Are DC ESG default funds fit for purpose?

According to data from the Pensions Regulator, 96 per cent of members in non-micro schemes are invested in a scheme’s default strategy.  

“The purpose of the default is that it is intended to satisfy the needs of the majority of members,” explains Hymans Robertson’s head of DC investment, Callum Stewart, who senses that the TPR’s default membership record of “mid to high-90s is too high”. 

Many pension providers have given their default funds ESG tilts. Stewart agrees with providers that think “some degree of ESG integration in defaults is now a necessity”. 

There is a preference to hold on to companies rather than exclude where you believe you have the ability to influence

Callum Stewart, Hymans Robertson

“I think those who don’t have that are now laggards and will find pitching for new business quite challenging,” he adds. 

ESG equity funds have outperformed defaults

In December 2020, Standard Life launched an ESG DC default fund for pension fund clients of its Standard Life Assurance business and its scheme members. 

The fund’s strategy is similar to other funds in the market, excluding companies that are not aligned with the fund’s ESG policy. It has increased its focus of late on green technology and cut carbon intensity by 50 per cent compared with its parent indices, as well as placing a focus on stewardship. 

Gareth Trainor, head of investment solutions at Standard Life, explains that the fund is in its early stages and is investing for the long term. When asked about competitors, Trainor says that he is “not aiming to beat the competitors” and is solely focused “on consumer outcome”. 

Considering the performance of other default funds, other providers took an alternative route by implementing ESG strategy to their existing default schemes, rather than create an ESG default. Aegon’s BlackRock Lifepath Flexi Fund, for example, had 65 per cent of its Aegon Workplace Default Fund invested in ESG-focused strategies as of July 31 2022. 

Zedra client director Dan Richards notes: “This year an ESG equity fund has outperformed a normal equity fund, but of course that can be reversed.

“I would expect [a general ESG fund] to be slightly less volatile, because an ESG fund is incorporating more information. We’d expect it to be a little more predictable in the long run.” 

According to Stewart, the performance of ESG defaults was “at least in line with wider traditional markets”. 

“The current year has been slightly more challenging. If you look at it from a sensible time period, performance has at least kept pace with wider markets and in many cases outperformed, with modest tilting,” he says. 

Engage or divest?

The aforementioned default funds have ESG screening criteria that exclude certain sectors. Standard Life’s exclusions, for example, include thermal coal and “unconventional” gas.

While default funds will invariably exclude some companies whose activities fall foul of ESG criteria, providers including Aegon and Standard Life remain invested in businesses where they see the potential for positive change through engagement, arguing that through voting and internal pressure, companies would be forced to change their policy or business strategy as a whole. 

All of Legal & General Investment Management’s default options within its master trusts implement ESG to varying degrees. LGIM head of DC investments Veronica Humble says that it enacts “minimal exclusions across the board — pure coal miners and controversial weapons is more the consensus across the industry and we have decarbonisation targets across all of our defaults”.

“Our emphasis has been on engagement. We have the tilted funds and we will take into account those trends through overweighting or underweighting, but we want to retain that broad exposure,” she says.

Stewart explains that “the mainstream view is there is a preference to hold on to companies rather than exclude where you believe you have the ability to influence”. 

He gave the example of a fossil fuel company. “If the company is engaging with the asset manager on the need to reform the business operation, to be compatible with a lower-carbon future, then I think this is a company that may be worth holding on to,” he says. 

Meanwhile, exclusionary policies can harm investors, argues LCP partner Nigel Dunn. A notable amount of ESG fund performance deviation is caused by strategies that “exclude a lot of the index”, he says.

“We’re finding that some of these ESG funds exclude half of the index, so while you are a passive investor you are losing half of the overall investment universe.”

What do members want?

Experts agree that it is important to consider whether members really do want ESG integration, and how far ESG practices should be taken in these default funds.

Stewart explains the difficulties in balancing member engagement with stewardship, as “providers and trustees as asset owners have a responsibility to be active stewards and operate in a way that’s consistent with preserving longer-term value, but ultimately recognising that the member is the ultimate beneficiary”. 

“It is really important to have some kind of assessment of what it is that the members actually want,” he says.

The means by which providers collect information and allow this to influence ESG-related decisions can influence overall levels of engagement.

Richards makes the case for providers to be engaging more with members by “collecting member surveys…asking their policyholders ‘what do they want?’ Because how can you design a product if you have never asked members what they wanted?” 

He adds: “Around 80 per cent-plus don’t worry about what’s in their default.”

LGIM uses the Tumelo platform to allow members to view how their pensions are invested, offering them the option to “express a wish”. They are, however, not legal owners of these assets and so “can’t really vote” on decisions concerning the assets, Humble explains.

“We then provide the feedback on how we voted and why. We definitely have seen way more engagement through that — that engagement drives overall awareness,” she says.