Pressure on schemes to consider the impact of Environmental, Social and Governance (ESG) risks on long term returns is coming as a result of changes to policy and regulation as the government seeks commitment around key ESG issues. This is particularly related to issues around climate change, to help them meet their obligations to a variety of international accords such as the Paris Climate Agreement and the United Nations Sustainable Development Goals. Crucially, there is also increasing evidence that UK DC pension scheme members now expect more from their pension assets than just financial returns, with over 70% of people saying that they ‘want their investments to avoid harm and to do good for people and planet’.

While some have already made changes, there has been a degree of caution with many schemes yet to make any changes to portfolios. There may be many reasons for this, from concerns over fiduciary risk, to uncertainty in some quarters as to the benefits to member outcomes. However, as pressure from all sides grows and the long term risks become ever clearer, it seems increasingly likely that taking no action will not be an option.

So what approaches could DC schemes be looking at in order to better integrate ESG considerations into their default and member-selected investment offerings?

Bottom-up

Many strategies already used in scheme defaults have long taken into account ESG factors alongside financial risk and return prospects within their investment processes (mainly those which adopt an active approach), and, when done well, this may be sufficient to meet obligations. However, some schemes, Master Trusts and pension providers are beginning to move further by incorporating ESG focused strategies to sit alongside their existing core holdings while others have adopted exclusionary policies (e.g. removing exposure to tobacco or controversial weapons) that apply across their entire portfolios. These are all positive steps forward but we are at the beginning of a journey.

As approaches evolve and the universe of strategies suitable for DC investors expands, we think that employing a combination of strategies within a consistent ESG policy framework may help schemes achieve the right balance between meeting regulatory requirements, their member demands for action, and fiduciary responsibilities. Options here might include the following:

• Sustainable strategies that can be utilised across core asset classes. These are likely to be designed to be relatively mainstream (i.e. they seek to do less harm and do more good while maintaining similar risk and return characteristics to traditional market cap strategies). This type of strategy is likely to primarily make use of ESG risk-based (as opposed to ethical or moral) exclusions as well as portfolio tilts that aim to reduce risk and deliver targeted ESG outcomes (e.g. improvement in ESG scores, reduction in carbon intensity and/or increased exposure to green technologies). As a result, they may help fiduciaries to address ESG requirements on the majority of their 

portfolios without exposing themselves and their members to unintended risk and to create a consistent baseline from which to build.

- regulation requires schemes to take further action on climate change

- there is reasonable evidence that climate is a particular concern for a significant proportion of the member population and campaigns such as ‘Make My Money Matter’ (which aim to increase awareness and engagement among members on ESG matters) will only make this more likely in future

- particular themes, or combinations of themes, offer attractive long term investment opportunities to enhance return. Thematic or impact strategies may not be right for all schemes and they are unlikely to be suitable as core investment holdings. But as complimentary satellite holdings that may further enhance ESG outcomes, improve risk and return characteristics and /or address member requirements, they may be attractive for some. For example, thematic climate strategies may be helpful where:

• Alternative (ESG tilted) asset classes. While there are not yet as wide a range of options available in this space and some characteristics (such as illiquidity) may be problematic for some, we expect to see growth in this area with more DC friendly solutions being developed in areas such as private debt, infrastructure and real estate.

Top down

Replacing existing or adding new strategies to portfolios will potentially be a big step forward and we believe will help improve outcomes. But truly incorporating ESG factors within the strategic asset allocation (SAA) approach employed as a default, may have as big, if not bigger, impact. Our work to develop Paris Agreement-aligned and climate-aware multi-asset portfolios for clients suggests that by evolving SAA policies to capture more of the opportunities and reduce long term risks it may be possible to not only deliver good retirement outcomes for members, but also improve outcomes for the planet.

Our analysis suggests that improvements can be achieved through an evolution of the portfolio optimisation approach to incorporate ESG risk and climate opportunity factors into the development of strategic asset allocations and broadening the universe of asset classes utilised within the SAA.

Responsible investing is at the core of what we do The picture continues to evolve but we believe that it is becoming increasingly clear that the integration of ESG within defaults will be the new normal as growing member awareness of issues, along with changing regulatory demands, continues to drive fiduciaries to deliver defaults that improve outcomes for their members and the wider world. To this end, ESG solutions are very much at the heart of of Aberdeen Standard Investment’s development plans over the coming year as we continue on our journey to provide solutions that meet the expectations of DC members.