A look at IOPS supervisory guidance on the integration of ESG factors in the investment and risk management of pension funds

The International Organisation of Pension Supervisors (IOPS) is an independent international standard-setting body promoting good practices in pension supervision. It has 90 members (governmental authorities) and observers involved in the supervision of pension funds, including pension supervisors from 79 jurisdictions. Our work includes drafting principles, good practices and working papers on key supervisory and regulatory issues related to private pension supervision.

Recently, IOPS developed and published its supervisory guidelines on the integration of ESG factors in the investment and risk management of pension funds. We believe that these guidelines, as arising from the collaborative work of all member jurisdictions, constitute a valuable contribution of IOPS as a standard-setter to supervisors worldwide.

What was the path towards developing these guidelines? In June 2015, IOPS initiated a discussion on supervisory and regulatory aspects of environmental and socially responsible investment by pension funds. We were particularly interested in knowing whether our members identified any on-going or future supervisory aspects of environmental and socially responsible investment and how this type of investment in their view was becoming relevant in national regulatory and supervisory agendas. 

The conclusion was that in some of the jurisdictions the regulatory framework did not set any specific requirements or obstacles for environmental and socially responsible investment and that this type of investments was left to the discretion of fiduciaries of pension funds as far as the fiduciary duty of securing best interests of fund members was fulfilled. Some pension supervisors felt that the ESG area, although important, was more appropriate for policymakers than supervisors. 

However, we have witnessed numerous international and domestic initiatives related to ESG investments, including policy and regulatory developments. We have also observed that in their investment-analysis process, pension funds, like other institutional investors, take more and more ESG risks and opportunities into account. 

In the context of pension schemes, such activity may be instigated by fund members, investment managers or policy makers. Pension supervisors gradually became persuaded that they need to prepare themselves for these developments and offer some guidance to their supervised entities. Therefore, in 2018, the pension supervisors decided to develop some formal work on the integration of ESG factors in the investment policies by pension funds. 

The work on the ESG guidelines was initiated by IOPS members in February 2018 and the final draft was agreed in Beijing in October 2018. Subsequently, the guidelines were sent for public consultation from 28 January 2019 to 11 March 2019. We received responses from 20 stakeholders representing industrial associations, supervisory authorities, trustees, stock exchanges, individuals and several national and international organisations working on sustainability issues. The guidelines were published on 22 October 2019.

While discussing ESG factors, our main assumption was that they may have a direct, and potentially substantial, financial impact on the savings and well-being of pension fund members, particularly in the longer term. While ESG factors have both financial and non-financial components and in this respect are thus ‘hybrid’ factors, we assumed for the purpose of the guidelines that ESG factors would be considered as a subset of financial factors.

The IOPS encourages supervisory authorities to voluntarily adopt and implement the guidelines that are non-binding. The guidelines are meant to provide guidance and serve as a reference point for supervisory authorities. Our position is that the guidelines are not intended to induce pension funds into ESG investment; they also introduce the principle of proportionality – that is, taking into account the size and capacities of particular pension funds – and are flexible enough to take into consideration all local circumstances.

IOPS guidelines on ESG integration

1. Supervisory authorities should require that a pension fund governing body consider environmental, social and governance (ESG) factors, along with all other substantial financial factors, that may contribute to achieving the long-term retirement objectives of pension fund members and their beneficiaries. In particular, such wider considerations should be taken into account in the pension fund’s investment and risk-management process.

2. Supervisory authorities should clarify to a pension fund governing body or the asset managers, possibly through regulations, rules or guidelines, that the explicit integration of ESG factors into pension fund investment and risk-management process is in line with their fiduciary duties.

3. When pension funds offer members investment options that partly take into account non-financial factors, such options may possibly result in sacrificing some return as compared to options that are defined on purely financial grounds. In this case, supervisory authorities should require that the potential and actual members be properly informed so that they can make an informed choice in selecting their investment options.

4. Supervisory authorities should require that when offering investment arrangements, the pension fund’s investment policy should consider ESG factors with no prejudice for the objective of obtaining an appropriate risk-return profile on purely financial grounds.

5. Supervisory authorities should require that a governing body and the asset managers involved in the development and implementation of a pension funds’ investment policy integrate ESG factors, along with all substantial financial factors, into their investment strategies (analysis and decision-making process). Supervisory authorities should avoid being overly prescriptive on how governing bodies should deal with ESG factors but rather emphasise the need to document the ways a particular governing body is treating such factors. Supervisory authorities should also request that in case these factors are not integrated in investment and risk management process, a governing body and the asset managers provide explanations. Integration of ESG factors may be subject to the principle of proportionality, ie, the scale of the pension funds and complexity of its governing structure.

6. Supervisory authorities may wish to issue regulations, rules or guidelines on how a pension fund’s governing body or the asset managers when setting up their investment policy, should analyse ESG factors.

7. Supervisory authorities should require that a governing body or the asset managers involved in the development and implementation of the pension fund’s investment policy will report to supervisory authorities how they integrate ESG factors in their investment and risk-management process.

8. Supervisory authorities should issue regulations, rules or guidelines on how a pension fund’s governing body or the asset managers, when setting up their investment policy, should report to its members and stakeholders on substantial financial factors, including ESG factors.

9. Supervisory authorities should require that, in their investment policy statement, a governing body or the asset managers of a pension fund disclose to members and stakeholders information about the pension fund’s investment policies in relation to long-term sustainability, including ESG factors, stewardship and non-financial factors. Where appropriate, pension funds should also regularly provide reports on their engagement with investees as well as request companies in which they invest to disclose their ESG-related policies.

10. Supervisory authorities should encourage a governing body or the asset managers of a pension fund to develop appropriate scenario testing of its investment strategy. Such tests should consider all substantial financial factors, including ESG factors. The scope and complexity of stress tests should be subject to the principle of proportionality.

The main message of the guidelines is that pension supervisory authorities should clarify to a pension fund governing body or the asset managers, that the explicit integration of ESG factors into pension fund investment and risk-management process is in line with their fiduciary duties. The guidelines also propose, among other things, that pension supervisory authorities should:

• Require that a governing body and the asset managers involved in the development and implementation of the pension fund’s investment policy integrate ESG factors, along with all substantial financial factors, into their investment strategies;

• Require that a governing body or the asset managers involved in the development and implementation of the pension fund’s investment policy report to supervisory authorities how they integrate ESG factors in their investment and risk management process;

• Require that a governing body or the asset managers of a pension fund disclose to members and stakeholders information about the pension fund’s investment policies in relation to long-term sustainability, including ESG factors, stewardship and non-financial factors;

• Require that pension funds regularly provide reports on their engagement with investees as well as request companies in which they invest to disclose their ESG-related policies;

• Encourage a governing body or the asset managers of a pension fund to develop appropriate scenario testing of its investment strategy.

Even though we treat ESG factors from a purely financial perspective, one of our guidelines addresses the situation when pension fund members are offered investment options that take into account non-financial factors (for example, ethical considerations). If such options may result in sacrificing some return as compared with options that are defined on purely financial grounds, we suggest that members should be properly informed so that they can make an informed choice in selecting their investment options.

With regard to our future work on ESG-related topics, we need time to see how the regulatory framework and investment practices will develop in IOPS members’ jurisdictions. The IOPS intends to collect regularly the experiences of its members with regard to how the guidelines are being translated into action. 

The stage of implementation and related experiences will definitely vary by country. Moreover, many issues that are more technical related to ESG investments such as ESG metrics (eg, defining ESG and how ESG risks should be measured) and their rating (eg, defining the rating methodology to assure consistency across different providers) are still being discussed by policy makers and financial market practitioners. 

The revised Programme of Work 2019-20 assumes that the IOPS will develop a framework and methodology to support implementation of the guidelines by pension supervisors, for example in such areas like risk assessment, disclosure or scenario testing, that will help IOPS members to apply the guidelines in practice.

Dariusz Stanko is head of the IOPS Secretariat at the OECD

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