Good morning. It is no exaggeration to say the pensions industry is a lynchpin of the economy. Pension fund investments are a critical source of capital for UK companies, and potentially for infrastructure as well as savings vehicles.
Collectively, you hold over £150bn of UK equities. That figure illustrates the scale of your influence, but it goes much further than merely delivering returns to fund tomorrow’s pensions for today’s workers.
Careful husbandry over long timescales, a core duty for any pension fund, is an essential component in a system of responsible capitalism that encourages the pursuit of long-term value rather than short-run, sometimes illusory, returns.
So I would like to focus today on the work we are doing in government to support such a system - because it is clear we have a long way to go before we can say it exists.
Equity investment has become increasingly complex and intermediated, with more and more links in the chain. As a result, the different players are often working to their own agendas and timescales to the detriment of long-term value creation.
Too often, traders go after a quick buck rather than looking for sustainable returns based on sound stewardship of companies. Holdings are bought and sold to turn a short-term profit with no thought given to the underlying fundamentals.
This phantom chase was at its most frantic in the financial markets, where banks took dross and sold it as gold. But that lack of responsibility - the failure to take calculated investment risks based on sound principles - is more widespread.
The issue of so called short-termism is part of a wider debate about capitalism and whether it should be constrained by a wider sense of responsibility. So, what do I mean by responsible capitalism? Let me explain by quoting Adam Smith, who said:
“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our own necessities, but of their advantages.”
But Adam Smith himself was scathing about some forms of business behaviour - particularly those that led to the suppression of competition. He wrote “people of the same trade seldom meet together even for merriment and diversion, but the conversation ends in a conspiracy against the public.”
I realise that there some irony in using this particular quote in a speech to a trade association conference. But Smith’s conception of self-interest is distinct from the crude, material, selfishness we have seen. Elsewhere in his writings he discusses the notion of sympathy, or fellow feeling, and emphasises its importance. So Smith’s butcher or baker cannot pursue their self-interest and obtain what they want without also meeting the needs of the customer.
The pursuit of self-interest is not inherently irresponsible: the desire to trade and profit produced meat, beer and bread in Smith’s day, and today has given us iPads, foreign holidays and life-saving drugs. What connects these things is their reliance on individuals acting in their own interests to deliver goods and services that benefit us all.
It is difficult to reconcile Smith’s butcher, brewer and baker with the complexity of today’s capitalism. Indeed the modern public company with dispersed shareholder ownership did not exist at that time. But they would have recognised the key role that trust and confidence play in effective markets. Without them, no economy can function effectively.
We have seen too many examples of irresponsible capitalism recently. Companies not paying their taxes. Employees making up the numbers or gambling the future of the entire company. Customers being sold complex products they neither need nor want. Managers helping themselves to lavish remuneration packages at the expense of customers, their shareholders and their workforce.
Sir Roger Carr, the CBI’s President, acknowledged the problem at its annual conference on Monday. He said:
“Standards have been variable, greed prevalent and fairness forgotten in a number of sectors - banking and media at the forefront - but others from all walks of life showing signs of bad behaviour.”
As someone who found myself labelled “anti-business” for criticising the excesses of banking and media barons I empathise totally with Sir Roger. He, like me, is of course pro-business.
But like many in this room and in business we share a sense of dismay at some recent behaviour. I believe the majority of businesses play by the rules, pay their taxes and contribute to the economy. Where they don’t, Government has a duty to intervene. But as owners, institutional investors have a major role in challenging and correcting this behaviour.
Our task together is to reform the system in order that trust is restored because, without it, the capitalist system cannot function effectively.
There are fundamental questions about why parts of the capitalist system have gone awry. At least part of the industry’s problem is one of distorted perspective - a prevailing focus on the short term at the expense of the long-term.
The Kay Review
This was the supposition which led me to invite John Kay to look at this problem in the round. And he has subjected the UK’s equity markets to rigorous independent review with support from Sir John Rose, formerly of Rolls Royce, Chris Hitchen of Railpen and James Anderson of Baillie Gifford
His findings amount to a compelling argument that today’s transactional cultures and the pursuit of short-term gains in financial markets are undermining the core responsibility of company directors and institutional investors to act as effective stewards of the assets they control.
The long-term pursuit of value creation has been crowded out by a focus on short-term gains.
Company directors have a clear legal responsibility to make decisions with regard to the long-term. This is part of their duty to promote the success of the company. Engagement by investors needs to change to support directors to meet this responsibility. The focus should be aligned with the timescales of the company’s business model - which may be very long term.
And the stewardship relationship must be based on an understanding of company fundamentals. That’s the best way to create an environment of trust and challenge, which enables those managing the company to take sound long-term decisions on investment and strategy.
John Kay found there is a particular problem in how the performance of active asset managers is currently measured. Faced with the need to deliver short-term performance, active asset managers will have an incentive to focus on what the market is doing - seeking to outperform other asset managers - rather than to engage with companies to understand and foster the creation of value.
So pension schemes and other asset holders need to issue clear mandates for active asset managers. They must set targets to achieve absolute returns that meet the needs of savers rather than just chasing the market.
That approach will send a strong signal that it’s time the short-termism ended and was replaced by a clear-sighted focus on long-term value creation.
I am grateful to John for his cogent analysis of the problems in the corporate sector. Today I am publishing the Government’s response to his review. It focuses on restoring relationships based on trust and confidence to the investment chain. The report has provoked constructive debate on many of the issues raised, and progress is being made on a number of the recommendations.
The Financial Reporting Council has revised the Stewardship Code to give a sharper emphasis on long-term company strategy, reinforcing the message that engagement has to be more than a box-ticking exercise. Instead, it requires genuine dialogue with companies about the long-term prospects for growth.
Investors are also recognising they need to engage collectively with companies. The review recommended an investor forum to maximise their influence, and there are encouraging signs that this will happen soon. I am happy to be a catalyst but it is not for government to create a new quango - a forum will only succeed if it is created and run by the investors it represents.
High on the to-do list for any forum is to tackle overly complex incentive schemes which encourage short-termism and tend to pay out asymmetrically. Some executives see spectacular rewards for good performance but there is no corresponding fall in pay when performance is poor.
John Kay called on companies and asset managers to change their own practices. Our reforms to executive pay - including giving shareholders a binding vote on pay policy for the first time - will support this by empowering investors to engage more effectively with companies.
We have come a long way in the last year. The shareholder spring has shown there is real appetite among shareholders to be much more challenging of unjustified pay awards.
The crucial factor is ensuring investors have the information they need to make long-term decisions, on pay and a range of other issues. John Kay was scathing about the effect of quarterly reporting on long-term investment. I agree with his analysis, and the government will work with our European counterparts to change the law so it is no longer required.
But there is a challenge here too for asset owners, including pension funds, who need to look beyond quarterly performance to judge their managers.
Our narrative reporting reforms, to encourage better quality annual reports that put the numbers into context, will help. The new rules, which come into force next year, will make reports simpler, more relevant and more focussed on forward looking strategy.
Trust is also the product of behaviour - a commitment to act with integrity and expect integrity from each other.
The term ‘fiduciary duty’ is used a lot in the debate on these issues, but it means different things to different people. We need clarity, with consistent standards of behaviour required throughout the investment chain.
So today we are making it clear that all intermediaries should act in good faith in the long-term interests of clients or beneficiaries.
These standards should be universal and immutable. We need to achieve them by making sure that our regulatory framework supports them - but also by promoting them as behavioural norms in the investment industry.
So we will ask the Financial Conduct Authority to consider whether their regulatory rules and approach support these standards and, where necessary, we will argue for changes to regulatory requirements at EU level.
In addition, we are asking the Law Commission to conduct a review of the legal obligations on investment intermediaries seeking to act in their clients’ best interests - and to report back as soon as is practicable
Takeovers bring the discussion of duty and long-termism into particularly sharp focus. Company directors have a legal duty to promote the success of the company. A duty that requires that decisions be made with regard to the long-term consequences.
Company directors must recommend that shareholders reject a bid if they believe that the transaction will destroy long-term value, or that the premium being offered does not reflect the fundamental value of the company. Directors must give their best advice to shareholders. Shareholders must then decide what to do.
Owners and asset managers have a vital role here. In order to protect their long-term financial interests they must challenge management to explain the strategy and logic of large deals and provide robust, consistent push-back where they have concerns. Events continue to show it is as true for the shareholders in the bidding company as it is in the target.
I understand that the Takeover Panel are carrying out a review of the impacts of last year’s changes to the Takeover Code. I look forward to seeing their findings, and their assessment of the progress that has been made.
In the light of the debate around takeovers in the wake of the Kraft acquisition of Cadbury, I was anxious to ensure that takeover activity should be subject to greater transparency over fee incomes, and that rules should not play into the hands of short-term speculative investors. I therefore welcomed the reforms by the Takeover Panel.
But government also has a wider role to play here - particularly in strategically important sectors. This is recognised by the current legal framework, and we are not proposing to change it. It is important that companies focus on creating sustainable competitive advantage, not on complex merger and acquisition strategies that destroy shareholder value.
Takeovers are part of a wider context: the need to ensure that the bedrock of the capitalist system - the competitive market - functions as effectively as possible. The government is consequently strengthening the regulatory framework to create a single, powerful competition authority - the Competition and Markets Authority.
It will have a duty to promote competition for the benefit of consumers and will observe the principle of supporting long-term growth. This objective will be formally embedded in its performance framework.
We will also ensure that the Competition and Markets Authority works closely with sector regulators to more vigorously tackle competition issues in regulated sectors.
All of the areas I’ve discussed depend on effective engagement between companies and their owners for progress to be made. So to fuel to the cultural change that’s required, we are endorsing John Kay’s ‘Principles for Equity Markets’ - and the directions for market practice which flow from these.
In particular we have challenged leading industry bodies - including the NAPF - to review the report’s Good Practice Statements. I am delighted the NAPF has accepted this challenge.
And to measure the headway we are making on John Kay’s recommendations we will publish a progress check in eighteen months’ time, setting out how Government has taken forward the recommendations and how well companies and investors have stepped up to the plate.
Industrial Strategy and Financial Services
There are other major policies afoot which have at their heart an attempt to inject a more long term approach to business decision making. One is the industrial strategy in which we sit down with sectors like aerospace, life sciences, automobiles, energy supply chains, and others to plan the long term implications for skill development, technological change and innovation and procurement.
Another is financial services. Tim Breedon’s recent review for me found the UK has one of the most sophisticated financial centres in the world. But UK businesses outside the financial sector aren’t getting the benefit from this. There is a kind of enclave development unconnected with the real economy.
One specific example is that while the City can provide a range of sophisticated services to international business, British medium and small companies cannot get long-term, patient capital for love nor money.
So, we need to fundamentally change the system so the financial services industry serves businesses, and not the contrary.
We are taking a number of steps to reform the banking industry, but we need to go further and reshape the business finance market. That is why I have announced the creation of a business bank that will have as its core mission to stimulate competition in the business finance markets and make them work for businesses.
With a clean balance sheet, and £1bn worth of funding, this bank will be tasked with expanding lending and investment to the manufacturers, exporters and high growth companies that power our economy, in particular addressing the need for long-term, patient capital.
We will shortly announce the appointment of an advisory group for the bank. Its task will be to help shape the design and its future activities.
There are many other areas that will help promote long termism, and truly responsible capitalism, such as greater diversity in workforces - especially in the boardroom, the growth of social enterprise and alternative models such as employee ownership and mutuals. I cannot hope to go into detail on all of these areas in this speech, but we are making good progress.
This then, is the government’s clear priority - ensuring we have a market economy rooted in a system of responsible capitalism. Expectations of the market system have changed since the financial crisis - after paying for its reconstruction, UK citizens must see and share in the benefits of recovery and growth.
The far-reaching reforms I have discussed today will help, but they are the start of a much longer process. One that requires a change in attitude and behaviour among key players in the system.
Many companies are beginning to recognise this, and are investing in jobs, skills, supply chain development, and other areas that will help create long-term value.
It is only by responding to these concerns that we can restore trust in markets - and as major shareholders you are in a uniquely strong position to help achieve that.