Gold standard DC provision in an ESG-focused climate

The most successful providers will be those that plan for the long term, and balance social and climate considerations with members’ interests.

Responsible or sustainable investing can mean different things to different people and the same goes with pension providers. The maze of ESG information can be hard to navigate and measuring a provider’s responsible investment credentials is challenging when each takes a different approach and sets its own goals. At times it feels as if we all need to become sustainable experts or at least seek the help of one.

Our ongoing assessment of defined contribution (DC) providers found that a few have 70% to 80% of their default offering based on some form of sustainable investing, and some have already started to integrate impact investing. However, other providers have very little sustainable investing exposure, which shows there is scope for more innovation in DC strategies. 

It is great to see some master trusts and providers committing to net zero carbon emissions across their default investment strategy by 2050 or earlier. But the tricky part comes when we start questioning providers on how they are going to reach these ambitious targets – we have struggled to get answers from some firms more than others. 

Divergence in net zero approaches

While we do not expect providers to have all the answers now, we need to have a better understanding of what their roadmaps to net zero looks like to make sure they are credible. 

The challenge is that approaches to net zero can vary considerably among DC providers. This became clear at our webinar, Leaving a lasting impression through ESG, in November 2021 where a wide range of providers and master trusts spoke about their approaches. Some were being more radical with their strategy to reduce their carbon footprint than others. For example, Cushon Master Trust has adopted an aggressive net zero objective including a 50% immediate reduction in its carbon footprint. 

Julius Pursaill, scheme strategist at Cushon, said the provider’s objective is to send a signal that threatens the social permissions that have allowed organisations to continue to pollute and hopes “we will accelerate the broader societal transition that we need.”

Meanwhile, other providers that have set longer-term net zero targets believe it is important to engage and exercise their voting rights while investing in companies that still have a long way to go to reduce their carbon footprint. 

That is why it is very hard for employers to choose between different master trusts. But as advisors, we need to be alive to the fact that certain solutions are going to benefit some DC providers more than others. For example, Cushon can do carbon offsetting because of its smaller size and lack of legacy assets. That approach isn’t suitable for a larger legacy DC provider, which needs to reach net zero across several billions of pounds of assets. 

So, just because some providers will not be able to adopt certain solutions doesn't make them a worse provider, and that is why it is important to dive deeper into the detail behind those 2050 targets.

Climate change has dominated conversations within DC providers especially since last year’s COP26 summit and the introduction of mandatory climate reporting under the Taskforce on Climate-Related Financial Disclosures (TCFD) for large pension schemes and master trusts from October 2021.

We are starting to see more climate awareness being integrated into the default. Some providers have taken the view it is about general ESG integration while others think climate change is a  more significant factor and have, therefore, tilted more towards climate. 

Another important topic is the interconnectedness of biodiversity and climate change, which refers to the important role of ecosystems. It will be impossible to hit net zero targets without a radical approach to natural climate solutions. 

Providers lag on social issues

The coronavirus pandemic drew attention to the societal part of ESG as companies with strong client and supplier relationships as well as robust employee programmes were ranked higher by investors and their stocks performed better. 

The World Economic Forum’s Global Risks Perception Survey 2021-2022 lists three societal issues among its top 10 global risks over the next 10 years – livelihood crises, social cohesion erosion and infectious diseases. 

It is, therefore, surprising that most providers are still lagging on the ‘S’ side of ESG. It has arguably been easier for companies to measure progress on environmental and governance – while this has been more challenging on social issues. That is partly down to a lack of reliable and tangible data.  

At our webinar, Veronica Humble, head of DC investment strategy at Legal & General, said: “While there are great stories out there about social impact, we need better data.” For example, the way social factors are measured is mainly through diversity, such as gender diversity, which is reported on. She said this can be achieved under stewardship and engagement approaches.

There is a risk that providers adopt a silo mentality and only address environmental issues in the portfolio – or just include an overlay of social considerations.

There needs to be more integration of social factors because the ‘E’ and the ‘S’ are very much interconnected. For example, if companies want to ensure positive social outcomes, such as the health and safety of employees, then thinking about climate and environmental issues is a good first step. 

Gold standard DC

What does gold standard DC provision look like? That is a challenging question to answer, but I have some thoughts.

Given the long investment horizon in DC and the fact that providers will be responsible for members’ savings for decades to come, having a credible plan to reach net zero commitments is crucial. 

It will be important to understand the motivations behind the investment strategy and what is the value for the member. Why are we prioritising this particular risk and what other risks might be introduced as a result?

Physical and transition risks associated with climate change can affect pension fund members at different points of their journey. Members closer to retirement are most exposed to transition risk, while members in the growth phase can be more greatly exposed to physical risks. The distribution of those risks also differ whether members are largely invested in equities (e.g. during the growth phase) or bonds (e.g. later in the savings journey).

Master trusts and DC providers must think about these climate risks in the same way they think about the impact of inflation or interest rate changes on members’ net outcomes. There is still a way to go on developing solutions that address the nuanced effects of climate change risks on members pre-retirement and those far away from retirement.

Engagement and stewardship

We also want to see long-term stewardship of assets – for example, effective engagement with the underlying fund managers and investee companies. The level of stewardship still varies considerably among the various DC providers. 

In our research, one provider admitted they have little direct influence over the companies in which they invest through the pooled funds, whereas other providers said they are engaging more around voting and are also lobbying for certain exclusions despite being in pooled funds.

It is all well and good getting members’ views on certain ESG issues but if the trustees cannot do anything because they do not own the underlying assets, that makes all that hard work meaningless. 

We support engaging with members to still give them the opportunity to voice their opinions – but translate that into an expression of wish letter from the trustees to the sponsor, which puts pressure on the fund managers, which in turn put pressure on the underlying investing companies. 

The road to net zero and a more sustainable world isn’t easy. It requires long-term thinking – not just short-term announcements. In the future, the most successful and the most sustainable employers, pension providers and master trusts will be those that have planned for the long term and balanced social and climate considerations with members’ interests.