Until recently, there has been little expectation that DC schemes’ default funds would incorporate analysis of environmental, social and governance (ESG) issues. With a lack of engagement meaning that most scheme members end up invested in default funds, the majority of which do not explicitly take account of ESG issues, it is perhaps not surprising that ESG has often been perceived as a niche area that is likely to entail additional costs.

ESG vs SRI

There is frequently confusion about the precise meaning of the term ‘ESG’ and its relation to SRI (socially responsible investing). SRI is also known as ethical investing, and is based largely upon excluding certain investments from a portfolio, depending on an investor’s particular mission or purpose. ESG, on the other hand, does not exclude companies for specific reasons, but instead is concerned with researching and analysing environmental, social and governance issues as an integral part of an investment process. ESG analysis looks at all these issues and whether they are being managed to enhance or protect a business and therefore a client’s investment. Companies will therefore not be excluded for moral or ethical reasons, but solely on investment-led grounds.

Some DC schemes have already begun to offer members the option of investing in ethical indices, but, in view of the regulatory charge cap of 75 basis points, they have had concerns over the feasibility of including actively managed strategies that incorporate ESG research. However, if ESG analysis is fully integrated into a manager’s investment process, it is already part of the service that clients receive and not a ‘bolt-on’ with an associated cost. Possible actively managed solutions for schemes could include a diversified-growth fund which embeds ESG into the investment process, or which excludes certain stocks such as tabacco or weapons companies.

Ultimately, it is not the role of investment managers to impose a specific set of morals, as the decision to include ESG or ethical criteria in default funds resides with pension schemes themselves. However, a number of factors have recently prompted increasing interest in this area. On the one hand, concern is growing around areas such as climate change, with the realisation that there may be a considerable risk to humanity. Furthermore, in the aftermath of the global financial crisis, many have come to the view that things might have turned out differently had there been better risk mechanisms and oversight bodies in place. More generally, there is recognition that a company with a responsible culture and governance, long-term sustainability and a strategy for generating long-term future cash flows will make a more attractive investment for a portfolio.

There is recognition that a company with a responsible culture and governance, long-term sustainability and a strategy for generating long-term future cash flows will make a more attractive investment for a portfolio

The millennial effect

Another factor which may have an impact on the provision of ESG and ethical investing is the changing attitude of savers, in particular the ‘millennial’ generation. Climate change, for instance, is likely to have been an important part of the curriculum for an 18-year old today. Furthermore, the trend towards increasingly personalised DC pensions means individuals may play a greater role in making choices in future. When millennials realise there is no one acting in a fiduciary capacity on their behalf, they may in time take matters into their own hands and opt to move their money to asset managers that address their concerns over sustainability, social responsibility and ethics. Today, millennials’ words of support for ethical investing are not perhaps matched by their actions, as take up of ethically screened funds or appreciation of ESG being embedded in an investment process remains low. However, what is not currently front of mind for millennials today could well become so tomorrow.

Millennials may in time take matters into their own hands and opt to move their money to asset managers that address their concerns over sustainability, social responsibility and ethics

We are also seeing increased interest in such strategies from those closest to retirement, who may be considering handing over wealth to the next generation. As for other investors, as well as being prodded by their children or parents, the force of media and of recent disasters could play a part.

Conclusion

There is clearly some way to go before there is a full appreciation of the value and importance of ESG in DC, but there are signs that social issues are becoming increasingly prominent and might result in greater engagement among savers in DC and beyond. As a result, there could be a greater expectation in future that an investment manager should at the very least be able to demonstrate that ESG issues are viewed as part of its investment process for a default fund to be considered sound and fit for purpose.

Newton defined contribution investments
www.newtonim.com/dc

This is a financial promotion. This document is for professional investors only. Issued in the UK by Newton Investment Management Limited, The Bank of New York Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA. Registered in England No. 01371973. Newton Investment Management is authorised and regulated by the Financial Conduct Authority. These opinions should not be construed as investment or any other advice and are subject to change. This document is for information purposes only. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell investments in those countries or sectors. T6329 12/17.

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