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Why is Responsible
Investment not getting more traction in DC Default Schemes?

Sam Cobley

In this blog, Sam Cobley reflects on the success of DC Schemes in implementing responsible investment strategies.

Over a year ago, Laura Myers wrote a blog encouraging Trustees to think more about incorporating Responsible Investment (RI) into their DC Investment Strategies. A year later, I wanted to reflect on the success or otherwise of DC Schemes in implementing this cry to action.

By way of a reminder, RI incorporates Environmental, Social and Governance (ESG) factors into investment decisions, including good stewardship practices such as voting and engagement. It is not a product; it is a way of investing that can be meaningfully applied to the majority of asset classes. Over the last couple of years, RI has been a buzz phrase in the investing world driven on by the combined effects of regulatory support, empirical evidence and substantial media coverage.

There  are numerous studies that show a positive relationship between company performance and ESG. Therefore, incorporating these factors into investment decisions can indeed positively contribute to financial performance while ignoring the fact could be a material long-term financial risk. Finally, media coverage on ESG issues has also grown exponentially in recent years, and as a result both members and trustees are much more aware of ESG as a concept. So, in light of this, how advanced is RI take up in DC? I would reason that at present we have definitely boarded the train, but are currently trying to work out our destination.

To first present the facts: substantially more than half of DC schemes offer members an “ethical” self-select option. This is typically a fund that excludes certain companies based on moral considerations, rather than an “ESG-themed” fund which emphasises ESG factors for financial reasons. When members are surveyed, an ethical investment option is consistently high on the list of member priorities. However, take up (the point at which members vote with their cash) is generally low.

Why is this? I believe that whilst some schemes are to be commended for focusing on ESG in member communications, there is little focus on the expected performance of these funds. Therefore, members may still be of the opinion that investing in ethical or ESG-themed funds is a conscious decision to accept lower returns. This is a conundrum for trustees: future returns cannot be guaranteed, but at some point communication should address the fact, in my view, that RI does have the potential to improve member retirement outcomes.

Given that RI has this better return potential, the take up of RI in Scheme default solutions has been surprisingly patchy. I would lay the blame for any failings at the feet of all parties: consultants, investment managers and trustees alike.

As a consultant, I can clearly see that there is appetite from trustees  to consider introducing an ESG-themed fund into a DC default; however, a lot of trustees also seem to be unwilling to be early movers. How long do they require before they are convinced? Two representatives of these ‘early movers’ are attending our DC conference and will be sharing their implementation journey and member experience.

I also remain unconvinced that existing products provide a sensible, cost efficient means of integrating RI within default lifestyles in a way that offers the potential to make a material impact on DC member outcomes. Of those ESG-themed funds that DC schemes have introduced so far, the majority are passive, incorporate only a few ESG factors and often can deviate from a conventional market cap index (eg the MSCI World) by a relatively small tracking error (say 50bps). As such, any ESG-themed fund would only be able to provide modest benefit / protection for members against ESG-related upside and downsides –hardly a game changer. Couple this with the fact that trustees rarely make a 100% allocation to these funds, and that ESG-themed strategies are often more expensive, then the small potential incremental benefit of RI integration is under significant threat of being eroded by fees.

So what needs to change?

I believe investment managers have a huge opportunity to innovate and develop market-leading DC-suitable ESG-themed funds. The big challenge is fees: there are a number of credible actively managed ESG-themed funds that have a track record of providing positive risk-adjusted returns, but are currently too expensive to be included in DC default solutions at a meaningful allocation. That said, by reducing fees, managers may experience an influx of assets by effectively expanding their market to include DC Schemes. Only one question would then remain – would trustees be willing to become perceived ‘early movers’ into these funds? As consultants it would be our job to provide suitable evidence, comfort and guidance to convince the trustees to cross the Rubicon with us .

How do we rate your managers on RI? Take a look at our recent survey.

Want to hear more about RI in DC? Come to our DC conference.