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Solving the ESG - Friendly Default Fund Conundrum
FundsTalk
SUSTAINABLE INVESTING is the issue du jour for the UK pensions industry. Regulation is nudging pensions in this direction but there’s also now a common-held view that ESG isn’t value-destroying and may in fact offer a hedge against intensifying environmental, social and governance risks.
While many providers, like Scottish Widows, offer pension scheme members a range of sustainable fund options, the industry has been grappling with how best to cater for the vast majority of disengaged savers in default funds.
IMPORTANCE OF DEFAULTS
Currently, around 90% of members elect to stay within their scheme’s default fund. It’s easy to see why - not only do default funds simplify what is often an overwhelming choice, they’re also seemingly endorsed by the sponsoring employer or pension provider.
The Pension Policy Institute (PPI) forecasts that by 2030 there could be 17 million members enrolled in DC workplace schemes in the UK, representing £554bn¹, with most of these assets likely to be in default funds.
So the decisions made by plan trustees and pension providers about the composition of default funds will have significant implications for the future financial security of UK workers.
REGULATORY SCRUTINY
ESG is a fast-growing regulatory concern. At the very least, trustees must have a policy on ESG and climate change issues, including stewardship activities. They must publish these policies on publicly-available websites and inform scheme members about them in their annual benefit statement. Additionally, DC schemes with 100 or more members are required to have a stewardship policy in relation to their scheme’s default investments².
Similar changes are being introduced for contract-based schemes and their Independent Governance Committees (IGCs). The FCA has confirmed rules to extend the remit of IGCs to report on their firm’s policies on ESG issues, consumer concerns and stewardship. They would also require IGCs to report on how the firm has implemented its ESG policies, which includes what IGCs think about the adequacy and quality of implementation. The new rules come into effect in April.
The FCA says: “Consideration of ESG risks is not about firms being altruistic, but about how long-term risks are factored into investment decision-making. For example, climate change and the transition to a low carbon economy is a risk – and an opportunity – that providers should think about. This is important for pension products, which by their nature are for the long-term.”³
60% RISE IN THE NUMBER OF ESG
INDICES TO 37,000
SAYS INDEX INDUSTRY ASSOCIATION.
STEWARDSHIP
Scottish Widows, along with other larger pension providers, are actively engaged in stewardship. Stewardship and portfolio-level ESG integration have historically been viewed as separate functions, but the boundaries between them are blurring. For a growing number of asset owners, voting and engagement practices are simply part of an overarching ESG integration process.
At Scottish Widows, for example, we’ve analysed our average customer holdings to determine the top 20 companies we invest in: Royal Dutch Shell and BP being our largest holdings. We’re working with other shareholders to influence the agenda and participate in meaningful industry shareholder resolutions. For example, last year we acted directly as the second-largest shareholder on a resolution to BP calling for the business to become more transparent in the way it’s managing climate change risk, which was ultimately supported at the company’s AGM by over 99% of shareholders. We were also involved in similar discussions with Royal Dutch Shell, seeking to link executive pay to the reduction of carbon emissions. This was accepted by the company without the need for a formal shareholder resolution.
Where investment management is outsourced, as at Scottish Widows, regular stewardship activity is typically undertaken by the third party managers. They’re expected to demonstrate an effective approach to sustainable investment and for this be embedded in relevant policies, investment processes and standards.
The FCA encourages pension providers to think how they can do more to protect consumers from risks, take advantage of opportunities, and improve pension outcomes.
But when it comes to directly integrating ESG into a default fund, which approach to take is not straightforward.
REFLECTING ON MEMBER FEEDBACK
Scottish Widows’ IGC has taken soundings from trustees, employee benefit consultants, corporate advisers and, most importantly, scheme members to help inform our thinking on this conundrum. We surveyed 2,000 DC pension savers to gauge their knowledge of, and interest in, responsible investment, particularly testing exclusions, ESG, ethical and impact approaches ⁴.
Responsible Investing remains an unfamiliar concept to most. Only 16% of those surveyed had either heard about ESG or were familiar with the idea, with similar levels of unfamiliarity for the terms ‘exclusions’, ‘ethical’ and ‘impact’. People also struggled to evaluate the financial impact Responsible Investing ideas have, which fuelled uncertainty around them. Behind this sits an inbuilt ‘norm’ that doing good and making money are mutually exclusive, with fewer than 1 in 5 expecting a positive financial outcome.
But when fully explained, ESG became a ‘no brainer’ and was felt to be a step that any reputable investor would be looking to make. There was 84% agreement that ESG should form part of a default option if it resulted in stronger, more stable returns.
People were unable to decide for themselves what’s ‘good’ or ‘bad’. There was no single issue that received universal buy-in. The ones that received the greatest support are prescribed by bodies such as the UN. But exclusions as a concept resonated the strongest. This is because the impact is easy to understand: industries and companies with unsuitable business practices no longer receive investment. And there is no middle ground: these companies are completely avoided.
Ethical and impact investing appeared not as popular due to their subjectivity and assumed performance trade-off. This was even more evident when people had time to digest the ideas and think through how they might be implemented. The issues these approaches speak to are highly personal – pension holders don’t want it to be ‘forced’ on them.
The research concluded that members thought an element of ESG integration may be desirable, with priority given to safeguarding long-term performance of their investments.
This feedback reinforces that we should seek to integrate those material ESG factors that are financially relevant to the risk and return. At the same time, the variation of views on ESG issues reminds us that members expect to look beyond the defaults to a fund range that allows them to align their personal beliefs with their investments choices.
PASSIVE OR ACTIVE?
In the cost-conscious world of pension defaults, many providers, like Scottish Widows, have opted to take a passive approach to investing. While sustainable investing is most commonly associated with active management, there has been significant growth in the number of funds that track ESG-friendly indices.
The Index Industry Association recorded a 60% rise in the number of ESG indices in 2018, to more than 37,000 ⁵. This proliferation of ESG indices reflects the variety of approaches, ranging from excluding controversial sectors or stocks to integrating ESG ratings. The latter is typically based on financial indicators to highlight which companies are in a better position to manage ESG-related opportunities or risks. But integration can vary from tilting towards higher-rated companies to a single-minded focus on the best performers – and everything in between.
How do pension providers choose from such a growing menu of passive or quasi-passive ESG investment strategies? Looking at whether the strategy achieves an improvement on the underlying benchmark in terms of carbon emissions or other ESG criteria, and at what cost, might be a good place to start. Consideration should also be given to how objective an index provider’s ESG scoring is. There’s sometimes quite a difference between ESG scores on certain companies between index providers, although there’s generally consensus around the best and worst.
IS CLIMATE CHANGE THE MOST URGENT ESG CONSIDERATION?
For several years, the World Economic Forum has ranked climate change and extreme weather events among the top three global risks ⁶. The governments of 184 countries are party to the Paris Agreement, which aims to restrict global average temperature increases. Yet, according to the Global Carbon Project, Global CO2 emissions continue to grow, reaching a record high in 2018 which it believes will be broken again soon.
The DWP’s definition of how pension trustees should take account of “financially material considerations”, specifically references the inclusion of climate change, and the FCA is involved in several sustainable finance initiatives underway at EU and UK level. One of these is the EU’s Sustainable Finance Action Plan. It includes introducing two new categories of climate-related benchmarks, such as a carbon footprint benchmark, so that the performance of investments can be tracked against them.
The government and regulators understand that if worldwide goals on limiting global warming are to be met, more needs to be done. And this could have a significant impact on how pension trustees and providers consider ESG factors within default funds going forward.
FOR SEVERAL YEARS, THE WORLD ECONOMIC FORUM HAS RANKED CLIMATE CHANGE AND EXTREME WEATHER EVENTS AMONG THE TOP THREE GLOBAL RISKS.
SOURCES:
1 PLSA – ESG risk in default funds: analysis of the UK’s DC pension market, Feb 2017
2 Sackers, ESG and climate change for pension funds
3 FCA: Extension of IGC responsibilities
4 Understanding customer appeal of Responsible Investing, Scottish Widows IGC
5 Business Wire: Index Industry Association Survey Reveals 3.7 Million Indexes Globally