As the cost-of-living crisis escalates, pension fund trustees are under pressure to consider social risks more fully in their portfolios.
In the ESG investing universe, the social and governance elements often take a back seat to the environmental. But there is growing awareness among pension fund trustees that the E, S and G are inextricably linked. They represent interrelated risks that not only have a financial impact on portfolios but also consequences for our wider society, says Marisa Hall, Co-head of the Thinking Ahead Institute, an investor-led non-profit organisation.
“Environmental issues have been a top priority for trustees, particularly with the publication of the IPCC [Intergovernmental Panel on Climate Change] reports and various commitments to net zero,” she says. However, recent events such as Covid-19 and growing concerns about modern slavery are focusing minds on social risks in portfolios.
Prompted partly by the pandemic, there has been a growing focus from shareholders on how employees are being treated in terms of fair pay and general wellbeing. With the cost of living rising more sharply, the treatment of employees and their renumeration “will continue to be a priority”, according to the Investment Association.
“Trustees will naturally be looking at the big picture,” says Dan Neale, Social Themes Lead for the Church Commissioners for England, which manages more than £9 billion in assets. “System-level social risks should definitely be on the agenda; those social risks that threaten social and economic systems and well-functioning financial markets. Responsible investment teams should be working with trustees to ensure alignment and understanding of key system-level risks,” he adds, noting that the Church Commissioners recognises inequality as a system-level risk alongside climate change and nature loss.
In the UK, much of the increased attention has been driven by a Department for Work and Pensions (DWP) consultation on the social risks in occupational pension schemes, says Hall. A shift of emphasis was further signalled in comments by UK Pensions Minister Guy Opperman, noting that trustees are not fulfilling their fiduciary duty if they do not factor social risks into their investment decisions.
The DWP has launched a taskforce to help pension schemes understand and account for social-related investment risks. The taskforce will be a minister-led, cross-department working group, with financial regulators also invited to join. It will support pension fund trustees in identifying reliable and accurate data and metrics about social risks.
Willing, but unable?
Some argue that managing social risks via investment is a core task for pension trustees. Given auto-enrolment, says Charlotte O’Leary, CEO of Pensions for Purpose, trustees should remember that pension fund members are very much a part of and not apart from society, making them “in every sense” able to save themselves and contribute to ensuring they have a world worth living in and retiring into.
But she admits social factors are less well understood and harder to measure due to a lack of standardisation. “While a small number of pension funds are looking to include measures such as employment, housing, and wellbeing, this is very much a minority. Environmental factors have been prioritised due to mandatory TCFD [Task Force on Climate-related Financial Disclosures] reporting requirements without a full understanding of the interplay between climate, biodiversity, and social factors,” says O’Leary.
Many trustee boards want to take social factors into account in their investment decision making, but are held back by uncertainty over the best approach, says Vanessa Hodge, UK Sustainability Integration Lead at investment consultants Mercer. “Unlike systemic risks like climate change, which might have obvious risks and opportunities at asset class and sector levels, social factors can appear more dispersed at the individual company or issuer level.”
With few widely accepted and standardised metrics, trustees often rely on asset managers’ issuer selection and due diligence to mitigate and manage social risks. “This raises the importance of trustee stewardship duties where trustees should direct and challenge their managers’ voting and engagement activity, demanding tangible examples of the impact those decisions have had. Possible metrics include living wage compliance and gender pay gaps, but not for all regions,” Hodge adds.
The reality for many hard-pressed pension fund trustees is that their capacity to focus on social risks is “somewhat limited”, says Keith Guthrie, Deputy Chief Investment Officer at specialist fiduciary manager and pension provider Cardano. “They have many pressures to understand environmental risks, particularly climate change, which is more of an immediate pressure because of regulatory demands such as TCFD reporting requirements, which are consuming a lot of trustees’ attention at present.”
Social risks may be complex, specific and hard to measure, but they can have significant financially materiality in the long term, while also having wider ramifications.
Jessica Attard, Director of Health and Social Programmes at non-profit organisation ShareAction, says in a world where inequalities have been widening, life expectancy is stalling in some developed countries, and the effects of the climate crisis are increasingly being felt by vulnerable communities all over the world, social risks “have never been so important”.
Social risks are particularly relevant for pension funds which, ultimately, exist for the benefit of employees who want to retire into a “just, healthy and equitable world” she says. “The pandemic has shown that social risks, including poor population health, can pose huge financial risk to companies and the economy. Investors would be remiss to ignore such risks.”
Attard endorses Opperman’s recent observation. As part of their fiduciary duty, pension fund trustees must consider financially material risks, and these include social risk, she says.
Policies to mitigate and manage social risks, including poor population health, should be clearly set out in responsible investment policies and management mandates, Attard adds. These should also include respecting human rights, particularly where investments are made either directly in countries with poor human rights records or where corporates are operating in or sourcing from these countries.
At the Church Commissioners for England, Neale suggests the responsibility to address systemic social risks is particularly strong for universal owners.
“Trustees for universal investors need to embrace the idea that addressing system-level risks requires system-level stewardship; going beyond selection, engagement and/or divestment of assets to look at market incentives and failures, policy and reporting, collaborative engagement, and company transitions,” he says. “Understanding how a portfolio addresses or contributes to systemic risks will help trustees plan for the long term.”
For defined benefit pension scheme trustees, the strength and policies of the sponsor is a critical factor in trustees being able and willing to support the scheme, says Hodge. This could be influenced by market perception of the way the sponsor treats staff, how supply chains are managed and how local communities are respected. “We would argue that when considering the strength of the sponsor covenant, as well as when considering investment strategies, trustees have to acquire the time and the skills to consider social risks and their impact,” she says.
Hall also notes the importance of social risk on the employer covenant and says understanding begins with education and awareness. “One of the issues revealed in the DWP consultation was that pension fund trustees need to understand that the social risks related to the sponsor covenant can vary. Questions about ‘what are social risks’ and ‘what exposure a fund has to various practices within the portfolio’ need to be asked.”
Standards and frameworks such as the UN Global Compact and ShareAction’s Workforce Disclosure Initiative bring together a lot of data that can help pension fund trustees to better understand social risks, she adds.
Cultural and legal issues persist around fiduciary duty in regard to social risks, despite legal opinions dispelling these myths, notes O’Leary. “Research shows that whilst a majority of pensions trustees had already received training on making social impact investments, the vast majority wanted more training for themselves and their investment teams on the topic, suggesting an awareness around this skills gap.”
Social risk priorities
The materiality of social issues is becoming increasingly clearer to investors, says Attard, partly driven by improvements in data and disclosure, prompted by regulation. For example, the UN’s Guiding Principles on Business and Human Rights are being written into EU regulations and reporting requirements. But there are many related shifts afoot, such as the food industry coming under increasing regulatory pressure to support customers to stay healthy.
“There are growing expectations on investors to ensure companies are providing diverse, equitable and inclusive workspaces; and also that they consider the health impacts of their investments. This includes the impacts of companies on the health of their workers, consumers and the communities they impact,” she adds.
One of the reasons that social risks should be prioritised is that they can directly affect the beneficiaries of the pension fund and their dependants, says Guthrie.
“Crucial issues which have significant financial materiality include diversity of workforce and boards and human rights issues such as modern slavery in value chains,” he says. “Trustees wanting to make an impact should look at social opportunities in addition to the social risks. There are several possibilities of making positive social impact while earning solid financial returns. Examples we would highlight are investing in social housing, which produces good cashflow for a pension fund whilst having a tremendous positive impact on affordable housing.”
Hodge says there are three key questions pension fund trustees should ask of portfolio companies: does it look after its staff, support best practice along the full supply chain, and respect the local communities and its consumers? Key areas of focus should be modern slavery, human rights, health and safety, forced migration and fair remuneration.
Structural inequality, between and within regions, is significant and should be a priority focus, says O’Leary, emphasising the links between environmental and social factors. “Our net zero goals are effectively meaningless when those on low incomes and in more deprived areas cannot invest in the technology or behaviours to change our consumption and carbon output,” she says.
”How can we expect those on low incomes to adopt more expensive, new environmental technologies or behaviours when their primary concern is providing shelter and food? How can we transition to new low-carbon vehicles, infrastructure, and heating systems without the investment to do so at a large enough societal scale?”