Should ESG be a default for DC schemes?

Auto-enrolment will soon enter its busiest phase, while the increasing shift from defined benefit to defined contribution schemes as the focus of regulation will continue.

This shift is also likely to extend to matters concerning environmental, social and governance factors.

ESG has become mainstream in DB pensions and trustees have started to recognise it as a factor relevant to the financial performance of their investments.

However, there is clearly some way to go before DC schemes achieve the same level of ESG integration.

Part of the problem may still be the temptation for trustees to confuse financially relevant ESG factors with ethical or moral preferences that are non-financial in nature.

Mixing up ethical and financial concerns

A common trap is for trustees to focus on ESG as part of the DC fund choices but to largely ignore it as part of their default fund.

In response to an ESG challenge, trustees may say, "But we have an ethical fund among the fund choices for people worried about that sort of thing".

Not only does this mix up ethical concerns with ESG as a financial factor, but it also ignores the fact that the vast majority of members are likely to be invested in the default fund, and that the trustee’s fiduciary duty is to act in those members’ best financial interests.

Trustees of schemes with DB and DC sections in particular set themselves up for a fall if they specifically include ESG in their investment beliefs, or statement of investment principles, for their DB investments, but don't give it a second thought in their DC default fund.

Some schemes are starting to address this, and the recent adoption by the HSBC pension scheme of a newly created multi-factor global equities index fund for its default DC option is a good example of what can be done.

The fund weights constituents according to certain defined ESG factors and incorporates a ‘climate tilt’ to address the investment risks associated with climate change.

As we go through the year, we can expect to see more trustees taking this sort of approach in their DC default funds.

Stuart O’Brien is a partner at law firm Sackers