Pension funds are increasingly taking sustainability into account in their investment portfolios, but does this have an impact in the “real” world?
The Association of Investors for Sustainable Development (VBDO) annually examines the performance of the responsible investment policy of Dutch pension funds. The benchmark pension funds report assesses the 50 largest pension funds in the Netherlands, together accounting for 92% of the assets managed by the sector with a total value of more than € 1,435 billion. The extensive research also shows the performance of the sector as a whole. This benchmark reveals, among other things, that considerable steps have already been taken in the field of policy in recent years, but there is still room for improvement in the translation into practice.
Sustainability is increasingly part of the investment process
The results of our 15-year study show that the pension sector has gradually taken steps towards socially responsible investment (SRI). In recent years you can even speak of an acceleration. We have ascertained that SRI has been part of investment beliefs at all pension funds since 2018.
The so-called Environmental, Social, & Governance (ESG) related risks are slowly being mapped by more and more pension funds per investment category and per sector. But now institutional investors are also including climate scenarios in the assumptions of Asset & Liability Management (ALM) studies. The market is developing accordingly. Numerous new specialized parties are emerging that offer instruments to analyze these sustainability risks at company and portfolio level.
This movement is reinforced by an increasing focus on sustainability risks from legislation and regulations. Consider, for example, the management of climate risks (including from IORP II and regulators who request stress tests). The financial sector must also report on material sustainability information, including the CO2 content of investments. According to the EU Disclosure Regulations (effective from March 2021), large companies and financial institutions must publish the extent to which they meet the goals of the Paris Climate Agreement. The detailed criteria that the EU has set in the EU taxonomy are relatively new; they are a classification for financial markets to determine what is a sustainable activity and what is not.
… But is this enough?
Making sustainability increasingly monetized indicates that the financial sector is serious about sustainable investing. Although this is certainly a positive development, it does not mean that we are achieving a sustainable world with it. A number of possibilities for improvement emerged from the benchmark pension funds.
It could be better…
Firmly anchoring the responsibility for sustainability in the organization
While most pension funds (70%) are advised by experts, only 16% of pension fund boards have demonstrable knowledge about SRI. Societal issues such as natural resource depletion, human rights, climate change, biodiversity and health raise factors that are relevant to pension funds and their participants. To what extent are social costs actually discounted in investment decisions, so that companies that generate social value are also more attractive investments?
Knowledge about these developments and about the possibilities in which they are translated into investment policy should be a larger part of the fiduciary obligation of board members than it currently is. And this knowledge and the possibilities need to be addressed in the various committees. Only with knowledge of the facts and sufficient internal countervailing power can boards make careful considerations and then give direction and control over the implementing parties.
Making better use of sustainable investment instruments
Another striking result from the benchmark is a lack of coordination between the SRI policy of the pension funds and the actual investment portfolio. To give substance to a (sometimes ambitious) policy, various sustainable investment instruments are used. Exclusion, ESG integration, engagement, voting and impact investing are the most important tools. Although pension funds often have a policy that is well formulated, its implementation is not always consistently and fully applied across the various investment categories.
All pension funds make use of exclusion, whereby the investor consciously chooses not to invest in certain companies or countries because of undesirable activities or behavior. ESG criteria also play a role in investment decisions in the majority of pension funds. However, this is done in various ways and we see large differences in their depth per investment category. Examples are the inclusion of violations of human rights in accordance with the guidelines of the UN Global Compact, and the realization of CO2 reduction. We especially see this in the equity portfolios.
A positive development is that 74% of the pension funds enter into discussions with listed companies to raise awareness of abuses and to bring about positive change regarding environmental and human rights. Such engagement can lead to different decisions within companies that result in tangible improvements. However, there is virtually no engagement in the fixed income market. Nevertheless, pension funds could exercise more influence here, for example, at the time of issuing and refinancing debt securities.
… But do we achieve a sustainable world with this?
The ways of implementing SRI mentioned above mainly focus on reducing sustainability risks in the investment portfolio. This is in accordance with the current financial models depending on which risk / return considerations and scenario analyzes are made. We have already mentioned CO2 reduction. Reducing CO2 in an investment portfolio leads to a lower climate risk for the portfolio. Investors are increasingly taking this into account in their investment decisions.
However, a lower CO2 in the shares or fixed-income investment portfolio does not mean lower CO2 emissions in the world. In order to achieve the latter, attention must also be paid to the real impact of the investments. This is not only about climate change, but also about other social developments. Only by attending to the real impact of investments can pension funds also become part of the solution. After all, SRI is not about a sustainable portfolio, but about a livable world. For a “real” sustainable investor, the truly “real” impact is therefore paramount.
From our 15-year research into SRI policy and its implementation by pension funds, we see that we are far from reaching our goals. Slightly more than half of the pension funds invest in impact investments. But there is hardly any question of steering on real impact or broad social value creation.
Not only is it difficult to create real impact, but the concept is at odds with the rules of the game; the creation of social value does not play a role in traditional financial models. To analogize, it is just like fruit and vegetables. The most important consideration is not only an organic cucumber or not, but also the question why fruit and vegetables are actually more expensive than cookies, soft drinks and chips.
Activities that create social value should also be given financial value by the market. And for activities that do not provide social value an imposed penalty could be considered. Unfortunately, such models hardly exist and are, in any case, not part of current financial models. Perhaps a challenge for an actuary, for example, to think about how this shortcoming in the market can be corrected on a model basis. The last word has not yet been said about this and we are happy to contribute ideas.
This article previously appeared in De Actuaris, volume 28, no.3.