A new study has found that UK defined contribution funds are significantly exposed to environmental, social and governance (ESG) risks related to human capital, business ethics, product safety, and data privacy and security.
According to the study, which was released from by UK-based Pensions and Lifetime Savings Association (PLSA) and Sustainalytics, an independent ESG and corporate governance research firm, a fully indexed default fund is likely to contain a large number of companies that trail in ESG policy.
“We no longer understand ESG as a niche product designed to enshroud investors in a warm glow of righteousness,” said PLSA’s Luke Hildyard, “but as a critical component of the wisest investment strategies.”
The report said that empirical evidence shows that ESG integration is “positively associated with financial return, and that the downside impacts of many ESG risks, including climate change, are intensifying.” It also said the recent move by HSBC to shift the equity of its default fund into a climate-tilted factor index “could sit at the vanguard of an important new trend among DC plans in the UK.”
ESG investing has gained significant momentum in Great Britain, with £1.4 trillion in assets under management in the wider investment community in 2015, up from £500 billion in 2013. It also said the number of defined contribution plan members in the UK will increase dramatically over the next 10 years. According to the Pension Policy Institute (PPI), there could be 17 million members enrolled in defined contribution workplace plans in the UK by 2030, up from 11 million today, with an aggregate pension total of up to £914 billion ($1.14 trillion).
A typical default fund offered by defined contribution plans in the UK has a 71% allocation to equity and is most heavily tilted towards banks (7.7%), pharmaceutical companies (6.4%), and oil and gas firms (6.0%).
“Signs of the investment community’s growing interest in ESG are manifest,” said the report, “and include continued growth in the volume of managed assets that incorporate ESG research, increasingly sophisticated integration approaches, and the integration of ESG factors across asset classes.”
In order to manage ESG risks, the study recommends pension plans include the following courses of action
- Include Allocation to Passive ESG trackers in Default Fund. Passive trackers that follow an ESG index are a cost-effective solution for plans looking to manage ESG risks in their default fund.
- Incorporate ESG Risk Analysis into Global Equity Allocation Model. DC pension schemes can reduce ESG risk in their default funds by tilting toward UK equity. “FTSE 100 companies score favorably in Sustainalytics’ rating model due to their relatively advanced ESG policies, programs and disclosure practices,” the study said.
- Develop Forceful Stewardship Strategy. Stewardship strategies typically involve engaging with investee companies to encourage responsible social and environmental practices, and developing proxy voting guidelines. “Forceful stewardship is thus a critically important part of minimizing ESG risk, even if a passive ESG strategy is also in place,” according to the study.
By Michael Katz
Key ESG Issues in a Typical Default Fund
Industry | Portfolio weight | Key ESG issues |
Banks | 7.7% | Business ethics, Data privacy and security, Human capital |
Pharmaceuticals | 6.4% | Business ethics, Human capital, Product safety |
Oil and gas | 6.0% | Community relations, Effluents and waste, Health and safety |
Food products | 5.3% | Healthy living, Product safety, Water use |
Software and services | 4.3% | Business ethics, Data privacy and security, Human capital |
Source: Sustainalytics