Pension funds want ESG guidelines

The International Organisation of Pension Supervisors (IOPS) is an independent international body representing entities involved in the supervision of private pension systems all over the world. We have 86 members and observers from 75 jurisdictions and territories worldwide. Our main goal is to improve the quality and effectiveness of the supervision of private pension systems throughout the world. This includes enhancing their development and operational efficiency and allowing for the provision of a secure source of retirement income in as many countries as possible.

As president of IOPS, I have found increasing interest in ESG matters from many of our members; indeed, a recent survey of members found ESG one of the issues where IOPS should set standards. Considering this, the IOPS is now developing draft guidelines on the application of ESG factors in the supervision of pension fund investment. The use of these guidelines is not be mandatory but we believe they will encourage pension funds in IOPS countries to incorporate these factors in their decision-making process in some way.

Why ESG is important

Recent data from Willis Tower Watson states that global pension funds manage more than $42 trillion. This gigantic pool of resources is mostly invested with a long-term horizon in companies, projects, vehicles and investment instruments all over the world. Pension funds’ main mission is unobjectionable: deliver the best portfolio profitability with an assumed risk level, according to their fiduciary responsibility; however, in recent years, this vision has gradually incorporated a more holistic view with regards to global wellness. “Responsible investment” recognises that, in addition to adequate profitability, there are several other factors that should be taken into consideration, such as ESG concerns.

The Organisation for Economic Co-operation and Development (OECD) states that ESG factors are “indicators used to analyse the investment prospects of a company, [evaluating their performance based on] environmental, social, ethics and corporate governance criteria”. To incorporate ESG indicators, pension funds should identify environmental, social and governance risks related to the purpose of the company or project in which they intend to invest. Some examples are:

• Environmental risks: physical risks caused by environmental change.
• Transition risks: changes in policies, laws, markets, technology, investor’s feelings and prices.
• Liability risks: legal or moral responsibility to cover financial losses caused by events environmental change has induced.
• Social risks: related to working conditions, including slavery and child work, local communities, indigenous communities, conflicts, health problems and security
• Governance risks: related to the remuneration of executives, bribes and corruption, political lobbying and donations, diversity and the board of director’s structure, fiscal strategy, etc.

Awareness of ESG factors in investment strategies is becoming more relevant; nevertheless, adoption is still in its early stages. Several international organisations are suggesting the adoption of such principals, including: the Principles for Responsible Investment; the Task Force on Climate-related Financial Disclosures; the new European Union directive, institutions for occupational retirement provision (IORP) II; and the Network of Central Banks and Supervisors for the Ecologisation of the Financial System. Also, the OECD has published general guidelines about how investment funds can incorporate these factors.

Global Sustainable Investment Alliance data shows that $22.9 trillion of assets were professionally managed under responsible investment strategies in 2016, up from $13.3 trillion in 2012. This fast growth signals that all institutional investors are starting to incorporate, or at least consider, ESG factors in their investment decisions.

Because pension funds should be focused on long-term goals, according to a lifecycle approach, it is essential that pension fund providers or managers start considering structural long-term factors in their investment decisions, such as environmental and social conditions.

Here are the main reasons to invest in companies or projects that consider ESG factors:

• Such companies seem to be associated with better long-term yields
• They usually promote an improvement in the relationship between long-term risk and return
• They have positive environmental and social effects on the country
• ESG factors can be integrated into investment prospects without sacrificing diversification or returns

Returns

Empirical evidence seems to indicate a positive or neutral relationship between financial performance and the consideration of ESG factors. A meta-study published by the Journal of Sustainable Finance & Investmentin 2015 analysed the results of 2200 studies and showed that it’s worth considering ESG factors in investment strategies.

The report states that 90 per cent of the studies found a neutral or positive relationship, with variations by region, between financial performance and the inclusion of ESG factors. It seems natural that companies that follow governance best practices, such as having a board with real independent members, adequate equity structure and aligned incentives between managers and shareholders, would have a greater probability of getting a higher yield. Also, if companies take care of internal issues such as gender equality, diversity, water and environmental care, they will probably have better yields in the long term because these are characteristics associated with a well-managed company.

ESG factors have been gaining more relevance in the portfolio composition of institutional investors, including pension funds. The ESG global survey that BNP Paribas conducted in 2017 found that 79 per cent of global institutional investors now incorporate ESG factors. Among those who do, half invested nearly 25 per cent of their portfolios in specific strategies based on ESG criteria. That proportion is expected to increase to 50 per cent or more by 2019.

Carlos Ramirez Fuentes is IOPS president and president of Mexico’s National Commission of the Retirement Savings System (CONSAR).