Is it time for DC defaults to embrace ESG?

This week, Nest revealed its investment in UBS’ Life Climate Aware World Equity fund, while the London Pensions Fund Authority saw its strategy come under fire for an allocation of less than 1 per cent to fossil fuel companies.

However, setting a cost-effective ESG strategy is more complicated for smaller DC funds.

If you have divestment as an option it lends greater weight to your engagement activities

Luke Hildyard, Pensions and Lifetime Savings Association

Where a scheme is invested in a pooled fund rather than a segregated mandate, it may lack the clout to influence managers to engage with companies or vote against measures.

And with faith in active management particularly low among charge-capped DC schemes, trustees may find that their passive index strategies do not allow for divestment.

“[ESG] is an immensely complex subject to deal with simply because of the degree of removal that the trustees have from the governance structures of the companies,” says Richard Butcher, managing director at professional trustee company PTL.

According to Butcher, the issue is further complicated by short-termism in the pensions industry, with schemes evaluating managers over periods of several months. That can act as a disincentive to managers to promote long-term sustainable growth within companies.

When embracing ESG, he says, “you accept that it could actually diminish your returns in the short term”, which is a difficult pill to swallow for schemes.

No excuse

Nevertheless, it seems inevitable that DC trustees will have to further adopt ESG-led strategies, especially if the launch of the pensions dashboard proves a boost to member engagement, as Catherine McKenna, head of pensions at law firm Squire Patton Boggs, predicts.

“While in theory schemes would welcome this, practical implications may include trustees being prepared to answer tricky questions from members who are suddenly more alive to issues such as ethical investment,” she says.

A 2014 study by the Pensions and Lifetime Savings Association supports the idea that there is member demand for responsible investment.

It found that 70 per cent of UK pension scheme members said they wanted their pension provider to avoid investment in unethical practices, with a further 49 per cent saying they would be prepared to accept lower returns or higher volatility in pursuit of these ESG goals.

A boost to corporate governance

For trustees concerned about their ability to engage with companies on sustainability issues, the Department for Business, Energy and Industrial Strategy’s green paper on corporate governance reform may offer some help.

Practical implications may include trustees being prepared to answer tricky questions from members

Catherine McKenna, Squire Patton Boggs

Although watered down from Theresa May’s original suggestion that workers should be represented on company boards, the proposals do include raising reporting standards for large privately owned companies, tackling executive pay and strengthening shareholders’ ability to hold companies to account.

The paper received a cautious welcome from asset managers. Joshua Kendall, ESG analyst at Insight Investment, says the proposal to extend reporting requirements to private companies is an important aid to long-term investment.

“Corporate governance standards must be upheld by all institutions, including unquoted companies, to maintain trust in our financial markets. For us, it is a fundamental quality factor when making a long-term investment.”

But for publicly owned companies, some managers say the current legal provisions are already sufficient for holding directors to account.

Sticking with current legislation “would also retain the unitary board structure, which we continue to believe is the most effective governance structure”, says Ryan Smith, head of corporate governance and ethical research at Kames Capital.

He says he favours a framework where “all directors continue to have an obligation to employees rather than carving out a specific director for this role or as a ‘stakeholder’ director”, and notes that powers to approve remuneration policies, introduced in 2013, need time to “bed in”.

What are trustees' roles?

If strengthening fund managers’ ability to engage with companies is not an obvious solution to improving ESG investment practices, trustees may have to take on responsibility themselves in their manager selection decisions.

Some DC schemes have begun to integrate sustainable practices into their default offerings.

The HSBC Bank UK Pension Scheme notably helped launch Legal & General Investment Management’s Future World Fund – which includes an ESG tilt in its smart beta construction – in November last year.

And it is this low-cost approach to responsible investing that has been lauded by the PLSA and ESG researcher Sustainalytics in a joint report which was published last week.

The report, which suggests that the HSBC shift could be “at the vanguard” of DC’s move into responsible investment, identifies human capital, business ethics, data security and product safety as the most material ESG issues to a typical default fund.

While a high number of industries in its typical portfolio are exposed to energy and emissions-related issues, the report concludes that they do not yet represent as immediate a threat in the short term.

“We see climate change as a background risk driver,” says Doug Morrow, associate director at Sustainalytics, before cautioning that if environmental risks do develop as expected, a typical default fund would be “systemically exposed”.

Neither did he see evidence that ESG returns emerge only over the long term, noting that hedge funds have started to make short-term plays around governance issues.

Follow HSBC example

In response to the range of risks identified, Morrow’s paper recommends that DC trustees consider non-active ESG products.

He notes: “They have a cost advantage over actively managed funds, which is important given the charge cap.”

Of course, for trustees seeking to tailor their existing arrangements, they may run into problems persuading pooled fund managers to vote in line with their beliefs, and non-ESG passive strategies do not equip trustees with the threat of divesting from a specific company.

That, for Luke Hildyard, policy lead for stewardship and corporate governance at the PLSA, means that ESG processes and divestment have to be incorporated into the make-up of the solution.

Shareholder engagement, he argues, is greatly weakened by trustees choosing a mandate that does not facilitate divestment from unsustainable practices.

“If you have divestment as an option it lends greater weight to your engagement activities,” he says, but concedes that engagement is still the “preferable” first step.

Solutions such as that employed by the HSBC scheme are not without their critics.

“It has been said that there is no such thing as ESG fact, just ESG opinion. Subjective opinions don’t tend to make for the rigorous, systematic and repeatable application of rules which smart beta requires,” says Jeremy Richardson, senior portfolio manager in RBC Global Asset Management’s global equities team.

But for trustee boards still debating the merits of ESG itself, it may be that they need to act before their members demand it.

Neil Davies, associate at Barnett Waddingham, notes a “perception that adopting an ESG focus is not a good use of a scheme's governance”.

But, he adds, “with an increasingly large cohort of DC members, and a society that is generally more engaged with corporate governance, this is gradually changing”.