Are DC defaults still lagging on ESG?

Nest’s strategy on ESG issues to date has leaned towards engagement rather than divestment. It avoids just two sectors. One is the armaments industry and, more recently, the master trust has announced it will sell all its tobacco shares.

We are starting to see in the growth phase, where there is a significant allocation to equity, ESG factors are increasingly taken into account

George Fowler, KPMG

Diandra Soobiah, Nest’s head of responsible investment, says: “ESG is absolutely integral to our default fund and is a fundamental part of our decision-making process.”

She adds: “From a governance perspective, some… sin stocks tend to score quite well. We believe it is really important that we have a seat at the table and keep on voting and engaging with them.”

Poor air quality in many of our towns, thousands of workers out of work and shareholders out of pocket by the collapse of such firms as Carillion and BHS, and mounds of plastic everywhere – nearly everyone in Britain is affected by environmental, social and governance issues.

This has led to more and more members wanting their pension funds to incorporate their values, and managers of default funds are taking note.

“The level of noise from members is still small but is rapidly growing,” says George Fowler, partner in KPMG’s investment advisory business.

David Bird, director of the LifeSight master trust, backs this sentiment: “It isn’t something that comes up generally from members. There is a small group of people who are interested in it and when they do so, they do it with a passion.

“We have a lot of contact with members when onboarding. We have started an annual employer forum. At the first one, ESG wasn’t a massive issue. It has hugely risen up the agenda in the past year.”

Sea change

Five or 10 years ago, the prevailing view among trustees was that a bias to ESG by negative screening out would compromise returns.

Today Mr Fowler says: “Trustee boards believe that if you have bias to ESG you no longer compromise on performance but are going to improve risk-adjusted returns.”

Mr Fowler emphasises: “It is the level of detail that it is gone into where we have seen the biggest change in the past 12 months. We are starting to see in the growth phase, where there is a significant allocation to equity, ESG factors are increasingly taken into account."

Trustee understanding and awareness of the difference between ethical investing and ESG plays an important role.

Raj Shah, head of defined contribution investment at consultancy Hymans Robertson, says: “A first step is helping trustees understand the difference between ethical investing, [a value-based] approach to investing, and responsible investment.”

He notes that, for DC pension plans in particular, which have a long-term time horizon, considering ESG issues and particularly climate change is very important.

According to Mr Fowler, “all default funds to an extent will take into account ESG”. But there is a way to go. A May 2019 report from Defaqto lists all the default funds’ ESG policies. Ten defaults do not list any specific policy.

Another master trust that is leading the way on ESG is Willis Towers Watson’s LifeSight.

Mr Bird says: “In our default fund, for most of the journey members are in an equity fund which employs ESG strategies for more than 56 per cent of the assets. When a member gets closes to retirement, other asset classes are introduced, but we don’t have an ESG strategy for classes such as bonds and gilts.”

“One of our next challenges is how we bring ESG overlay into infrastructure and property – that’s on the agenda for tomorrow,” he adds.

More and more ESG strategies available

Regulation has been a driver for change in the past couple of years, with regulators now making it clear that trustees need to take account of the material financial risks arising from ESG factors. 

There are also an increasing number of different ESG products to choose from. Alistair Byrne, head of pensions and retirement strategy at State Street Global Advisors, explains that more investment strategies are becoming available. For example, there are now pooled smart beta/ESG funds that can be put on platforms and used by pension plans of all sizes.

“A number of large DC schemes and master trusts have embedded ESG into their default strategies. In many cases, it is a first step and the strategy will evolve in coming years. We also know that many other schemes are working on revising their strategy to include ESG,” Mr Byrne notes.

He adds that “trustees are also paying more attention to stewardship” – looking at managers’ policies on voting and engagement and their track record of activity, particularly on contentious votes on issues such as climate change.

However, one issue surrounds data. Mr Byrne says: “ESG ratings and score can be inconsistent. There is a need for thoughtful analysis to build best-in-class measures to base investment strategies on.”

Lack of choice for members?

Without a legal requirement for the trustees of a DC occupational scheme to provide an ESG-friendly default fund or even as an option fund, Penny Cogher, partner at law firm Irwin Mitchell, says it can be impossible for members of even quite big DC schemes to choose to invest their pension pots in an ESG fund itself.

The mainstream investment advisers do not seem to be recommending that trustees set up an ESG-friendly fund as one of their options.

“Trustees could talk to their members to canvass views about this, but they seem very reluctant to do so and are advised by their lawyers and investment advisers that it is quite impractical to do so,” Ms Cogher notes.

So, should there be a legal requirement to offer an ESG default fund? Ralph McClelland, partner at law firm Sackers, says: “There is a strong argument that, in designing or choosing their default fund, DC trustees are already under a fiduciary obligation to take into account financially material ESG factors, which would include climate change. “

He says that trustees must also act prudently. “The question for trustees, given the direction of legislative travel, is what ‘prudence’ looks like in the current environment.”