Keeping up with a disruptive and fast-moving investment backdrop

The pensions industry is no stranger to disruption. Regulation - specifically the introduction of auto-enrolment - has been the driving force behind the transformation that the UK defined contribution (DC) pensions sector has experienced in recent years. The People's Pension, for example, now represents over four million members and some £8.5bn in assets, compared to fewer than 100,000 members with under £1bn just five years ago.

DC schemes continue to rise in numbers and, with the risk ultimately resting with individuals, regular communication with members about their investments is key. However, while the common belief is that the millennial generation may become more engaged, schemes need to be realistic about the levels of engagement today.

It is important to focus interaction on critical points such as what a member can afford to contribute, the age at which they wish to retire, and high-level attitudes to investment risk.

In future, engagement on ESG topics may be a way to generate interest from the end-investor, but, members will need to be able to relate to the examples and the investment terminology used - talking in terms of growing businesses, for instance, rather than ‘beta' or ‘alpha'. However, there is no doubt that, with ESG and sustainability considerations rising up the agenda, such factors are becoming increasingly significant for trustees, who, whether they represent defined benefit (DB) or DC members, ultimately have the fiduciary duty to act in the best interests of their scheme members.

Defining ESG

As an industry, we recognise that we have a responsibility to talk coherently about the challenges of responsible investment. The definition of the word ‘sustainable' has evolved in recent years, and is now normally used in an environmental context. This can touch on people's values and emotions, and the industry therefore needs to get it right - for example, including a large oil producer in a sustainable portfolio or index without reference to the long-term implications on the planet is unlikely to resonate with a large part of the membership. Asset managers will need to think about their belief statements and the consistency of their product suite.

Data relating to ESG factors, unlike financial data, is largely unstructured, and therefore requires additional analysis - or machine learning - to interpret it. However, if schemes think that constructing a portfolio on this basis can add value to members' outcomes (and not just their financial returns), they should be obliged to do it. If the data hints that making changes to portfolios could help and add value in this regard, schemes should act.  

Having benefited from strong equity returns over recent years, many DB schemes have been de-risking, increasing allocations to bonds and bond derivatives. Therefore understanding ESG considerations from a fixed-income perspective will be particularly important. Trustees often struggle to understand what applying certain ESG criteria, or excluding certain investments, will mean in terms of the pattern of future risk-adjusted returns.

The beginning of a trend

It is impossible to show a causal relationship between an ESG assessment and a specific return over a quarterly or 12-month reporting period. What is important is to consider the longer-term impacts as themes or trends play out. For example, could climate change mean that a factory in Bangladesh, a key part of a multinational business' supply change, will be under water and unable to operate in 15 years' time - and is management fully aware of this risk? Our job as investors is to work out whether a company's profits will be affected by these types of developments.

Trustees need to take a view as to what the future may hold and articulate their beliefs as to what markets and the broad economy will reward. There may be trends related to climate change which schemes are unable to profit from but which are nevertheless very relevant to the investment backdrop.

Not all doom and gloom

While discussions around climate change and ESG issues often revolve around the threats, such disruption also leads to opportunities. Over the last decade there has been an explosion in the development of ‘green' technology across the planet, with much of this progress occurring in the US. There is huge potential to analyse patterns to help identify technological solutions and investment propositions for managing the effects of the changing environment.

The pace of change - and potential for disruption - is only likely to accelerate over the coming decade, as further technological advances take hold and the impact of climate change becomes clearer. Politics in particular may remain unsettled, as large portions of society feel they are losing out and push back - and vote - against a world that seems to be moving too fast. In such an environment, it will be vital for investors to pick out the key themes that are driving these developments in order to identify the long-term opportunities and threats for pension schemes.

Julian Lyne is chief commercial officer at Newton Investment Management

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