Is ESG on course to become the norm in DC defaults?

Late last year the UK government said it was “minded” to make pension fund trustees produce ESG statements. Since then, further pressure has been applied as Mary Creagh, chair of the Environmental Audit Committee, wrote to the 25 largest pension funds to ask how they manage the impact of climate change risk on their holdings.

On a financial level, E, S and G are risk factors associated with poor governance, regulatory clampdowns or environmental disasters among others, which could impact the returns of pension funds.

You can’t do one thing for DB and not think about it for DC

Stuart O'Brien, Sackers

For active managers, logically this means it should be included in analysis of investments like any other risk, says Andy Cheseldine, client director at Capital Cranfield Trustees.

He adds that when ESG is applied to passive management, it becomes “a form of smart beta” where the largest risks are managed out. “The first, second and third priority is risk,” he says. “Then you can start to look at ethical investment.”

Risk management is however an endless task. All risks are important but not all are as big as each other.

“There’s an infinite amount you could spend on governance, but does it all pay back; how much is cost effective for the members?” Pension funds should therefore look to find out “which are the low-hanging fruit, where do you get the most bang for your buck”, according to Cheseldine.

ESG 'makes more sense in DC'

ESG risks are mostly long-term, but trustees too often focus on factors that have a more immediate impact.

“ESG is becoming more common, but trustees tend to look at short-term stuff more,” says Cheseldine. He added: “I think everybody is finding their feet a little with ESG.”

This is especially true of defined contribution funds. HSBC’s announcement in 2016 that it would use a fund with a climate tilt for its DC default option made UK headlines, as responsible investment is still only a self-select option in many DC schemes.

This defies logic, as DC savers tend to be younger and are more likely to be affected by the impact of addressing or ignoring ESG risks, in terms of their savings as well as on a more general level.

Cheseldine says ESG "makes more sense" in DC, whereas [defined benefit] "has a short-term horizon because you’re looking to buy out or at least derisk into bonds or gilts”.

In government bonds especially, ESG is in its infancy.

The UN Principles for Responsible Investment only explored the application of ESG factors to government bonds in 2013 after the sovereign debt crisis; it concluded they can be material for creditworthiness and performance, but this insight has yet to filter down into most institutional portfolios.

DC savers, on the other hand, often have a large equity exposure during the accumulation phase, where ESG has traditionally been applied. This would make default funds prime candidates for ESG integration.

DC members could sue ESG laggards

As trustees often look after both DB and DC schemes, considering ESG for DB but not DC poses a governance, perhaps even legal, problem.

Stuart O’Brien, a partner in law firm Sackers, said: “You can’t do one thing for DB and not think about it for DC.”

Trustees should consider what their statement of investment principles says about ESG before dismissing it for their DC default fund.

“If in your SIP you’ve said we think climate change poses a risk and expect our managers to take that into account, but haven’t done that on the DC side… you’ve got an internal inconsistency,” he said.

DC members whose pension pots lose value because an ESG risk was not addressed could, in theory, point the finger at trustees.

O’Brien ruled out “a huge looming spectre” of litigation from DC members, but the possibility that litigation is brought does exist.

The charge cap hurdle is surmountable

DC trustees who want to integrate ESG into the default option have to square the cost circle however, by making a strategy fit into the charge cap of 0.75 per cent – a great part of which is usually already eaten up by administration costs.

O’Brien admits this is not easy. “If you are adopting a purely passive strategy it’s quite hard to reduce exposure to carbon intensive industries,” he said, but added that there are strategies that can work, including factor-based ones.

He expects more managers to come to market with an ESG offering that will fit into the charge cap.

TPR guidance on ESG in DC is clear

Laura Myers, partner at consultancy LCP, also observes attitudes slowly changing among trustees.

She notes that where previously DC schemes focused more on providing an ethical fund option, trustees are now considering integrating ESG risk factors in the default strategy.

“However, many trustees seem to be unwilling to be early movers; consequently ESG themes in the default are still in early stages,” she says.

She adds: “The prevalence of ESG in DC is something I hope we will see increase over time now we have clear guidance on considering these factors from the [Pensions] Regulator.”

Based on recommendations the Law Commission made four years ago, in its report on ‘The Fiduciary Duties of Investment Intermediaries’, the regulator says: “Where you think environmental, social and governance factors are financially significant, you should take these into account. Likewise if you think certain ethical issues are financially significant.”

UK is 'johnny-come-lately' in DC ESG

The trend towards ESG integration can also be observed in manager searches. Joey Alcock, a senior associate at bfinance, says among the consultancy’s global clients, “for global equity searches at least 50 per cent, if not meaningfully more, would include ESG”.

ESG integration is becoming “fairly commonplace”, he says. The level of complexity in the approaches is also evolving, and there is now a wide range in terms of how deeply ESG is embedded.

“What form of ESG integration people are seeking ranges from relatively straightforward exclusion to more meaningful alignment of impact investment and the UN’s sustainable development goals,” he says. “The degree to which ESG is sought depends on who the stakeholders are.”

While ESG is gaining speed across the globe, there are regional differences. Scandinavia has been an early mover in both DB and DC; in the UK, ESG for DC schemes “is still a fairly nascent market”.

But the trend is there. “It’s obviously going to be a distinct feature of the pensions landscape in the future,” says Alcock.