Environmental, Social and corporate Governance (ESG) issues in pension scheme investment have been a popular topic for the pensions press for a while and is an item that continues to creep up trustee agendas. Despite this, confusion remains in some quarters about ESG and trustees sometimes struggle to see what ESG might look like in practice as part of a scheme's asset portfolio.

When it comes to ESG, it’s best to think of a DC scheme’s objectives as having two key components: firstly, to establish a default fund appropriate to the needs of the membership, keeping this under review and updating it as necessary; and secondly to ensure an appropriate choice of investment arrangements for those members who do not wish to invest in the default arrangement.

A common trap to fall into in a DC scheme is to focus on ESG as part of the second component, but to largely ignore it as part of the first. A not infrequent refrain from trustees in response to an ESG challenge might be that they have an ethical fund among the fund choices, but to look at ESG in this way is to make two fundamental mistakes. First, it mixes up the non-financial factor of ethical investment with ESG as a financial factor, and second it ignores the fact that the vast majority of members are likely to be invested in the default fund and that the trustee duty is to act in those members’ best financial interests.

DC default funds will almost certainly be held in a pooled fund or a combination of pooled funds and may be accessed through an insurer platform structure. In practice, therefore, ESG is likely to be a case of selecting a fund for the default strategy (the objectives of which take account of the ESG factors which the trustees have identified as financially significant) and monitoring it against the trustees’ ESG policies. The adoption in 2017 by the HSBC pension scheme of a newly-created multi-factor global equities index fund for its equity default DC option, worth £1.85 billion, is a good example of what can be done. The fund weights constituents according to certain defined ESG factors and incorporates a ‘climate tilt’ to address financial risks to the portfolio associated with climate change.

Trustees of all schemes, including DC schemes, should have a clearly understood approach to ESG and consider documenting this in a policy. If nothing else, having such a policy should make it easier to respond fully to questions or challenges from members of their pension scheme. Once trustees have determined what their overall approach to ESG is going to be they should then think about how that can realistically be incorporated into their investment portfolio, based on their overall policy and governance budget. Where ESG issues are delegated, copies of the managers’ policies should be requested and reviewed to ensure that they meet the trustees’ needs. Manager reporting requirements should also be aligned with the trustees’ own ESG policy.

Having established a set of ESG beliefs, the form of a scheme’s engagement with these issues will be determined by how a scheme’s assets are held and the nature of the legal relationship between trustees and their managers. Integrating relevant ESG considerations into a scheme’s investment approach is likely to involve a more in depth analysis of a scheme’s wider strategy. The challenge for DC schemes is balancing the tensions between selecting or constructing funds which have a long-term view appropriate to members’ interests with the practical requirement for liquidity to enable members to transfer.

Based on how the ESG story has been evolving in recent years, we only see the need and demand to build it into DC schemes getting stronger and stronger. As a result, trustees would be well advised to futureproof the schemes they are responsible for by considering ESG issues and their integration into schemes as soon as possible.