How DC schemes can consider climate change in investment strategies

Increased awareness of the dangers of ignoring climate related risks, coupled with increasing regulatory pressure to evidence how these risks are being taken into consideration by asset owners and mandatory climate risk related reporting requirements have seen climate change rise up the corporate and trustee agenda.

Despite these pressures, a 2020 study¹  found that only 43% of DC trustees were considering climate change in their investment strategies, showing that for many schemes, they may be starting from scratch.

Whilst clear trends in post-retirement behaviour amongst DC members are yet to become known, what is obvious is that defined contribution will be a main source of income for most retirees over the coming years. This means climate considerations are a very important risk to manage for savers and retirees. In addition, pots will be at their largest when closest to retirement and given the high probability that members will use their tax-free lump sum provision around the same time, it is important that climate risks are considered to ensure DC member pots also remain stable at this point in the member journey.

Integrating climate considerations into member portfolios can therefore not only preserve value at retirement but also ensure a better starting point for members looking to use part of their retirement pot as a drawdown vehicle.

For DC schemes or Master Trusts who are now looking to integrate climate objectives into their portfolios and review their post-retirement options, a good place to start is to focus on improving fixed income allocations as this is typically a larger proportion of the assets closer to retirement and often managed passively.

As a first step, we would suggest analysing the current climate profile of your credit portfolio. This should include reviewing any immediate risks as well as considering the expected pathway of carbon emissions over time. This can be a more robust method of assessing whether a portfolio is on track to achieve long-term objectives, compared to backward looking metrics.

With a clearer picture of their current climate profile, trustees can then review what changes are required to mitigate the risks and target alignment with the Paris Agreement.

One way to mitigate the climate risk is to limit the investments to only green bonds or the lowest emitting issuers and sectors – we believe this is sub-optimal. For one, this could expose investors to the risk of ‘coldwashing’ – where a portfolio reports very low emissions but fails to drive wider and longer-term industry decarbonisation, one of the fundamental principles of the Paris Agreement. After all, it is the global temperature that DC members would experience in retirement and not the portfolio temperature that their investments are aligned to. We believe there should be a healthy balance between green bonds and other assets that can fulfil investors’ objectives.

Secondly, rather than exclude entire sectors, such as the oil & gas or construction industries, investors should be selective to pick the climate leaders within each sector to maintain exposure to a diversified opportunity set and to finance a whole-of market transition. This balanced approach has multiple potential benefits and can enable investors to contribute to the net zero goal more actively besides ensuring the robustness of their investment portfolio.

Vitally, DC schemes and Master Trusts must also remember that climate investing is constantly evolving. Each day we see new and more ambitious commitments from companies and a greater breadth and detail in the data we receive. This information is critical to assess how climate-aware credit portfolios are achieving their financial and climate objectives. Investors need to monitor their credit portfolios through a new climate-focussed lens, acknowledging that each company will follow its own path. Portfolio emissions and scenario testing are useful tools, but investors should also consider the depth and validity of the data, and how it changes over time and therefore how it is actively used over time.

For those members targeting an income drawdown, they will want to alleviate potential shocks from physical and transition risks to maintain or improve their pension pots to generate a higher level of income for a longer period of time.

If targeting an annuity, either at retirement or some time thereafter, well-designed, climate-aware strategies should also be more resilient to unexpected shocks, increasing the stability of capital to achieving a higher retirement income.

Whatever a members desired retirement objective, there is a clear case for incorporating climate change across all investment strategies in the default to help mitigate against both the physical and transition risks posed by climate change. Their pensions would be worth more, in a world worth living in.