IN FOCUS6-8 min read

Why DB trustees should care about ESG and climate risks when close to buyout

Since the gilts crisis in late 2022, the average time for UK pension schemes to reach a sufficient level of funding to buyout their liabilities with an insurance company has reduced to c. 5 years . This may lead some trustees to view ESG and climate risks as a lower priority given this short time horizon. However, traditional de-risking might give a false sense of security. Trustees must manage ESG and climate risks to prevent their journey from being derailed over the short to medium term.

16/11/2023
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Authors

Caryl Embleton-Thirsk
Head of ESG, UK Client Solutions, Schroders Solutions

Trustees widely agree that ESG factors, including climate change, can be financially material to pension schemes. However, as time horizons shorten and other issues such as de-risking and securing benefits through buyout become priorities the importance of ESG factors may be underestimated.

We challenge this thinking – a short time horizon can increase the impact of all risks, including ESG risks, because there is less time to repair any short-term losses. ESG and climate risks can also be proportionately more important for mature schemes given that traditional risks such as interest rates, inflation and market exposures will have been largely removed.

1.1 Will climate risk bite sooner, not later?

Climate risk can be split into physical and transition impacts. While physical climate risks refer to the direct consequences of climate change, transition risk refers to the impact of moving to a low-carbon world on businesses, economies, and markets. Transition risk is more immediate because markets are forward-looking and will respond quickly to changes in information. Transition risk might materialise gradually over time, or there could be sudden step changes.

In the chart below, we show the potential impact of three climate change scenarios on a mature pension scheme targeting a buyout before 2030 with a “low risk” investment strategy. Our analysis shows that even when traditional investment risks are low, a funding level reduction of 3% could occur within a year in a “disorderly transition” – where markets suffer a sudden fall in response to changes in climate change policy, regulation, or new information. In such a scenario, the pension scheme would fall well behind its journey plan, potentially delaying buyout for 3-6 years.

Climate Change funding level scenario analyis chart

Source: Schroders Solutions, for illustrative purposes only.

Notes:

Failed Transition = Net zero not achieved, global warming reaches over 4 degrees above pre-industrial levels

Orderly Net-Zero transition = Paris goals met with global warming increase of 1.5 degrees above pre-industrial levels

Disorderly Net-Zero transition = sudden divestments required to align to the Paris Agreement leading to disruption to financial markets, with sudden repricing followed by stranded assets and sentiment shock


It’s crucial to note that the impact in markets could happen at any point, especially as we approach 2030 and global decarbonisation targets are missed. The scenarios considered here are not ‘worst-case’, and some argue that many climate models understate the impact of climate risk . Physical risks, typically modelled as impacting after the mid-2030s are also building faster than anticipated, indicating that even mature schemes cannot ignore the potential for these risks to derail their plans.

The dangers of derailment

A journey plan derailment could have significant implications. It may necessitate recourse back to the sponsor for additional funding, potentially at a time when the sponsor may also be facing financial challenges due to the same market conditions. It could also force the scheme to materially re-risk to make up for the shortfall, which could introduce new risks and further destabilise a scheme's financial position.

Additionally, a setback would likely occur at a time when a scheme is paying out significant amounts in pension payments, further straining its resources. The need to extend the timeframe for achieving the buyout could also introduce additional uncertainty and risk, as market conditions and regulatory requirements could change during the extended period.

In short, a significant climate event could disrupt the scheme's journey plan, creating a complex web of challenges that trustees would need to navigate to keep the scheme on track.

1.2 ESG considerations within buyout-aware portfolios

Climate risk, and more generally ESG risk, are key considerations in journey planning , even when traditional investment risks are low and well managed, for example, by using the Liability Driven Investment (LDI) and buy and maintain credit strategies that are common in cashflow driven investment and buyout-aware portfolios.

LDI

ESG considerations for trustees include:

Engagement, voting and exclusions: Whilst there is no scope to use voting as a lever for change for Gilts, the LDI manager has scope to influence through selection of counterparty banks and their role as a service user. Exclusions can also be applied within non-government cash holdings.

Investment approach: The investment universe in such a mandate is much more limited. Nevertheless, there are important decisions around the use of Green Gilts and the investment profile of cash funds.

Buy and Maintain Credit

Within buy and maintain credit, managing the risk of default is key to investment outcomes, and ESG is critical to identify risk and financial materiality in both sectors and individual companies:

Engagement, voting and exclusions: The buy and maintain manager can continually engage with bond issuers across all its mandates. Although there is no scope to vote, there is much more scope for the investment manager to engage at the point of rolling or new issuance. Ultimately, the manager can exclude if engagement is unsuccessful (either for new issuance alone or for existing holdings).

Investment approach: The buy and maintain portfolios are designed with long-term pension liabilities in mind. Long-term corporate bond issuance is typically more concentrated in certain sectors (e.g. utilities), in turn resulting in more concentration of ESG risk. There is a much greater focus on the initial credit selection skills of the investment manager. Credit selection must also fully integrate sustainability, climate transition and manage sustainability concentration risks.

1.3 ESG considerations when selecting an insurer.

ESG should remain a key consideration at the point of insurer selection. Trustees need to be mindful that their chosen insurer can take on responsibility for the payment of members’ benefits many decades into the future. It may be natural to focus on price as the key factor in the choice of insurer, however, systemic risks such as climate change could affect an insurer’s future financial strength and trustees are in a strong position to engage on ESG risk management. With the evidence pointing to increasing impacts from climate change hitting us earlier than expected, insurers may also increase premiums as they reappraise the scale and speed of the emergence climate change risk on their long-term investment portfolios.

Conclusion

It is crucial for DB trustees to recognise the significance of ESG and climate risks, even when nearing buyout. By incorporating these risks into their journey plans and insurer selection, trustees can safeguard the long-term sustainability of their pension schemes.

To achieve this, trustees should continuously evaluate ESG risks, integrate ESG considerations into investment strategies, ensure their fund managers are incorporating sustainability in security selection, and ensure their chosen insurer can manage long-term ESG risks. By taking these proactive steps, trustees can navigate the complexities of the endgame and secure a sustainable future for their pension schemes, even in the face of evolving ESG and climate challenges.



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Authors

Caryl Embleton-Thirsk
Head of ESG, UK Client Solutions, Schroders Solutions

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