Trust, but Verify
Regulation and education are being touted as solutions to the imbalance between investment consultants and pension trustees exposed by climate risks.
UK pension fund trustees have a lot of responsibility on their shoulders, with multiple tasks required to ensure members’ benefits are paid in full when they are due.
Their day-to-day work includes accounting for and mitigating all material risks that could impact the pension scheme’s financial returns in the longer-term. Increasingly, this involves often complex sustainability themes, which is giving rise to concerns of over-reliance of advisors.
“Legally, trustees must act in the best interests of their beneficiaries. Understanding climate risk in particular is recognised as part of this fiduciary duty,” Charlotte O’Leary, CEO of Pensions for Purpose, tells ESG Investor.
For trustees like Joanna Wright – a trustee at Avon Pension Fund and Green Party Councillor for Lambridge, Bath and North East Somerset Council – getting to grips with the full scope of investment considerations isn’t easy.
“The average councillor knows […] very little about pensions,” she admits. “You are expected to know an awful lot – not just about pensions, but everything else going on in the world that may impact pension savers. Therefore, you hope there are people in the room who know what they’re talking about.”
Trustees’ growing dependence is focusing attention on the investment consultants which provide them with crucial guidance on portfolio management, risk assessments, and asset manager selection.
According to Joe Dabrowski, Deputy Director of Policy at the Pensions and Lifetime Savings Association (PLSA), trustees are also increasingly turning to investment consultants for advice on systemic themes such as climate risk analysis, biodiversity and natural capital, and leveraging AI to enhance sustainable investment decisions.
“As trustees look to transition their schemes to net zero, they will be heavily dependent on consultant skills and expertise on priority ESG factors,” Dabrowski says.
“It is vital that consultancies are fully equipped to provide high quality advice and services across these themes.”
But concerns about a growing resource imbalance and limited scrutiny recently led a group of non-profits and think tanks to call on HM Treasury to expedite plans to regulate all activities of investment consultants. Signatories of the letter include ShareAction, Pensions for Purpose, Make My Money Matter (MMMM) and Carbon Tracker.
Shades of grey
As trustees are bound by law to seek advice on choosing investments under the Pensions Act 1995, the group argued that this advice should also be regulated.
Already regulated activities include manager selection, stewardship recommendations, discretionary management and marketing of investment products.
Unregulated activities include adjacent areas such as strategic asset allocation, risk management frameworks, educational services and ESG policy development.
“Almost all of these are activities that trustees will be dependent on their consultant to support them on, and they have significant implications in relation to sustainable investment,” Dabrowski says.
The lack of clear distinction between regulated and unregulated advice from investment consultants creates a legal grey area, O’Leary agrees.
“This ambiguity is particularly problematic given the potential conflict of interest, where consultants offer manager selection services but are also fiduciary managers of assets themselves,” she says.
The letter referred to the role investment consultants played in advising pension schemes to adopt liability-driven investment (LDI) strategies, which were at the heart of a pensions crisis following former Prime Minister Liz Truss’s disastrous 2022 mini-budget on leveraged LDI products.
“In a subsequent evidence hearing to the Treasury Select Committee, the chief executive and the interim chair of the FCA [Financial Conduct Authority] referred to the ‘gap in regulation’ in relation to investment consultants as being one of the problems,” the group said.
There have been previous calls to regulate investment consultants.
The FCA’s 2017 Asset Management Market Study highlighted concerns with the structure and competitive dynamic of the investment consultancy market, recommending it be brought “into the regulatory perimeter”.
The FCA reiterated its position in April.
“There is widespread support for [this], ensuring advice meets high standards and safeguards both beneficiaries’ savings and wider interests,” says Oscar Warwick Thompson, Head of Policy at the UK Sustainable Investment and Finance Association (UKSIF).
Last year, the UK government published a summary of responses to a call for evidence on whether pension trustees work effectively and are supported to make decisions in the best interests of pension savers. It highlighted concerns about the extent of trustees’ reliance on investment consultants.
“Given how important this link is in the investment chain between asset owners and the funds they invest in, we need to move on from the question of why consultants should be regulated – in our view, the important question is around when this will finally happen,” says Claire Brinn, UK Policy Manager at NGO ShareAction.
Embracing change
As sustainability themes move up pension trustees’ agendas, investment consultants are adapting to demands for related advice.
This is especially true of climate-related risks, following the UK government’s decision to mandate annual reporting against the Task Force on Climate-related Financial Disclosures (TCFD) framework for the country’s largest pension schemes from 2021 and smaller schemes from 2022.
“Trustees can often address climate change a lot more effectively with the support of their investment consultants,” says Claire Jones, Head of Responsible Investment at investment consultancy firm LCP.
This is particularly true for smaller pension schemes that don’t have large in-house teams, as they lean more heavily on their investment consultants’ expertise, technology and resource to inform and implement their decisions, she notes.
“When selecting a new investment manager, trustees can use our research to compare the suitability and effectiveness of potential managers’ approaches to climate change,” Jones says. “We can also support trustees in asking probing questions when they meet managers, helping them make well-informed decisions.”
Consultants can also advocate and facilitate policy-level engagement on behalf of trustees.
In July, LCP published a call to action urging regulators and policymakers to address systemic climate-related financial risks through five policy asks, including ensuring climate regulations focus on real-world impact not just disclosures, and addressing barriers preventing pension schemes from investing in scale in climate solutions.
These asks were endorsed by 35 pension schemes with a collective £84 billion (US$109.9 billion) in assets.
More broadly, consultancy firms are demonstrating a willingness to collaborate on sustainability themes.
Last year, a report from the Net Zero Investment Consultants Initiative (NZICI) highlighted progress on the development and delivery of internal training programmes as well as net zero-focused client-facing materials and tools.
In addition, the Investment Consultants Sustainability Working Group (ICSWG) brings together UK-based firms to improve sustainable investing practices across the investment industry.
In July, ICSWG launched a workstream collaborating with regulators and policymakers to help enable pension scheme trustees to make more impactful decisions that will boost sustainable investment and enhance scheme members’ outcomes.
However, it is also important to note that pension scheme trustees have a variety of opinions and priorities which consultants are obliged to cater to.
“I am one of many trustees, and investment consultants have to listen to a whole range of voices,” says Avon Pension Fund’s Wright. “How do they juggle those opinions and take that forward? How do they reach both hearts and minds?”
In addition to regulation, there is an argument for ensuring trustees receive mandatory education on how sustainability-related themes can positively or negatively impact investments.
“By equipping trustees with the skills needed to navigate sustainability and climate themes independently, reliance on consultants can be reduced and accountability enhanced,” Pensions for Purpose’s O’Leary says.
“Trustees would be better positioned to critically assess external advice, fostering a more balanced relationship between consultants and themselves.”
Efforts have been made by The Pensions Regulator (TPR) to plug trustee education gaps. In February, TPR urged trustees to familiarise themselves with frameworks such as the Taskforce on Nature-related Financial Disclosures (TNFD) and Taskforce on Social Factors (TSF) to improve their understanding of wider material ESG considerations.
“It is not realistic to expect trustees to attain the level of knowledge and understanding of investment consultants on the specific areas they advise on, or that is likely to be required to make effective sustainable investment decisions – particularly given trustees’ competing priorities,” counters PLSA’s Dabrowski.
However, trustees should build their knowledge enough to challenge consultants and asset managers to take ownership of their investment policies and understand the implications of their fiduciary duty, he adds.
Protecting trustees
The letter to HM Treasury highlighted criticism surrounding consultants’ use of scenarios which have significantly underestimated both the scale of future climate-related damages and their near-term risks. This means investment consultants have potentially provided trustees with incorrect investment advice, the letter warned.
“Bad advice [drawn from these climate scenario models] goes against pension members’ best interests and threatens the world they will retire into,” says Huw Davies, Senior Finance Adviser at campaign group MMMM.
UKSIF’s Warwick Thompson also argues that advice provided by consultants is sometimes “overly restrictive” – particularly regarding the interpretation of fiduciary duty in relation to sustainability goals.
“The inconsistency in how trustees interpret their fiduciary duties can stem from the varying advice they receive from consultants,” he says.
“While trustees may feel less constrained by the law itself, they can be limited by guidance from their advisors on which factors are considered financially material to their investments.”
Mark Campanale, Founder of climate think tank Carbon Tracker, tells ESG Investor that investment consultants have not been effective enough in setting and implementing investment strategies which prepare asset owners for the energy transition and the decarbonisation of pension funds.
“Consultants are still stuck in the old paradigm of ‘change happens slowly, so don’t move too fast’. This is reflected by their demonstrable bias towards engagement approaches and avoiding benchmark tracking error and potential poor performance associated with rapid climate actions,” he says.
“This suggests short-term returns are still afforded higher priority than long-term sustainability (both financial and environmental) and meeting net zero goals.”
Introducing further regulation could ensure much-needed accountability across all sustainability-related advice provided, while enhancing transparency regarding how these risks are assessed.
“Consultants could be mandated to disclose their methodologies for assessing climate risks, offering greater transparency,” O’Leary suggests.
In addition, periodic reviews or audits by regulators would ensure that consultants stay aligned with best practices in sustainability, she says, while implementing standardised frameworks for integrating climate risks would enable consistency across all consulting firms, and mandatory transparency around ESG expertise would help trustees make more informed choices.
“This would build trustees’ confidence in the advice they receive, reducing concerns about potential biases or poor-quality research,” O’Leary adds.
“As sustainability action accelerates, the ideal relationship between investment consultants and trustees would evolve into a more collaborative partnership, with both parties contributing sustainability expertise.”
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