While the majority of the working population pays into an auto-enrolled defined contribution pot, the bulk of the UK’s current private sector pension wealth is concentrated in closed defined benefit portfolios.
That’s because auto-enrolled pensions have only existed since 2012 so neither contributions nor the investment gains have had much time to accumulate. In comparison, defined benefit schemes have existed for many decades.
(If you want to know more about why private sector defined benefit schemes fell out of favour as well as how and why previous governments developed auto-enrolment then I recommend my pensions landscape series of posts.)
The importance of legacy
The Office for National Statistics regularly assesses pension wealth, which it divides into three different categories.
Active pension wealth receives regular contributions. Preserved pension wealth no longer receives payments but is not yet paying out benefits in contrast to pensions in payments which are supplying an income.
Of these three categories most auto-enrolled pensions will fall into active pensions while closed defined benefit pension schemes – which can be thought of as legacy pension schemes – will be in either preserved or pensions in payments.
For the period from April 2016 to March 2018, nearly half − 48% − of all private pension wealth was held in pensions in payment. Just over a third, 37%, was in active pensions while 15% was held in preserved pensions.
In other words, there is approximately £3.8bn currently held in closed defined benefit pension schemes while there is around £2.2bn in auto-enrolled pension pots. These numbers aren’t exact but they give you an idea of the size of the wealth accumulated in these legacy pension schemes.
If the aim is to embed sustainable investment principles in all UK pensions, it’s important we incorporate these strategies into these much larger defined benefit portfolios as well as auto-enrolled pensions.
Different portfolio construction
You would be forgiven for thinking this is straightforward: we apply the same principles to these closed defined benefit schemes as we do to auto-enrolled pensions. But that’s not possible because these pensions are invested in different asset classes.
Rather than a pot which is open to new contributions, closed defined benefit pensions have to rely principally on investment growth of an existing set of assets to pay the future benefits promised to members.
Over the past decade or so, the investment strategies of DB schemes have changed significantly. They have become focused on the ability of interest rates and inflation to erode the value of the investments over their decades-long lifetime.
As a result, these portfolios are much more heavily invested in bonds than a typical auto-enrolled pension scheme. Half of a defined benefit pension scheme is invested in government bonds, while around 20% is invested in corporate bonds and 30% in equities or alternatives.
Sustainability and corporate debt
Applying sustainable investment principles to a portfolio principally invested in fixed income is not the same as one which is mainly invested in equities.
In this post I outlined the three key tools available to make a portfolio able to protect the planet and improve society. They are exclusion, evaluation of ESG characteristics and engagement.
While it is possible to use both exclusion and evaluation of ESG characteristics in a corporate bond portfolio, without the voting rights which accompanies equity investments it’s not immediately obvious how to petition companies to change corporate behaviour.
But fixed income investors are adept at persuading companies to adopt more sustainable practices.
That’s because they are primary issuers of capital rather than buying existing shares in the market. As companies need this funding, this puts the investor in a strong position when it comes to negotiating with the executive board.
Not only can it be easier to negotiate more effectively with companies which issue corporate bonds but this can have a greater affect than influencing equity holdings. That’s because company debt portfolios tend have a high proportion invested in industrial and utilities companies.
As these companies contribute more to global warming then the companies which make up an equity index, changing behaviour at these firms can have a disproportionate benefit to the planet.
Influencing the UK government
While it’s important for defined benefit pension to apply sustainable debt principles to corporate debt, this only makes up around a fifth of the portfolio. With half of the assets of a typical DB scheme held in UK government bonds, if a pension scheme is serious about investing sustainably they must have also strategy for this asset class.
It’s less straightforward to embed sustainable investment principles into a sovereign debt portfolio. It’s not easy to assess the ESG characteristics of a country rather than a company nor is it as easy to engage with the UK government as it is to speak to executive boards.
But it’s not impossible. Schemes can engage directly with the Treasury and the Debt Management Office as well as organisations such as the Pensions and Lifetime Savings Associations. They can also respond to government consultations and through participation in the green financing framework.
As one of the largest lenders to the government, pension schemes have the potential to make a real difference to the sustainability of the UK. It’s just a matter of harnessing that power and finding the best channel for this influence.