Demand for schemes to consider ESG in the default is hotting up - but getting it right is far from straightforward, writes Sara Benwell

For far too long, savers who want their workplace pension invested responsibly have had to look outside the default at more specialist ESG funds. But now – the tide is turning and trustees and scheme managers are facing increased pressure to build ESG into their default options.

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This makes sense. Most experts agree that over the long-term ESG factors can significantly affect how well a fund performs – and it is therefore important that these risks are managed just like others such as inflation, market and currency risk.

In fact, when viewed through this lens, it seems absurd that ESG continues to be separated out as a niche risk, rather than something that we should be managing for savers as standard.

Diandra Soobiah, head of responsible investment at NEST explains: “We believe these factors should be considered and managed as an integral part of the investment process. That applies to default funds particularly… The vast majority of savers stay in their scheme’s default fund and ask few questions about how their money is being managed, expecting it to be well looked after and to provide for them in retirement.

ESG factors represent long-term financial risks in investment portfolios”

“It’s our duty to meet those expectations and managing a whole range of risks, including ESG risks, is key to giving members the smooth, sustainable returns they want and need.”

Alistair Byrne, head of investment strategy - European defined contribution at State Street Global Advisors adds: “On the positive side, well-governed companies that take care of their impact on environment and society should be less risky. On the other hand, where companies have poor governance or have activities detrimental to the environment and society, investors can suffer losses when these activities are challenged by consumers or outlawed by regulators and legislators.”

“It’s crucial that the default fund manages [this] risk for those members and there is a growing appreciation amongst trustees, regulators and asset managers that ESG factors represent long-term financial risks in investment portfolios.”

Why aren’t we doing it already?

Given the huge body of research, which suggest that ESG investments often outperform over the longer term, it’s hard to understand why these factors aren’t included in the default as standard.

One answer is that the concept of ‘ESG’ is too muddied and the various definitions and interpretations, not to mention the different ways of factoring in the risks, makes it difficult for trustees to know which way to turn.

It’s easy to make broad political statements about the need for ESG - it is rather harder to implement”

Hannah Lewis, director, Behave London explains: “The use of a broad-brush phrase like ‘ESG’ is off-putting. It’s badly explained and lacks a standardised definition across those who rate funds.

“It’s also worth noting that Responsible Investing is an umbrella term, but ESG-investing has been developed as a risk-performance tool. However, by “non-experts” it seems as if these terms are being used interchangeably. This is potentially problematic, as the terms are not clear and the outcome can look very different depending on where your focus lies.”

Steve Delo, independent trustee and managing director of Pan Governance adds: “Of course, it is easy to make broad political or regulatory statements about the need for including ESG - it is rather harder to implement given the rather blurry nature of the definitions, the vagueness of the articulation of the risks and the significant uncertainty of when investment markets will start to price in ESG concerns that may not currently be priced in.”

Here providers must play a role. If we can achieve a broader industry consensus around how to define ESG and better tools for evaluating the investment options, it will be far easier for trustees to rethink their defaults with environment, social and governance factors in mind.

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Long term goals versus short term evaluation

Another issue lies in the long-term nature of ESG investing, since many DC trustees are evaluated over a far shorter time horizon, regardless of how far away retirement may be for members.

This is particularly true for environmental factors, many of which are not yet priced properly into the market and may not be for 25 years. The question becomes, how long will members and regulators accept sub-optimal returns in the short term on the assertion that the market is wrong about ESG?

The poor old trustee needs to be a bit more near term than that”

Delo explains: “The E and S parts of ESG are the most tricky. A ubiquitous political statement is that many people in DC schemes, will be saving for 40+ years from now and therefore environmental issues are possibly going to have an adverse impact on investments over such a time frame.

“That may be a reasonable assertion but the poor old trustee needs to be a bit more near term than that, given the tendency of this industry to compare returns over shorter periods (and draw often wholly spurious conclusions over such periods) and for members to do the same.”

“I believe the length of time frame here makes this a massive challenge for trustees trying to do ESG in a meaningful way, as opposed to just box ticking, tinkering on the margins or making a token gesture.”

Taking a considered approach

However, this doesn’t mean that trustees can’t or shouldn’t start thinking about ESG. Instead, it suggests that a more considered approach is required.

Delo asserts that what is needed here is time, training and for trustees to consider a whole range of viewpoints.

He says: “A strong and coherent policy that has been carefully thought through and which can be practically implemented should be the objective - not a lot of waffle and nice words that actually mask the fact that you are not doing anything of note.

“Be honest - if you’ve done the training and carried out the research and have concluded that there is nothing meaningful you could/should/want to do, then say so and justify it. But if you have concluded action needs to be taken, be clear about why and what you are trying to achieve and communicate it as well as you can.”

This makes sense. If trustees are to start implementing ESG within defaults, there need to be clearly stated aims and objectives. And this will help if returns take a hit in the short term. If the strategy and time horizons are clearly laid out, there is less likely to be panic if investment performance takes an early dip.

How we do it – NEST

NEST is one scheme that is ahead of the curve on ESG. The mastertrust incorporates factors into its investment management processes through a variety of actions, including selecting the right fund managers, active ownership, risk monitoring and directly in its asset allocation.

In fact, when it comes to deciding which fund managers to use, the organisation assesses each manager’s approach to ESG as part of its tender process.

The mastertrust also takes its active ownership responsibilities seriously and expects the same of its fund managers. As the scheme mainly invests passively in equities, voting and engagement is an important way to influence and help steer companies towards better long term financial sustainability.

Soobiah explains: “While most voting is undertaken by our fund managers, we monitor their activities against our own voting policy and will engage with them on topics that we are particularly concerned about. We can also vote our own shares directly for a proportion of our global equities portfolio should we need to. For example, in 2017 we voted against the pay policy at Shell because it didn’t link executive incentives to a forward-thinking climate-related strategy, which we and other shareholders were expecting to see.”

The mastertrust has also recently introduced a new building block fund into its default strategy to address the long-term risks and opportunities associated with climate change. The fund, which is forward-looking and adjusts its investment in companies based on their likely future contribution to achieving the Paris climate goals, aims to prepare members’ pots for the long-term transition to a low carbon global economy.