102 employers and covers about 90 thousand workers and pensioners. It is a hybrid plan in the sense that plan contributions are deposited into worker retirement accounts, and accumulated retirement savings are converted into annuities at retirement. The Integrated Annual Report for the FY ending 30 June 2013 is Sentinel’s second one. In its introduction the organization acknowledges: “...this integrated reporting process is a journey, and this is a further step towards providing a balanced, accurate, and clear account of our performance relative to our strategy”.

The Sentinel Report has six major sections in the following chronological order:

Mission (p1): short statement why the organization exists and the purpose of the Integrated Annual Report.
Key Organization Performance Highlights and Milestones (p2-7): key events/accomplishments in FY 2012/13 and key organizational milestones going back to inception in 1946, mainly graphs and photos.
Who We Are and What We Do (p8-15): fund history; plan design; investment structure; stakeholder communications; organization design; board of trustees composition and the meeting attendance records of its members.
Board Chair and CEO Reviews (p16-25): award-winning investment and pension operations outcomes despite difficult economic and financial markets conditions; successful completion of major merger; growth opportunities beyond the SA mining sector; unique basket of investment and pension product offerings; in-house member advisory service; strong product quality and risk controls; strong governance principles and practices; concerns about evolving government social security policies.
Board of Trustees Report (p26-60): a matrix of Sentinel’s six major stakeholder groups, their key issues, the organization’s response/engagement strategy, and outcomes; statement of four organizational objectives, the strategies through which they will be achieved, and key performance indicators to measure success; strategic performance review; a matrix of eight areas in which risks will be defined, monitored, and mitigated; four possibilities where risks might be converted into opportunities.
Statutory Financial, Actuarial, and Administrative Reports (p61-81): Report of the Independent Auditor; Financial Statements and Notes to the Financial Statements; Report of the Independent Actuary; Administrative Information on contacts, addresses, and external service providers.

So how does Sentinel’s Integrated Annual Report for 2013 stack up against the new IR Framework of Guiding Principles and Content Elements? That is the question we address next.

Practice vs. Theory

A first observation is that there are many similarities between Sentinel’s Integrated Annual Report and any good ‘regular’ Annual Report of a pension organization. So what is different? For us it was how the Board of Trustees Report integrated information about who Sentinel’s key stakeholder groups are and what their issues are, with organizational objectives, strategies, outcomes, and with how risks were defined, monitored, and mitigated. The use of matrixes was especially effective in integrating information.

So, for example, the Stakeholder Matrix has five integrative elements:

Stakeholder: six stakeholder groups were identified (workers, pensioners, employers, organized labor, government, service suppliers, regulator).
Key Issues/Concerns: identified for each of the six stakeholder groups (e.g., for pensioners: “a sustainable pension that keeps track with inflation”).
Response: solution to the key issue/concern (e.g., for employers wishing for benefits that meet employee needs: “a flexible benefit product with participation flexibility”).
Engagement Strategy: methods through which the chosen response is going to be delivered (e.g., website, newsletters, special studies, face-to-face meetings).
Outcome: what does success look like? (e.g., increased member satisfaction, enhanced reputation, stronger working relationships, and better government policies).

Similarly, the Risk Management Matrix has two integrative elements:

Risk to be Managed: the Matrix describes eight risks to be managed (e.g.,”’longevity risk’ is the possibility that actual average pensioner longevity exceeds expectations, leading to underfunding in the Pensioner Portfolio”).
Control: describes how each of the eights risks is going to be managed (e.g., “we will manage ‘liquidity risk’ through ALM and cash-flow analyses and maintaining an adequate liquidity pool”).

These two matrix examples show how integrated reporting forces integrative thinking about organizational objectives and strategies that should result in better outcomes. The Sentinel organization is to be congratulated for their impressive progress in what they called their integrative reporting journey.

Three Possible Next Steps in the Journey

Sentinel noted that the 2013 Report was “...a further step towards providing a balanced, accurate, and clear account of our performance relative to our strategy”. We end this Letter with three ideas that could be considered as future steps on the integrative reporting journey.

Actual Income Replacement Outcomes: Given the purpose of the organization, there is one outcome that should stand above all others: maintaining workers’ standard of living after they stop working. The Report sets this target out as an income replacement rate of 75% of salary with 80% post-work inflation indexation. However, we could not find any information in the Report as to whether this goal actually has been, is being, or will be achieved over time.
Pensioner Annuity Balance Sheet: While the Report clearly states that at retirement “a monthly pension benefit (annuity) is purchased from the fund”, there is no pensioner annuity balance sheet to be found in the Report. Instead, there is an asset-only Pensioner Portfolio, and a 1-page Actuarial Report that simply states: “The pensioners have a separate pool of assets....This pool was 113.9% funded as at 30 June 2013....”. We were unable to find any support for this statement anywhere in the Report. Given its materiality to the sustainability of the Sentinel enterprise, we would have expected significant support for this assertion in the Report (e.g., the basis for the projected future pension benefits, the discount rate employed to estimate the accrued liability, the mortality table employed, and the target funded ratio to be achieved).
Integration of Investment Strategies and Outcomes: The Report has separate sections on achieved fund returns versus benchmarks, and on its Responsible Investment/SRI activities. For example, it reports one, three, and five-year returns for its four major investment options versus CPI and Market Index benchmarks. It also reports in considerable detail on its RI/SRI program in the form of active proxy voting and corporate engagement activities and its outcomes. What we could not find in the Report were any explicit linkages between the investment strategies of Sentinel’s team of external investment managers and the organization’s aspiration to be a leader in the RI/SRI space. For example, what kind of investments do its managers favor? Are they high-conviction investors? How have they interacted with investee organizations? Maybe most tellingly, what were their portfolio turnover rates? We could not find answers to these questions in the Report.

Again, we emphasize that Sentinel’s 2013 Integrated Annual Report is an impressive document. Here we simply point out that, in our view, steps could be taken to make an even more impressive one in the years ahead.