The role of ESG funds in pension investment strategies

ESG funds

Need to know:

  • ESG funds, which are different from ethical funds, consider the environmental, social and governance impacts of the organisation being invested in.
  • Employers should use positive case studies to demonstrate to employees how their pension investment is affecting wider environmental, social and governance factors and projects.
  • An organisation’s default investment fund for auto-enrolment should incorporate ESG factors, rather than providing them solely on the self-select investment list.

According to Navigating ESG: a practical guide, published by the Defined Contribution Investment Forum (DCIF) in April 2018, 52% of knowledgeable defined contribution (DC) pension savers are highly interested in responsible investing.

Employers are looking towards ethical and ESG funds to stay ahead of the pension engagement curve. But what role can they play within a pension investment strategy?

ESG funds versus ethical investing

ESG funds consider how certain variables might affect organisational performance and sustainability. Scott Thompson, director of business development at Impax Asset Management, explains: “ESG is an attempt to take off the blinkers and think more widely around what factors, coming from an environmental, social or governance criteria, could impact that [organisation] in a way that a narrow look at financials might not consider.”

The Future World Fund, for example, designed and funded by the HSBC pension scheme and managed by Legal and General Investment Management, increases members’ exposure to organisations with green revenues.

On the other hand, ethical funds consider the sector of the organisation in which  the pension scheme wants to invest. For example, some employees may not wish to invest in tobacco, alcohol or armaments.

Why should ESG funds sit at the pension investment table?

Catherine Howarth, chief executive officer at charity Share Action, says: “Employers should start to focus more on [ESG funds], because it really counts for their staff in the long-term. We think ESG is just superior from a financial investment point of view.”

Thompson adds: “[ESG funds] align with what [employers] would hope would be the long-term outlook of the pension fund. The pension fund is there to meet the needs of its members, and those usually stretch over decades.”

Simply focusing on financials could mean overlooking interesting investment opportunities, adds Thompson: “Millennials are wanting to quantify the non-financial returns that result from these investments. It’s great to make a 5%, 10% return each year, but they also want to know what impact [they are] having. There’s no point having greater financial returns if as a result of that [there is] greater inequality or environmental damage. That will be the world they retire in to.”

Storytelling to engage

The DCIF found that 80% of 22 to 34-year-old pension savers are more interested in environmental issues today than five years ago, and 74% feel more strongly about making sure that organisations are well managed.

However, Andrew Clare, professor of asset management at Cass Business School, says: “What people say they want and then how they actually invest is sometimes quite different.”

So, how can employers best promote their ESG fund to employees? Employers could share case studies about organisations that are creating jobs, building housing, shifting to renewable power or paying the living wage. “Why don’t [employers] start doing really clear communication around the great things that are happening to manage ESG risks and to encourage responsible, sustainable performance from the hundreds of [organisations] in [the] pension fund?” Howarth asks. “Communicating that well creates more trust in pensions at a time when trust is low, and can help get people feeling confident and positive about saving into a pension scheme.”

Alastair Byrne, head of European DC investment strategy at State Street Global Advisors, agrees, adding that focusing on positive changes will also pack more punch: “It’s less engaging to focus on the exclusions and the fact [employees] haven’t invested in weapons [organisations]. I would be drawing out the positive examples of investing heavily in [organisations] that are driving positive environmental or social changes.”

“As part of really demonstrating that their values are for real, [employers] are making that connection between staff pensions and their corporate values, in a really integrated, joined-up and ultimately more convincing way,” Howarth adds.

Default option

Byrne says: “[There is] a growing acceptance now that ESG is about managing long-term financial risks, and therefore it’s really at the heart of what trustees should be doing for members.”

Embedding ESG factors into an organisation’s default investment fund for its auto-enrolment DC pension scheme is a must, says Howarth: “We would say it’s a breach of [the employer’s] legal duty to protect the pension savers not to be actively keeping an eye on ESG risks. This should run through the whole UK pensions industry like a stick of rock. This is very much about making this the new normal.”

Employers should also provide up to four different ESG fund options, adds Howarth, to allow employees to select one that aligns with their ethical or religious viewpoint.

Although ESG funds are in their infancy, the pensions industry is taking notice of the financial and engagement benefits. “At the moment, there is a slight disconnect between what people say they want and how they feel they want to invest and then what they actually do. But when those two things do connect, I think [employers] could see [a] major change and shakeup in the industry,” Clare concludes.