Contact: David Wilson (01962) 847407; [email protected]

1 Introduction

1.1 Recent press headlines have drawn attention to the fact that many local authority and other pension funds hold investments in companies associated with the arms trade. This follows a survey carried out under the Freedom of Information Act by the Campaign Against the Arms Trade (CAAT), to which the Hampshire Fund submitted a full response in March 2006, which is attached at Appendix 1. The County Council also issued a press statement in May 2006 as follows:

"The pension fund is subject to democratic scrutiny through the Pension Fund Panel, and the requirement is to invest only with the beneficial interests of the employees in mind. Having said that we do still retain the small ethical fund. Generally, it is impossible to exclude companies for tobacco, drugs, animal testing, free trade etc, as well as arms, because most companies are global and their operations stretch in so many different activities. We don't set out to invest in cluster bombs - many other organisations and companies may be part of the supply chain and the value of arms trades for those listed may only be a proportion of their total activity."

1.2 Two fund members, one contributor and one pensioner, have since written to the County Treasurer, objecting to any investment in the arms industry and requesting that such investments should be sold.

1.3 This report examines the issues involved and recommends that no change should be made to the Hampshire Fund's policy.

1 Ethical investment - the Hampshire Fund's current stance

1.1 The following extract from the Fund's Statement of Investment Principles (SIP) sets out the Fund's current policy on ethical investment.

Social, environmental and ethical considerations

· The prime objective of the investment of the Fund is to achieve the best financial return consistent with an acceptable degree of risk.

· However, the Fund recognises that the adoption by companies of positive social, environmental and ethical principles in planning their activities can enhance their long-term performance and increase their financial returns.

· The Fund has delegated to the fund managers responsibility for taking social, environmental and ethical considerations into account when assessing the financial potential and suitability of investments. Each manager must work positively with companies to promote forward-looking social, environmental and ethical standards, rather than adopting a policy of negative screening of stocks.

· Managers are asked not to invest in stocks that could reasonably be expected to cause embarrassment to the Fund.

· Aberdeen's ethical portfolio is invested in UK companies that promote environmental improvements, conservation of natural resources, safe products and services, and good staff and customer relations.

1.2 The Fund's current policy is perfectly clear and fully consistent with the County Council's responsibilities as administering authority. These responsibilities were clarified in the case of Cowan and others v Scargill, heard by Vice Chancellor John Megarry in 1984, commonly known as the Megarry Judgement. The case concerned the investment policy of the National Union of Mineworkers' Pension Fund, which had sought to avoid certain investments not to the liking of the union leadership. Megarry ruled that the prime objective of pension fund investment should always be the achievement of the best possible financial return consistent with an acceptable level of risk. Ethical considerations could only be secondary, for example if making a choice between investments of equal financial standing. Thus, the Hampshire Fund must always be invested in the long-term financial interests of both the Fund's members and the council taxpayers of Hampshire, who meet the cost of poor investment returns if employers' contributions rise.

1.3 However, the Fund accepts that positive social, ethical, and environmental policies can enhance long-term financial returns. It has delegated decisions on ethical considerations to its external managers, and expects managers to engage positively with companies to improve social, environmental and ethical standards.

1.4 Aberdeen's ethically screened portfolio, currently valued at only £13.7m, represents 0.5% of the Fund's total value. This does avoid investing in arms companies and other `unethical' sectors, for example tobacco and pornography. The Panel agreed in December 2005 to absorb the ethical portfolio into the main investment arrangements when the ongoing review of fund management is implemented later this year.

2 An ethical policy - screening or engagement?

2.1 The Hampshire Fund currently favours an engagement approach rather than negative screening of stocks. The effects of the two approaches are very different.

2.2 The effects of a policy of refusing to invest in a particular industry are indirect. The impact of one fund withdrawing from a particular sector would be relatively insignificant. However, if there was a significant disinvestment from the arms industry by pension funds generally, the effect would be seen in falling share prices and deteriorating longer-term investment prospects. There would be a tendency towards a `snowball' effect, as poor investment prospects would in turn lead to further disinvestment in the arms industry as more institutional investors withdraw for purely financial reasons. Any damage to the industry would be long-term as the cost of new capital for the firms targeted would tend to rise.

2.3 It should be borne in mind that our current index-related targets in the scheme-specific benchmark in themselves act as an incentive for managers to hold major stocks within the index, even if they do not rate companies highly on financial or ethical grounds.

2.4 The engagement approach favoured by the Hampshire Fund can have quicker results, but can only achieve them if it is implemented by managers who believe in the process. All of the Fund's current managers have engagement strategies, and use their influence to change investee companies' policies if such changes are likely to improve their investment prospects.

3 An ethical policy - the need for a consensus

3.1 The prime criterion when making investment decisions must always be the expected financial return. This must never be overridden by non-financial criteria.

3.2 Notwithstanding that, the determination of an ethical policy will always be difficult for a large pension fund serving a wide range of members. There is no consensus that the arms industry is a bad thing. The UK Government itself is a customer of the arms industry, and encourages arms companies to export their products. Many believe that the defence of the country is a vital safeguard that should be actively supported. Council taxpayers and fund members will inevitably have a wide range of opinions.

3.3 It follows that to adopt a policy of screening out arms companies would set a dangerous precedent. Other council taxpayers could argue that arms investments should be reinstated - for example because the arms industry is a large employer in Hampshire. Alternatively, they could argue that other sectors, for example tobacco and alcohol, should be excluded.

4 Other issues

4.1 It is often difficult to distinguish clearly between ethical and unethical companies, regardless of the criteria chosen.

4.2 Very few companies can be described as concentrating solely on the arms industry. Rolls Royce, for example, are also involved in the manufacture of civilian aircraft.

4.3 It could also be argued that there is little difference between an engineering firm that produces nuts and bolts subsequently used by an arms manufacturer to make weapons, and a telecoms company whose systems are used by an arms manufacturer.

4.4 Some argue that campaigns against the arms trade could be better focused on arms purchasers, rather than the suppliers. If there was no demand arms suppliers could not remain in business.

5 Conclusion

5.1 The Panel may wish to conclude that the Fund's policy of investing in arms companies as the managers see fit should continue. The Fund's policy of engagement, set out in the SIP, remains appropriate.

Recommendations

1 That the Fund's policy with regard to `ethical' investment, including investing in companies that also manufacture arms, should remain unchanged.

Section 100 D - Local Government Act 1972 - background papers

The following documents disclose facts or matters on which this report, or an important part of it, is based and has been relied upon to a material extent in the preparation of this report.

NB the list excludes:

1. Published works.

2. Documents which disclose exempt or confidential information as defined in the Act.

TITLE FILE

None.