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New research plots top sources of ESG risk for UK DC default funds

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Human capital, business ethics, product safety, and data privacy and security are the most material environmental, social or governance (ESG) issues a typical UK defined contribution (DC) default fund’s equity portfolio will be exposed to, according to newly released research.

The research was commissioned by the UK pensions trade body, the Pensions and Lifetime Savings Association (PLSA), and carried out by Sustainalytics, an ESG data and research provider.

Doug Morrow, associate director on the thematic research team at Sustainalytics and author of the study, said the research “sits at the confluence of two major trends in the UK”: the growing use of DC plans, and an increased interest in ESG investment strategies.

The research assessed the equities allocation (71%) for a typical DC default fund based on data from a Schroders FTSE Default DC Schemes report, and then plotted the most prominent ESG risks for a model portfolio.

Key findings included that “human capital, business ethics, product safety, and data privacy and security stand out as the most material ESG issues from an overall portfolio perspective”.

It said “[s]ome investors may find this surprising” given these issues receive relatively less coverage, but that they are “of central importance in many of the industries that happen to be overweighted in a typical DC default fund, including banks, pharmaceuticals, and food products”.

These industries accounted for more than 19% of a typical default fund’s total allocation, according to the research.

The PLSA said the research found human capital to be the single biggest source of ESG risk at the companies in which DC default funds invest, accounting for 11% of the ESG risk to which they are exposed.

According to Sustainalytics’ Morrow, pension funds can mitigate the key ESG risks in DC default funds by using products that track an ESG index. He cited the example of HSBC UK Pension Scheme’s decision to use a Legal & General climate “tilted” index fund for its equity default option.

Passive products are a “cost-effective” solution, said Morrow, especially given the UK’s 0.75% charge cap for default auto-enrolment funds.

Morrow also recommended for DC schemes to consider global equity asset allocation from an ESG risk perspective. According to Sustainalytics its analysis showed that schemes “can reduce ESG risk in their default funds by tilting towards UK equity”.

Schemes should also be “forceful stewards”, according to the report.

Luke Hildyard, policy lead for stewardship and corporate governance at the PLSA, said: “The PLSA commissioned this research to better understand the scale and type of risk facing DC pension savers. The findings demonstrate the importance of stewardship activities around issues including human capital, business ethics, data security and climate change.

“Over the coming year we will be developing further resources to help our members engage with asset managers and investee companies around these issues.”

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