Employees are increasingly aware their pension pots can be used to help to protect the planet and improve society. That’s a result of climate change becoming more salient and the success of campaigning groups such as Make My Money Matter.

This represents both an opportunity and a challenge for both pension schemes and asset managers. Explaining to members how their pension pots are making the world a better place is a great way to build trust and engagement.

But the way sustainable investing principles are included in auto-enrolled pensions could be seen as lacking purpose. As I explained in my last post, many pension providers invest the equity proportion of the pot in an ESG-tilted index.

While this helps to avoid the most egregious risks, it’s questionable whether this strategy goes far enough to help to protect the planet and improve society. This is principally a risk-management strategy which favours companies which already have strong sustainability credentials.

Going further

There is a way for asset managers of these strategies to do more – they can engage with the mediocre companies and persuade them to improve their corporate strategy. In theory, passive providers are well placed to do this as they are long-term holders of these stocks and can build powerful relationships.

But there are significant challenges for these managers to do this well. As this post outlined, the resources required to do this well are significant and it is a highly complex task.

Nor is it certain there are sufficient sanctions to ensure real change. It’s not clear a pension scheme would switch providers if a passive manager failed to deliver real change. And as passive providers have to mirror an index, they lack the ultimate sanction of disinvestment.

Active choices

Not only could pension schemes ensure their passive providers persuade companies in their portfolio to change, but they could also consider adding active strategies which have improving the ESG scores as a core part of their mandate.

For example, this could be an equity manager with the mission to create value by selecting companies with mediocre sustainability characteristics and engaging with these firms to improve these qualities.

Fixed income managers often hold more sway over a company despite lacking voting rights. That’s because as a source of primary capital, debt investors can exert considerable influence over a finance directors.

A private credit investor is, for example, in a good position to offer a company a lower interest-rate in return for improving their sustainability profile. The calculation by the manager is long-term improvement in the value of the company will outweigh the short-term reduction in returns.

Cost constraints

So why don’t pension schemes to improve the sustainable credentials of their portfolios by adding these types of funds? The problem is these strategies cost more.

The government introduced a 0.75% investment manager fee charge cap for auto-enrolled pension schemes in 2015. This has a noble goal: it wants to limit the amount returns could be eroded by charges. But it has helped to create a situation where cost is seen as a proxy for value.

The auto-enrolled market is fiercely competitive with share is gained through price. Insurance companies and master trusts offer costs considerably lower than 0.75% in order to win contracts.

That puts considerable constraint on the type of strategies which can be included in an auto-enrolled pension. This explains why, the cheapest option, passive equities are so popular.

Larger master trusts have the scale to be able to combine more expensive options within their portfolios but active sustainable funds, otherwise known as impact strategies, are not as yet a priority. That might change over time.

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