Need to know:
- While the idea of providing ethical and sustainable investment options has gathered popularity, the take up of these pension investments is still relatively low.
- Embedding environmental, social and governance (ESG) factors into default funds can be complicated, as it introduces additional risks and can distract from focusing on regulatory requirements.
- Ethical investing can be a useful engagement tool when done correctly, helping employees reach better retirement outcomes while having a positive impact on the world around them.
Introducing climate change and other environmental, social and governance (ESG) factors into workplace pension investments, and the communications around these, can be an effective way to improve member engagement. However, progress on boosting the take up of ESG options is still relatively slow, and more work needs to be done to make these factors part of the everyday fabric of pension investments.
More than just an option
While it is relatively straightforward to provide the option of a climate-friendly fund, in practice, just 9% of defined contribution (DC) pension savers select this where it is available, according to the Defined Contribution Investment Forum’s (DCIF) survey The key to unlocking member engagement, published in April 2020.
To make a real difference, socially responsible investment (SRI) principles must be embedded in default funds, where 95% of assets still reside. To do so, however, means introducing additional risks, not least trying to ensure that the default fund remains fit for purpose.
Helen Shackelford, partner at Lane, Clarke and Peacock (LCP), says: “There are lots of products available in the market that offer some form of responsible investing. However, there are different shades of green, as well as different management styles. Having one responsible investment fund option is unlikely to meet everyone’s needs.
“Employers should ensure that the funds offered to their employees reflect their employees’ preferences as well as managing financial risks, and that the provider they use is keeping pace with market developments to reflect change in needs. This should be reflected both in the default investment arrangement and in the self-select fund range offered.”
ESG pension investment has progressed considerably in recent years. Funds based on ethical exclusion, such as those that focus on avoiding fossil fuels and armaments, now look archaic compared with those that invest in businesses actively making a positive change to the environment or society, or in sustainable solutions such as alternative energy. Impact funds take this even further by investing in stocks expected to have a measurable social or environmental impact, typically linked to the UN’s 17 Sustainable Development Goals.
This progress also means looking beyond just the environment. While climate change continues to be a pressing issue at the forefront of people’s minds, the social and governance aspects of ESG are starting to gain more attention, as people increasingly take a holistic view of the world and their impact on it.
One example close to home might be concerns around the gender pay gap and diversity at boardroom level. More broadly, though, the human rights atrocities taking place in Xinjiang and Ukraine have been brutally exposed in the media, and their impression has been felt in many areas of life.
Ryan Medlock, senior intermediary development and technical manager at Royal London, says: “We are coming off the back of an extraordinary couple of years which have contributed to changing member appetite. The debate is very different to 12 months ago.
“There’s much greater focus on social issues, for example human rights as well as ethnic diversity. Not only that, but Covid-19 has placed a sharper focus on how different businesses have been treating their employees and customers. We’re also seeing further examples of these considerations in the terrible situation in Ukraine.”
For all the progress that has been made, embedding ESG factors into default pension funds is still tricky. Critically, sustainable funds tend to be concentrated in equities, and furthermore have a growth equity bias, as distinct from a value bias, which means they are likely to be overweight in technology, a sector that has plummeted this year.
There are only limited ESG options in other asset classes, such as diversified growth universe funds, while credit managers are less able to exert influence on organisations over responsible investment issues than equity managers.
Then, there are the overt risks, such as greenwashing, as the global issuance of green, social and sustainability bonds has surged in recent years. The Pension Regulator’s (TPR) Value for Money assessments, where every scheme under £100 million conducts an annual exercise comparing its charges and investments against three other schemes, are challenging enough without the further complication of taking account of an SRI bias.
“It’s really important that we don’t lose sight of the Department for Work and Pensions’ guidance on what an effective default fund should look like,” says Medlock.
“It’s all very well moving everyone to a sustainable investing default fund or an exclusions-based solution, but how does that fit with the DWP’s published guidance for offering defaults? Optimising a diversified mix of assets is more important than ever, particularly in light of the debate around inflation.
“It’s imperative to focus on this existing guidance when considering responsible investment and what is being offered as workplace default solutions and not dismissing those basic investment fundamentals for the sake of a ‘green’ label.”
In addition to taking a practical approach that considers regulatory demands, employers should think about how ESG pension funds fit with their business, rather than just hunting for the sustainable label.
Alan Morahan, chief commercial officer at Punter Southall Aspire, adds: “What we are seeing are employers asking more questions to assess whether or not SRI aligns not only with their employee benefits but their values.
“The world is always changing, but there is particular focus at the moment on how businesses are responding and adapting to this. Does [an organisation] conscious of its intergenerational workforce review how its retirement package applies to all age groups through the SRI prism?”
Obligation and opportunity
Currently, employers are not obliged to ensure that their pension offering includes SRI or ESG options.
Julia Chirnside, senior knowledge lawyer at Norton Rose Fulbright, explains: “In a trust-based arrangement, it is the scheme’s trustee that decides on suitable investments without needing the employer’s approval.
“In contract-based arrangements, the provider decides what investment options to offer. The Pensions Regulator encourages employers to establish management committees to keep this under review. Ultimately, the employer can vote with its feet and choose a different pension provider if there are not enough SRI options on offer.”
Fear of reputational risk is a contributory factor in driving small employers into the arms of master trusts that have the resources to monitor and develop ESG pension strategies. For this reason, large providers, such as Nest, Legal and General, Aviva and Royal London, that have pledged ‘net zero’ carbon emissions across their investment portfolios by 2050, have been emailing members highlighting their work on carbon targets and emissions reductions.
Jane Walker, principal, workplace savings team at Mercer, says it goes beyond the fear of reprisal, and also ties in with helping staff reach the best retirement outcomes: “Responsible investment is a good topic for building engagement, because it can make pension investments feel more tangible or real for members.
“We have seen success when combining traditional forms of communication such as newsletters and infographics with digital media such as videos and webinars.”
Hayley Williams, partner at LCP, advocates regular surveys and focus groups to pinpoint issues that matter to members and gauge how much they understand about the trustee responsible investment policies, and then sharing the survey results with members.
“Telling members about the scheme’s approach to SRI will only be worthwhile if we explain what it means in practice, and put it into context: if [they] are introducing a lower carbon fund, what impact does it have in real money? For example, £100 million more invested in lower carbon companies, and £100 million less invested in higher carbon companies,” she explains.
As Walker concludes: “Better engagement increases the value a member places on their pension savings, which, in turn, can lead them to make a number of positive choices that will improve outcomes in the long run. This includes elements like making additional contributions, nominating beneficiaries, keeping contact details up to date, reviewing selected retirement age and reviewing investment selections.”