Headwinds Ahead: Regulatory push for environmental, social, governance (ESG) outcomes creates challenging outlook for defined contribution (DC) schemes

As the UK DC market continues to grow at pace, challenges are emerging for both members and schemes: consumers’ life expectancy is growing, squeezing schemes’ durability; retirement confidence is being rocked by economic shocks; and the ongoing transition away from Defined Benefit (DB) schemes is increasingly placing onus on individuals to save for retirement.

In addition to these, the introduction of ESG regulation is also poised to play a key role in this challenging scenario. In the UK, from October 2021, schemes with over £5bn in assets, and authorised master trusts, were instructed to comply with Task Force on Climate-Related Financial Disclosure (TCFD) requirements.

Larger schemes with over £1bn in assets will also start to be required to comply from October 2022, and this summer, The Pensions Regulator’s new single Code of Practice is expected to address further climate change demands for schemes and trustees.

DC retirement hurdles
According to the head of BlackRock’s UK institutional client business, Jennifer Ryan, the majority of consumers still feel they are not saving enough for retirement. Raising awareness of resources and encouraging financial literacy is, therefore, a key priority.

“Financial literacy is certainly a big topic and making sure people understand the importance of saving for retirement is particularly crucial. We understand that a large section of the population still feels very unsecure about their retirement, and that they haven’t saved enough, so we are really trying to raise awareness.

“At the same time, plan sponsors are increasingly moving away from DB pensions into DC schemes and that puts more onus on the individual to be educated and understand,” she says.

BlackRock’s 2021 DC Pulse survey found 76% of millennials feel their generation will lack the same level of retirement income as older generations, while 68% of Generation X’ers echo this sentiment.

Retirement optimism has diverged since the pandemic: 76% of working baby boomers feel Covid-19 will have little impact on their retirement outcomes, compared with just 38% of millennials.

Additionally, longevity risk continues to put pressure on member outcomes in DC schemes, according to the Head of EMEA Insurance Segment and UK Asset Owner Client Coverage at MSCI, Mark Guirey, who says as members live longer, there is a greater requirement on them to save more to fund their retirement.

“The state of the pensions market today, following the introduction of pension freedoms, means that we are no longer in a situation where our investments automatically move into gilts and cash in order to take out an annuity,” says Guirey. “Rates, being as low as they are, means you would need a much larger pot in order to achieve a sensible level of income in retirement.”

According to Guirey, pension freedoms have resulted in more sophisticated solutions for investors, though the question remains whether individuals are comfortable with the choices presented to them.

“There is definitely a view that default options have been put in place by those in a better position to understand the associated risks, so that is the option most go with. Fewer feel comfortable self- selecting and making their own investment choices.”

Net zero drivers
Ryan says asset managers are increasingly focusing on ESG outcomes for their end investors, as well as actively encouraging auto-enrolment driven by funds like Nest over the last few years.

According to BlackRock research, 90% of DC participants believe schemes should, at a minimum, offer optional ESG investments.1

It also suggests those aged 35-44, and especially those with children, prioritise climate change over other concerns (48% vs. 32% of others).

Asset managers looking to extend their reach in the UK pensions market need to be able to help trustees meet disclosure requirements.

“We are seeing investors integrate sustainability into their investment processes for a variety of reasons. There is a real regulatory push towards, and greater social awareness of, ESG”, says Ryan.

“Plan sponsors often want to drive responsible investment for their own corporate purpose. But from an asset management perspective, we believe climate risk is investment risk. Our aim is to incorporate that into prudent risk management and portfolio construction.”

Here, sustainable indexing will play a key role. According to Ryan, it empowers both transparency and choice when it comes to the evolution of ESG considerations in DC schemes.

As it stands, 63% of DC assets managed by third parties are invested through index strategies.2 Such strategies give options to investors looking to build investments that meet their objectives, ranging from screening to thematic solutions, spanning across equity and fixed income.

Integration challenges
According to a 2021 survey by Cerulli Associates, 95% of DC pension schemes offer their members ESG options. However, just 43% of scheme default strategies invest in ESG-focused funds.

According to Ryan, indexing will be a “key enabler” in the adoption of ESG-based investing across the DC space, due to the increase in ESG index options available.

There is a clear distinction, however, between default options and member adoption, and between creating self-select options, and default options, according to Guirey: “These (Cerulli) figures show that most members were in the default option.

“Therefore, defaults need to consider ESG and climate associated risks. Those risks must also be integrated into investment solutions to take account of them.”

Guirey also points to the development of solutions and adoption of frameworks for integrating such solutions, from the Institutional Investors Group on Climate Change, to the Net Zero Asset Owner Alliance. He adds that industry focus should be on the innate value offered by such solutions, as opposed to the cost, as the world economy transitions to low-carbon.

“The cost-benefit aspect is something that needs to be appreciated because without innovation, we won’t meet targets. That applies to data providers, asset managers, pension schemes, Investment Consultants, the whole eco-system. There needs to be an appreciation for the associated costs of innovation and this is particularly important in the DC space where there is so much focus around cost. If we only focus on cost, it is likely we will miss the objective.”

Energy transition and client objectives
Ryan says engagement will be crucial to helping pension schemes navigate the emphasis on ESG, reiterating BlackRock CEO Larry Fink’s latest letter that highlighted ensuring a “just” transition means working with fossil fuel providers in a productive way.

BlackRock’s client transition framework – navigate, drive and invent – addresses navigating indices and tilting, implementing deliberate action within ESG impact portfolios, and focuses on supporting innovative technologies that will advance the energy transition.

Climate data providers like MSCI assess and rate companies through an ESG lens on an industry relative basis, according to Guirey. They also introduce newer data to asset managers, insurers and other industry participants, such as implied temperature rise or climate value at risk, which are TCFD alignment and climate change impact metrics, respectively.

Report, monitor, assess
There is also a vital role for technology to play. Here, Ryan says BlackRock is working to improve and incorporate metrics into its risk system – Aladdin. The development of Aladdin Climate is helping clients to deliver on increased reporting standards, she says:

“There is an important need for transparency, an important need for managers to work with their clients to help them reach that, and in terms of the products and financial solutions we deliver, the first measure is to ensure we incorporate risk metrics into our own processes.”

Guirey notes, MSCI has made a Climate Lab Enterprise tool available to its clients. The tool enables investors to monitor and track their assets alignment with their commitments towards Net Zero.

According to Guirey, the onus is on the Fund issuer to explain information clearly, make it readily available, easy to digest, and ensure it is provided in a consistent manner.

1Source: BlackRock DC Pulse Survey, May 2021.
2 – Source: Broadridge, “Navigator. UK Defined Contribution and Retirement Income 2020”, 2021.

Risk Warnings

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Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy.

This information should not be relied upon as research, investment advice, or a recommendation regarding any products, strategies, or any security in particular. This is for illustrative and informational purposes and is subject to change. It has not been approved by any regulatory authority or securities regulator. The environmental, social and governance (“ESG”) considerations discussed herein may affect an investment team’s decision to invest in certain companies or industries from time to time. Results may differ from portfolios that do not apply similar ESG considerations to their investment process.

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