Next month the Department for Work and Pensions will outline tentative plans on the best way for UK pension schemes to consider “social impact” factors when making investment decisions.
The publication – which will include recommendations relating to the broader area of environmental, social and governance investing – follows a body of work carried out by the Law Commission and several UK government departments.
The June DWP response will land amid an increasingly heated debate between members of the defined contribution pension community over whether or not sustainable investment factors have a place in DC investment strategies.
From the government’s perspective, the stance is clear. A DWP spokesman said pension schemes must take account of “all financial opportunities and risks” when they set their investment strategy, in an emailed statement to Corporate Adviser. “As sustainability will often have financial implication, trustees should be considering this too.”
Spotting the divisions
At the end of last year, the DWP and the Department for Digital, Culture, Media and Sport published an interim response to the Law Commission report on Pension Funds and Social Investment.
In that response they cited research from law firm Sackers, noting that pension trustees “consider ESG and external governance reviews to be low priorities,” adding that “some see ESG as a distraction or potentially detrimental to achieving the scheme’s goal”.
In a bid to standardise trustee approaches to ESG factors, the DWP’s June report is expected to clarify the legislation around how long-term financial risks should be evaluated, how best to consider non-financial and ethical concerns and the extent to which pension trustees should have an obligation to engage with the companies in which they invest. For corporate advisers, this poses a tricky dilemma.
Unlike other investor types, where ESG approaches have been increasingly embraced in recent years, the defined contribution pensions market has been far more hesitant in its adoption.
“ESG is talked about more by investment companies than anybody else,” says Chase de Vere spokesman Patrick Connolly. “In the real world, it is getting a limited amount of lip service.”
Connolly draws comparisons of the current ESG push from asset managers, with the marketing efforts to popularise “ethical funds” in the 1980s, saying that ESG, as a concept, is still far too loosely defined in order for the DC market to be able to fully embrace it.
“Investment companies say that a sustainable approach is more likely to do well over the longer term, but that is not necessarily being translated to investors. In theory, there should be some truth in it, but the reality is that I have not seen any evidence to support it,” he says.
Connolly’s view is not unique. Others in the sector recognise that trustees are struggling with the promises from asset managers, that investing sustainably will definitely lead to better longer-term returns.
PTL managing director Richard Butcher acknowledges that the debate between pensions trustees is raging, but stresses there is no clear consensus.
“Do trustees believe what they are told? Some believe the evidence that viewing investments through an ESG lens produces better risk adjusted returns, but there are also a lot of others that think ESG investing is something that people in sandals do, and they don’t want an awful lot to do with it.”
Despite the polarised views in the trustee community, the industry body representing workplace pension schemes – the Pensions and Lifetime Savings Association (PLSA), in February, published a paper endorsing ESG investment approaches.
In its report entitled ESG Risk in Default Funds, the PLSA policy lead for stewardship and corporate governance Luke Hildyard said “ESG factors are material to long-term returns.”
He says: “We no longer understand ESG as a niche product designed to enshroud investors in a warm glow of righteousness, but as a critical component of the wisest investment strategies.”
Hildyard wrote that research underpinning the report had resulted in the PLSA also reconsidering how it engages with ESG issues.
“From seeking to better understand the importance of ESG to pension fund investors, we now want to help our members fully integrate ESG into their investment strategy.”
The PLSA’s belief is that UK defined contribution default funds are “significantly exposed” to risks which are specifically ESG related. These include issues relating to human capital, business ethics, product safety and data privacy, among others.
As such, the trade group recommended that pension schemes “explore the use of passive ESG products in their default funds” and “incorporate ESG factors into their global equity allocation model.”
Master Trust View
Those seeking endorsements for ESG strategies, should look no further than the largest master trusts. Among the cheerleaders is Mark Fawcett, chief investment officer of multi-employer pension scheme Nest.
In publishing the provider’s first responsible investment report back in 2016, Fawcett said that master trusts “have a responsibility” to consider ESG issues because they are “relevant to long-term wealth creation.”
But while larger, master trusts have whole-heartedly embraced investment approaches that recognise ESG factors, some smaller master trusts have not done so, according to Schroders defined contribution strategy manager Hilary Vince.
Schroders – one of many active asset management groups to invest in notable volumes of research on the benefits of ESG investing – says where trustees believe ESG issues are “financially material” they should take them into account.
Vince acknowledges that some DC trustees have previously been reluctant to embrace ESG investment approaches and have sometimes stated that their reluctance stems from the investment risk being borne by the member.
However, she also says that this is beginning to change as trustees become more aware of the potential benefits both in terms of investment returns and member engagement.
She explains: “Trustees have had a lot of other things to deal with, so perhaps it hasn’t been as high up on their priority list as it might have been, but now they are recognising it is not just about excluding sin stocks.
“It is common sense. If you invest in a company that is well run and well governed, it is going to be more sustainable.”
Vince argues that the beliefs of pension scheme members have changed over the decades and she believes that issues such as climate change and modern-day slavery really matter to the millennial generation. If the actual ESG issues are unpacked for scheme members, she suggests, it could lead to increased levels of engagement.
“I’m not sure many of them [trustees] appreciate that this might be quite a big issue for their members. It’s probably something that hasn’t been a big issue for those members retiring from DB schemes… But for most in DC now, this is a really big issue for them.
“If they want to get members engaged with their pensions. This might be a really good way to do it.”
Vince’s views are endorsed by the PLSA in the aforementioned report, which concluded that engaged investors enjoy better returns. But with pockets of resistance still plentiful in the DC market, it seems there is a long way to go until trustees, advisers and investment groups are all on the same page.
The Government created illustrative examples of the possible trustee behaviour change that may follow from changes to the Occupational Pension Scheme (Investment) Regulations 2005, which are proposed by the Law Commission
|Without a regulatory change
|With a regulatory change
|General – A new trustee joins the board and asks how long-term risk factors such as environmental, social and governance risks (ESG) are incorporated into the scheme’s investment approach.
While the scheme’s Statement of Investment Principles state that they take a long-term approach to investing, the scheme’s investment managers are left to implement this in practice.
The scheme’s investment managers are employed on three-year contracts and assessed on a quarterly basis, so they are incentivised to take a short-term approach to investment that is inconsistent with the scheme’s long-term investment horizons.
|The other trustees are sceptical about the significance of financially material risks such as ESG, or their ability to take them into account.
Instead, they tend to see them as a distraction and potentially detrimental to achieving the scheme’s goals, feeling that they have enough challenges to deal with without adding ESG to the mix of factors to take into consideration.
The new trustee’s concerns are not taken into account.
Their investment managers continue to be assessed on a quarterly basis and take a short-term approach to investing.
|The trustees have in place a clear policy around long-term financially material ESG risks, stewardship and members’ ethical concerns.
They are empowered to raise these issues with their investment managers when looking at their advice and to appoint managers based on the evidenced consideration of longer time horizons for investment decisions.