Experts warn of the dangers of neglecting to consider governance

Environment and social governance (ESG) has become a fundamental principle for one of the country’s largest defined contribution (DC) schemes.

“For us, [ESG] is risk management,” said Kathryn Graham, head of strategy coordination at the Universities Superannuation Scheme, speaking at Workplace Pensions Live. “If you don’t fully understand all the risks in your business and the investments you make, then you’re missing something. You have to understand the long-term implications for a scheme that doesn’t follow the proper governance procedures.”

As well as integrating ESG into USS’ internal investments and agreements with external managers, USS offers its members a specific ethical fund.

Graham explained: “It was something our members had requested, so we spent quite a lot of time designing that and putting something together that has ethical bonds, cash, property, and equities. It emulates our standard default strategy as much as we are able, for members who want to make that choice.”

They are not alone. “We are being asked more and more about ESG by DC schemes,” reported Graham’s co-panellist Alistair Byrne, senior DC investment strategist at State Street Global Advisers (pictured). Byrne attributed the increased interest to auto-enrolment, which is bringing a large proportion of the UK population into DC pension schemes.

“There’s a sense that if you are not reflecting climate change, social and market practices then you potentially have risks in your portfolio that could damage the financial interests of members,” said Byrne.

Investment managers are evolving their approach to take account of schemes’ growing focus on ESG. “A lot of our products are index-tracking funds so we are investing right across the market,” said Byrne. “We are always going to be invested in stocks, so how do we deal with it? A whole part of our stewardship piece is about engaging with companies, voting at AGMs, making sure companies are taking adequate account of environmental and social factors, and taking action where they don’t.”

Divestment is one recourse fund managers can resort to when a company doesn’t listen to constructive. Increasingly, investment managers are evolving, offering products which screen certain sectors or stocks that do not fit their criteria, said Byrne. Conversely, investment managers can also allocate an overweight to companies or sectors that are most conscious of ESG.

For a while in DC, ethical investment meant offering one ethical self-select fund option to members. This is changing fast, says Byrne. “We know that so many members, even if they think about choosing a fund, don’t get around to doing it. If there is a standard default fund, 90% of them will still go into that. So ESG is about working on the default, it’s not about having an ethical fund for people to choose.”