Over the next 10 to 30 years, pension schemes face two major challenges: ensuring that member promises can be paid in full and on time and climate change
For many pension schemes, the most immediate concern – and a vital stepping stone to achieving their ultimate endgame objective – is addressing cashflow negativity. The latest figures show that in the UK, 73% of pension schemes are currently cashflow negative, with this figure only set to grow as more and more schemes close to future members and naturally mature.
Against this backdrop, we have seen a considerable shift in focus to the concept of cashflow driven investments (CDI) strategies, which aim to help schemes increase certainty over their ability to meet both their future cashflow requirements and their funding objectives.
At the same time, climate change has risen rapidly up the trustee agenda, due to mounting awareness of the dangers of ignoring climate risks for both investment portfolios and the wider world, as well as increased regulatory pressure on trustees to evidence how they are addressing these.
In our view, to successfully meet these twin demands, trustees must consider them jointly – not in isolation.
For schemes shifting their attention to CDI strategies, is it absolutely key that portfolios are built with at least climate goals in mind and might also consider having an explicit climate objective.
Failure to do so could lead to schemes implementing a portfolio today that will only require overhaul further down the line, in order to integrate a more aggressive climate strategy, resulting in a large amount of turnover and cost.
This does not need to be an ‘either-or’ consideration. The climate transition will occur over a number of years, so there is a natural alignment with the long-term nature of pension scheme liabilities – something that is particularly helpful when financing companies who are going to be part of the transition.
This is not to say schemes do not have challenges to overcome. A key question is how they can integrate climate goals into their existing cashflow strategy without compromising on either the yield or risk characteristics of their portfolio.
As a starting point, schemes need to understand what the current climate profile of their portfolio is, including any immediate risks. This will include reviewing current emissions but also the need to comprehend what needs to be done as part of a longer-term pathway to net-zero over the coming years, and the responsibility schemes have in facilitating the transition to a lower carbon world.
The next step will be implementing a strategy which takes these objectives into account.
Deep-dive fundamental research into long-term risk factors – such as climate change and broader ESG considerations – should already be an integral part of the selection process for any CDI strategy.
However, when adding specific climate criteria into the selection process, this should only ever be taken in combination with, and never at the expense of, other fundamental risk criteria such as downgrade risk or duration.
Schemes must also not be tempted to drive change by limiting themselves to specific asset classes, such as green bonds, or excluding the highest emitting sectors. Not only could this expose them to the potential risk of greenwashing – whereby assets are not always as green as they purport to be, or could be associated with lenders whose other activities could open them up to broader ESG risks – but it also removes the opportunity to drive longer-term change.
Fixed income managers, through both the scale of assets they deploy as well as the timeframe through which they hold them, can wield significant influence on behalf of their pension scheme clients through engagement – but only if they have a seat at the table and are able to hold companies to account on their transition to a lower-carbon world.
With these factors already being taken into consideration, schemes should expect to see only very minimal impact on the universe of investible assets for inclusion in their broader cashflow strategies.
Moreover, integrating these more explicitly should increase your overall portfolio resilience and help in the predictability of future cashflows, meaning they do not need to compromise on either the opportunity set available to them or the risks that they are exposing themselves to.
Following the implementation of your climate framework, financial and climate-related metrics can be regularly reviewed to ensure consistency and improvements over time. Considering a dashboard of climate-related metrics such as the absolute and relative carbon intensity of the portfolio, temperature alignment or emission pathways can be useful.
However, it’s important not just to focus on, or try to optimise, one or two metrics as each show a different aspect within the broader low carbon transition.
For example, while temperature gauges can be familiar and more easily reported on, the data quality still has a level of subjectivity. Nor is this metric tied to the overall risk profile of a company.
We are far keener on metrics such as climate value at risk, that not only give an indication of what risk a company might be exposed to in this moment in time, but also how climate might affect both the potential upside and downside risk profile of a business in the future.
Factoring climate considerations into cashflow driven investment strategies will not be a ‘set and forget’ exercise and schemes will need to ensure they are monitoring not just how they are reducing carbon today but how they are decarbonising the portfolio and the planet tomorrow.
But for schemes who integrate and consider these goals alongside – not in isolation to – other financial metrics, they should be able to successfully achieve both their climate and long-term cashflow goals.
Bruno Bamberger, solutions strategist at AXA Investment Managers