DC members must reassess passive approaches to achieve climate goals

Even with the appetite for annuities dwindling, fixed income can still range between 30 to 60 per cent of the strategic asset allocation for large master and single trusts, according to data from the Defined Contribution Investment Forum.

The bonds, often corporate, are required to fulfil the ‘holy trinity’ of investing — capital growth, preservation of value and potentially paying an income as focus on retirement outcomes increases.

Yet, despite myriad requirements that need to be met, we still see many DC schemes trying to do this via passive UK corporate bond mandates within their defaults — an approach we believe to be ineffective at meeting modern member needs including their climate ambitions.

Going global

As UK DC schemes grapple with how to provide both steady income and stable growth opportunities, one way they can improve member outcomes is by embracing a more global focus in their corporate credit allocations.

For example, while the spread and average credit rating for UK and global corporate credit indices may be broadly the same, expanding allocations to include the US dollar and Euro markets can increase the investible universe size by 20 times. This has huge implications for both the liquidity of the bonds held and the diversification of risks.

Higher liquidity would reduce trading costs, which, while not being shown directly in fund performance, could positively impact a credit portfolio that is being used for regular drawdowns in retirement.

Exposure to a global universe can also diversify risks within a portfolio. Avoiding fallout from political risks is just one example of how a global approach could dampen the impact of risk elevation within any one country.

Integrating climate objectives

The case for taking climate change seriously is clear. Extreme weather events and the abrupt introduction of regulation are just two of the ways in which climate change could increase the volatility of returns and the risk of credit defaults.

Perhaps more pressing for DC members is the enormous investor, political and regulatory momentum in climate-aware investing. This momentum alone, irrespective of how the physical risks will impact asset prices, justifies a consideration of climate risks due to the material financial impact it could have on bond portfolios.

Having access to a global universe gives DC investors a broader toolkit to implement a climate-aware strategy. This could be in the form of a sterling-focused strategy that has the flexibility to use the global breadth of a fully global strategy.

For example, the Euro-denominated market currently has a much higher volume of green bonds and a larger proportion of new green bond issuance, a critical component in any climate-focused strategy.

However, while shifting index allocations to a global universe can bring advantages, pension schemes and DC investors pursuing a purely passive approach will be limited in what they can achieve when it comes to both climate risk mitigation and contribution to the low-carbon transition.

This is due to a lack of control over the consideration of climate risks and impact as part of the security selection and portfolio construction process.

The effectiveness of a blended approach

Climate integration is more effectively achieved through a more blended approach, such as a buy-and-maintain credit strategy, which seeks to use the same fundamental credit research and skills as active management but with the low-cost edge of passive.

For example, when selecting between two bonds to invest, assuming all other characteristics are equal, a traditional passive approach will have no discretion to choose that with the lowest carbon intensity or the steepest pathway towards decarbonisation.

It will own both bonds, irrespective of their climate impact.

Passive bond strategies are also limited in their engagement activities, unable to wield the same influence over target companies as an active manager who would have both a willingness and ability to divest should a company fail to meet the required objectives.

This means DC investors using passive strategies could potentially be more exposed to higher climate-related risks, as well as having a lower impact on the overall climate transition.

Not only can moving away from a passive approach provide more opportunities to lock in higher yields through relative value investment opportunities, it can also unlock the ability to implement climate-aware investments, helping DC investors better meet their regulatory and member outcome requirements.

Sebastien Proffit is head of portfolio solutions, fixed income at AXA Investment Managers