Environmental, social or governance (ESG) factors have shot up the agenda in the DC pensions sector, driven by regulatory action, political momentum and asset manager product development. But confusion remains over what ESG does and doesn’t stand for, how it impacts performance and how its benefits can best be harnessed for DC savers within charge-capped products, said delegates at a Corporate Adviser round table event last month.
Advisers and consultants at the event said that three years ago ESG-led investment strategies were highly unlikely to be raised as an issue when setting up default pension strategies or discussing
AE options. Today they are fast becoming a key part of the DC pensions landscape.
Most delegates at the event predicted that within a decade an ESG-led investment policy would be a ubiquitous part of any default pension fund.
Increasingly asset managers are analysing a whole range of ESG factors as a part of the risk management and investment process. But many attending the round table agreed that there remains considerable confusion amongst employers and even advisers as to how these ESG strategies are deployed across the industry — and what the potential benefits might be for both employers and members.
At the crux of the issue is whether adopting an ESG strategy delivers better returns for members.
Nest, which has been a long-standing proponent of ESG investment strategies, argues there is now considerable evidence that pension providers and asset managers that incorporate ESG analysis as part of their investment process can deliver better risk-adjusted returns over the long term.
Nest manager of ESG and stewardship Diandra Soobiah said: “We certainly believe this is the case. All the academic and financial evidence we’ve seen looking at this issue shows a strong positive relationship between a company’s ESG track record and how it performs for shareholders.
“Companies that adhere to ESG principles in terms of how they are run tend to outperform, with lower volatility, lower cost of capital, and improved share price performance and profitability over the longer term.
“This is why it is fundamental to the way we manage money.”
One of the best known pieces of evidence that supports an ESG-led approach is a metastudy conducted by DWS (part of Deutsche Bank). This analysed more than 2,000 individual studies into the link between ESG criteria and subsequent corporate financial performance. It found a positive relationship in a large majority of these studies, which spanned a 35-year time frame, and found very little correlation between ESG investments and negative performance.
Despite the emerging evidence to support an ESG-led investment strategy, and the sense that an ESG approach sits well with companies’ corporate social responsibility obligations, those attending the roundtable agreed there still remained a “latent scepticism” within some corners of the industry about its potential benefits.
This comes from both corporate clients, who may not prioritise an ESG-led approach as well as some scepticism from trustees and even individuals within asset managers.
Some of those attending thought at least some of this scepticism was due to confusion about what is meant by an ESG-led strategy. Lane, Clark & Peacock senior consultant Nigel Dunn said: “There is the danger that ethical and ESG issues can be conflated.”
Delegates agreed an ESG-led approach isn’t about ethics, but is about good governance to avoid long-term risks and thereby avoid stocks that will be hit by those risks. An ESG strategy sees data analysed to identify potential risks, such as where companies are over-reliant on fossil fuels, which could impact future profitability, as regulation seeks to reduce usage to limit climate change.
Dunn said: “An ESG-led strategy is an important risk management tool that can support a more sustainable long-term investment approach.”
Participants at the round-table thought there was an important distinction to be made about values and value, and that an ESG-led investment strategy should focus more firmly on the latter.
But Aon head of DC investment James Monk pointed out that the two are not entirely divorced, and that an ethical dimension that flows from an ESG approach has the potential to engage consumers with savings and pensions.
If ethical factors influence politicians, who then change regulations with the aim of making certain sectors less profitable, then ethics do ultimately influence ESG strategies.
He pointed to the opportunity that climate change presents in terms of engaging with members. Many people are aware of the longer-term financial risks presented by issues such as climate change, and would welcome their pension provider taking a positive stance. “They want asset managers to be taking a proactive stance on their behalf to minimise these risks, as well as driving more positive change.”
Delegates debated how individual providers could deliver an ESG-led investment mandate.
Willis Towers Watson consultant Mark French pointed out that there were various approaches across the industry, and this can lead to very different definitions of what is meant by ‘an ESG investment fund’, particularly within the world of default DC propositions.
He said: “We can see providers using both divestment and engagement, and a combination of the two.”
With engagement, providers use their capacity as sizeable shareholders to raise ESG issues, and drive positive change through shareholder votes.
French said: “This stewardship aspect can be harder to define. Asset managers are using their influence to drive the sustainable agenda, but there seems to me to be a less clear-cut relationship with improved member outcomes.”
This can lead to some confusion within workplace pensions when it comes to defining and outlining what is meant by an ESG strategy.
Some providers – for example LGIM – claim that they adopt an ESG strategy across the entirety of their portfolios, including passive funds that simply track an index like the FTSE100.
This is because of their approach to stewardship and engagement — even on funds where there is no option to disinvest, if the company doesn’t improve its ESG credentials. By taking an active approach to voting in relation to virtually all the stocks they hold, they have made an ESG intervention, even for trackers that others might not describe as ESG funds.
Others only use the ‘ESG’ badge on portfolios where they can actively select and reduce exposure to individual companies or sectors which have good or poor ESG track records. This will also include passive strategies which take into account ESG factors, such as the FTSE4Good index.
Dunn said: “It seems to me that it’s more difficult to identify how stewardship affects returns. If an asset manager encourages a FTSE 100 company to adopt a fairer tax policy, reduce their carbon footprint or appoint more women to the board, then surely everyone who invests in that index benefits.”
Soobiah pointed out that there is often a divergence in ESG approaches when it comes to active and passive strategies.
She said that this issue is particularly critical when it comes to default fund strategies within auto-enrolment, which have to meet a charge cap, meaning there is often a reliance on more passive strategies.
She pointed out that investment managers can tilt portfolios to take account of ESG factor to take a more filtered approach. But where a passive strategy is not being used there can be a significant cost to consumers when it comes to ensuring a tilt towards a low carbon portfolio. Nest has worked with UBS Asset Management to create a new climate aware equity fund – the UBS Life Climate Aware World Equity fund – which tracks the FTSE Developed Index, but which either increases or decreases its exposure to companies depending on their alignment with the transition to a low carbon economy.
Soobiah agreed that it can be a challenge to communicate how corporate engagement and stewardship works, but she says the key is to pinpoint specific stories. “This is something we are keen to communicate with members. For example action by companies like Nest has forced companies like Persimmon to adopt a living wage.”
Lorica consulting and wellbeing partner James Biggs said if asset managers believe ESG strategies lead to better risk-adjusted returns then this should be embedded within the investment process, rather than leaving employers, or employees to “select” an ESG approach.
Many he said may be unwilling to do so, fearing it could lead to lower returns.
One of the challenges for asset managers is to construct an ESG default funds that reflects a diverse and large membership within the typical workplace DC scheme.
Dunn pointed out that the regulators initially proposed that trustees should look to improve governance standards by seeking members’ views on a range of ESG issues. But he noted that there was “considerable push back on that” from the industry.
As he pointed out, this can be hard to achieve through surveys, and may switch the focus more onto member-led values – which may be contradictory – rather than what trustees or IGCs believe is the best way to deliver long-term value instead.
That said, Dunn argued advisers and providers should listen to feedback from members and use this to help build a constructive ESG-led strategy that engages pension savers.
Biggs highlighted the communication challenge the DC pension sector faces in this respect. “Providers need to explain more clearly what their approach to ESG is, and how they deliver it, as well as what this means for member outcomes.”
He added: “But there is the danger that this generates just more jargon, which most people fail to connect with or understand, with those trying to explain their ESG strategies doing so in more granular detail than people have the patience to digest.”
Round table panelists agreed that regulation would drive changes within the sector. Soobiah said: “The recent Department of Work and Pension clarification on fiduciary duties, particularly in relation to looking at climate changes as a systemic risk, is a real game changer.”
These new rules – which come into effect this October – force trustees to consider whether a range of ESG factors, including climate change, present a financially material risk to the assets they manage.
At the same time the FCA has recently launched a discussion paper which looks at whether IGCs on contract-based schemes should have to consider the same factors. This is expected to land next year.
Although this latest piece of regulation doesn’t compel trustees to adopt an ESG-led approach, the fact they have to engage with the questions about how they manage the risk of climate changes, is seen by many as an important call to action.
Nest senior business development manager Stephen Argent added: “There is the possibility that trustees could be sued if they ignore these issues. It is an important wake up call for the industry.”
But although this rule change is only months away the consultants and advisers at the roundtable fear that a number of providers still don’t have a clearly defined ESG policy on their AE schemes.
French said: “There could be a wider range of options available, particularly from platform providers.” He points out that choices are limited for those looking to build their own solutions.
But he said that October’s regulatory “pinch point” should concentrate minds within the industry and he expected to see a wider choice of ESG-led options by this date.
Dunn said: “I have some sympathy with providers. They are essentially providing what the market asks for, and
to date there hasn’t been demand from the intermediary market or employers for these types of solutions.”
These regulatory changes are also expected to focus the minds of both trustees and IGC boards. Dunn said: “We’ve found that there may be a degree of scepticism about the benefits of ESG from trustees initially. But once they start to spend time and effort looking at the issues involved, we find there is a lot more receptiveness to the issues at stake.”
Monk pointed out that there can be an element of conservatism among trustee boards, and like any group there is the danger of a group-think mentality taking hold.
There is also the question of whether the trustees’ views on this issue are aligned with membership of a pension schemes. This isn’t always the case, according to Soobiah.
Dunn said consultants have a role to play here. “We need to ensure we ask the right question for clients and educate them about both the options and changing regulatory landscape before putting together a default strategy. Then there might be more choice out there.”
Looking ahead Biggs pointed out that this pace of change will continue.
He expected that in 10 years’ time, it will be the norm for default pension schemes – be they master trusts or contract-based – to integrate ESG strategies.
French said: “At the moment, there is little competition between providers when it comes to ESG as this is not a selection factor at present. But it is early days and I expect this to change.”
Biggs said this will present additional challenges from the intermediary sector, who need to “get under the bonnet” and understand how successfully these various ESG strategies are applied.
Monk added: “The role of the intermediary will be to provide transparency, and understand how important ESG factors are for the client, trustees and member to ensure an appropriate solution is selected. This can only be done though if consultants fully understand what providers offer in this space.”