Fund Solutions

‘Constrained’ Pension Funds Face Dual Challenge

Thinking Ahead Institute’s Hall stresses importance of education as pension funds seek to balance sustainability objectives with swirling economic headwinds.

Deteriorating economic conditions mean the world’s largest pension funds face the dual challenge of managing short-term funding pressures while better integrating long-term sustainability factors, according to the Thinking Ahead Institute.

In response, many funds are increasing their expectations of internal staff and external partners, while also leveraging technology and reinforcing governance structures to improve the quality and effectiveness of their investment decisions.

Assets under management (AUM) at the world’s top 300 pension funds increased by 8.9% to reach a record of US$23.6 trillion in 2021, according to annual research conducted by the institute, a not-for-profit investment research group made up of institutional asset owners and asset managers committed to mobilising capital for a sustainable future, in conjunction with Pensions & Investments.

The top 20 pension funds make up 41.0% of total AUM, down from 41.8% the previous year. Around US$170 billion is the entry level for this top grouping, which are championing technology, culture and governance to successfully manage the transformational change that is coming. Sustainability is not the primary goal for all funds, but it remains a prime goal of the industry.

Despite AUM reaching record highs, the rate of growth has slowed from the 11.5% increase recorded in 2020, and this slowdown could become a crawl as headwinds stiffen.

“Rising inflation and central bank tightening has implications for global growth, which may, in turn, endanger the long-term funding status of pension funds,” said Marisa Hall, Co-Head of the Thinking Ahead Institute.

And those conditions bring with them hard decisions as “stark short-term economic pressures alongside structural long-term changes only add to the difficulty of balancing short-term financial resilience with long-term financial and climate sustainability,” said Hall.

The report noted “resource constraints” as pension funds integrate ESG more fully, leading to an increase in collaborative activities. “Whilst most of the industry is managing climate-related risk in portfolios, the shift to real-world impact is in its embryonic stages,” it added.

Pension funds are under immense governance pressure from all sides, notes Hall, with growing politicisation of ESG in some regions clashing with calls for more substantial and urgent climate action.

Europe is driving ahead with its ESG agenda by upgrading and extending its taxonomy and sustainability disclosure rules, whereas moves toward increased climate and other disclosures in the US are being offset by efforts to slow down the sustainability agenda, notably in Republican-run states.

“Is this really ESG RIP or is there still a role?” said Hall. “The broader concept of sustainability means thinking about long-term outcomes, and they include real world outcomes as well as financial ones. Dealing with issues such as systemic risk are instrumental in achieving those desired financial outcomes.”

Harnessing intelligence

As pension boards grapple with the challenge of addressing the end of cheap money alongside a heightened focus on sustainability, the institute’s report highlights increased rigour on reporting climate action in response to growing regulatory scrutiny on greenwashing and overclaiming. It also points to resource issues constraining the industry’s efforts to embrace and deliver on ESG priorities.

Bigger funds are investing more resources in their people, processes and technology to build their internal intellectual capital, says the report. Whereas pension funds with smaller AUMs are increasingly farming out key investment decisions to more sophisticated outsourced CIO (OCIO) providers to manage complexity.

“Asset managers also have six times as many resources as asset owners,” said Hall. “There’s a skillset that we need to significantly improve to deal with the challenges of sustainability, climate, and biodiversity. Education is highly important.”

But the report points to successful pension funds upgrading their capacity by harnessing the power of artificial and human intelligence to build innovative financial solutions, deliver more accurate reporting, enable better organisational flexibility, and share knowledge more efficiently.

Access to reliable, comprehensive, benchmarkable and real-time ESG data on portfolios and investments remains a problem for CIOs, heads of sustainability and heads of ESG integration for all asset owners.

A new report from ESG data provider GaiaLens, ‘Preparing for Full ESG Integration’, has found that asset owners struggle to obtain the sustainability-related information they need across multiple mandates, with many unclear about the relationship between ESG performance and returns.

The study of large asset owners based in the US and Western Europe, collectively representing more than US$50 trillion AUM, suggested low levels of satisfaction with ESG index providers and limited understanding of ESG scoring and rating systems. It also claimed many asset owners found emerging ESG reporting frameworks “bewildering”.

Hall acknowledged ongoing challenges with ESG data, but said such concerns were gradually being replaced in the minds of the large asset owners by a need for better analysis.

“There’s a wealth of data,” said Hall. “The problem is more about being able to take that data and make it into a decision-useful form: do we have the right models in place? Are we acting on the information to make decisions? Are we doing enough mitigation? Are we doing enough adaptation?”

There is also a greater emphasis on governance – of the pension funds themselves, as much as investee firms.

“Many of the funds are campaigning for best practice in corporate governance,” said Hall. “Governance is huge. It’s something that will continue to be high on the agenda of trustee boards and that’s because to meet net zero commitments, you really need to resource the sustainability reporting model.”

She also sees pension funds working hard to decarbonise portfolios as well as looking to invest in a range of climate solutions to contribute to the climate change goal.

“You have two concepts here,” said Hall. “You have pension fund boards thinking about how they can manage climate risk and reporting and pension funds thinking about how they can contribute towards reducing the impacts of climate change. That climate risk versus climate change differentiation is important.”

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