ESG should be default option for DC schemes

They will receive at least an additional 3 per cent of their salary, thanks to their employers’ contributions. These new graduates will join the millions of members of defined contribution schemes, all at different points on their journey towards retirement.

The success of these schemes is partly down to inertia – and this has consequences.

Thinking about ESG is very different both across and within asset classes, and what is a genuine risk varies for each

Savers might know who their pension is invested with; but far fewer could describe how it is invested. Even fewer specify how they want it invested.

According to figures from the Pensions Regulator, 92 per cent of DC pension savers invest via a default fund.

While people’s personal views on areas such as climate change, inequality, environmental protection and positive social change might be expressed elsewhere in their financial lives, it is rarely reflected in how they save.

Focus on the risk

It is a challenging task for pension providers to try and reflect all of these values within default investment portfolios. A default fund will have thousands of members, many with conflicting beliefs.

But one thing they can agree on is the desire of achieving good returns without taking excess risk – and this is where ESG considerations can play a role.

Regardless of whether it is toxic emissions from energy producers, labour disputes at mining firms, or a lack of board independence at an outsourcer, if a risk could have a material impact on returns, then schemes should assess these as they would any other risk and integrate this into decisions.

This does not necessarily imply excluding particular sectors, although some may choose to do that.

Schemes might feel that they are being appropriately compensated for the risk, or that engagement with poorly performing companies might offer additional information or financial benefit.

What matters most is that pension schemes and their asset managers consider what ESG risks could mean for long-term returns.

Treat asset classes differently

Any material factors should be considered in long-term investment decision making, whether ESG in nature or not, and default funds should consider these issues as a matter of course. But making this work in practice has several challenges.

Firstly, thinking about ESG is very different both across and within asset classes, and what is a genuine risk varies for each.

In equities, ESG analysis can help you identify both investment opportunity and potential to grow your capital. However, for bond investors ESG lends itself to thinking about downside risk.

Similarly, the financial impact of poor governance can be very different for an unsecured bond compared to one that is ring-fenced and secured against physical assets.

What makes an ESG risk material also depends on your time horizon. The long-term effects of slowly rising sea levels on a company with productive coastal factories might not matter for shorter-maturity bonds.

For long-duration bonds secured against those manufacturing assets, the picture may be very different.

Passive ESG offers area for growth

The rise in passive investing offers other challenges. Often cheaper than active counterparts (and attractive for many DC schemes), investors are obliged to closely follow a benchmark, regardless of the contents.

Conventional passive funds retain tools such as company engagement and proxy voting, but divestment or even underweighting companies or sectors leads to tracking error.

The growth of passive benchmarks and strategies that tilt away from exposure to ESG risk will be an interesting area to watch.

Integrating these concerns into investment decision-making is not simple or straightforward, and schemes should appoint managers that can both analyse these risks and act appropriately to protect and enhance the returns of future retirees.

Doing this properly matters. The world that today’s graduates will retire into will have been shaped by the decisions currently being made by our large pension funds.

Tackling the potential risks of tomorrow, be they climate change, water scarcity, productivity or corporate governance, requires thinking ahead today.

Ashley Hamilton Claxton is head of responsible investment at Royal London Asset Management