As endgame targets and net zero deadlines have a part to play in pension funds' journeys, defined benefit schemes must strike a balance to meet these separate goals.
In 2021, the volume of defined benefit buy-ins and buyouts reached £27.7bn, according to research by Hymans Robertson. At the same time, pension schemes continued to work on their environmental, social and governance strategies.
Yet almost one in three of DB trustees say they do not think efforts to steer schemes towards net zero are “relevant” to them. For the derisking segment of the market, this raises questions about how trustees can balance fiduciary duties and risk exposures, while pivoting towards ESG objectives.
Fixed income ESG flows more than doubled over the final quarter of 2021, to £6.8bn from £3.2bn, according to data from Refinitiv, marking a step-change in the volume of institutional investment in ESG-labelled bonds.
Climate is a risk, so it must be factored into investment decisions. In that regard, it is derisking by necessity
Matthew Graham, Aviva Investors
When ESG investing initially became popular, strategies offered by asset managers were “generally equity-based”, says MJ Hudson senior adviser Karen Shackleton. This left DB schemes and other fixed income investors underserved, but it has changed “substantially” in recent years.
“Fixed income managers are now embedding ESG into their investment approaches, and private markets managers are beginning to do the same,” she notes.
Simultaneously, other investment vehicles such as real estate and private equity funds have risen in prominence, on the back of their “dual goal” of delivering a “financial return and delivering a positive impact on the environment or society,” Shackleton adds.
Derisk and reward
Broadly, the number of DB schemes considering the impact of climate change on their covenants has increased to 70 per cent from 50 per cent in 2021, according to Hymans Robertson. Four in five schemes above £5bn in assets either have or are working on a net zero target.
Yet, as the number of schemes targeting buyouts surpasses those opting for self-sufficiency, the need for trustees to balance their schemes’ risk exposure within a rapidly developing ESG landscape is set to become even more prevalent.
These professionals are required to take account of ESG considerations that are “financially material in the context of the scheme”, says Carolyn Saunders, partner and head of Pinsent Masons’ London office.
“Exactly what is and what is not financially material is likely to change as a scheme starts to derisk.
“However, the fact a scheme is derisking does not automatically mean ESG factors are no longer relevant. The exact position will vary from scheme to scheme — so ESG must not be ignored just because a scheme is derisking,” she points out.
Similarly, Shackleton says she does not believe derisking affects pension funds' ESG investment, particularly considering market developments over recent years.
“It may result in a change in the metrics, but it shouldn’t change the investment process, in terms of how these risks and opportunities are assessed by managers,” she notes.
Putting the ESG in derisking
Matthew Graham, Aviva Investor’s head of UK and multinational DB pensions, argues it is now “widely accepted” that schemes not taking climate considerations into account are not “thinking about of the key risk factors in an investment”.
“Climate is a risk, so it must be factored into investment decisions. In that regard, it is derisking by necessity,” he says.
From a risk management perspective, you cannot ignore how “companies, industries and governments” have been impacted by the pivot towards environmentalism, Graham notes.
“If you’re not thinking about all these major risks then you’re not keeping ‘low risk’ on the table,” he adds.
Subsequently, there is “no conflict” between meeting ESG goals and successfully reducing a scheme’s risk exposure, because all pension schemes, whether or not they are derisking, “need to be making investment decisions based on financial materiality”, Saunders says.
“The assessment for the scheme is the extent to which ESG considerations are financially material. Not all ESG considerations are long term, so even a scheme that is on a short derisking timetable may need to consider ESG factors,” she adds.
While there is an evident need to align investments with sustainable outcomes, particularly in line with net zero ambitions, DB schemes do not have the same degree of exposure to equities as other investors.
For Graham, the value DB schemes can add to sustainability efforts while undertaking derisking stems from engagement and the “ability to turn brown to green”.
However, the engagement within other asset classes is not as straightforward or established as within the equity space, and so will be “an area for continued development”, as asset managers seek to engage in newer areas, such as public credit, private markets and real assets, he notes.
ESG How to handle disagreements over ESG on trustee boards
Pressure to align on sustainability can often lead to a lack of consensus within the board over what approach to take, and how quickly to take it.
In real assets, the precedent to engage is already there, as “77 per cent of the buildings that will be around in 2050 have already been built — you can’t just divest”, he adds.
Engagement must also come in the form of member communications, outlining how a scheme is working towards environmental goals while continually derisking, Graham stresses.
But as schemes creep towards their endgames, and net zero pledge deadlines draw ever closer, the extent to which trustees will integrate ESG considerations alongside other fiduciary duties over the coming years is yet to be seen.
