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Returns at risk if DCs fail to incorporate climate in default strategies, UK actuarial body warns

IFoA warns of growing risk of climate litigation in a ‘call to action’ to defined contribution schemes and advisors

The Institute and Faculty of Actuaries (IFoA), the international professional body for actuaries, has warned UK-based defined contribution (DC) schemes that failing to factor climate change into default strategies could hurt returns and leave them exposed to litigation.

In recently updated guidance, the actuarial body states that “failing to incorporate climate-change considerations into DC default investment strategies now risks poorer financial outcomes for members and legal action against those charged with governance of investment strategies”.

Since the IFoA’s unprecedented climate risk alert to members in 2017, it has produced a number of guidance documents on the issue for actuaries working in different fields, including those advising insurers, UK trust-based defined benefit (DB) and DC schemes.

Its latest paper Climate Change: A call to action for actuaries working in defined contribution pensions is an update to guidance it put out in 2018. 

In it the IFoA highlights a number of UK-based DC schemes that have already taken positive steps. For instance, £12bn (€14bn) master trust NEST last year detailed plans to shift its default pension strategy towards a Net Zero investment portfolio by 2050, with at least £5.5bn (€6.5bn) of equities pledged to climate aware strategies.

Aviva too announced this year that it will align its default funds with a Net Zero by 2050 goal. As part of this effort, the UK-based insurer is planning to invest more than £5bn (€5.9bn) into low-carbon equities and climate transition strategies over the next 15 months.

Last week, HSBC Bank’s corporate pension scheme also made the commitment to be Net Zero across its £36bn (€42bn) DB plan and its DC one by 2050 or sooner. In 2016, HSBC’s scheme became the first to include a positive climate risk tilt in its DC default fund by investing £1.85bn (€2.2bn) in Legal & General Investment Management’s pioneering Future World Fund. 

The IFoA’s guidance acknowledges that getting to grips with climate change will likely lead to higher running costs for schemes in the short term. For example, it highlights that climate-aware strategies “typically have higher investment management costs than standard index-tracking strategies”. But the body adds that schemes should consider the “overall value for money of such investments when compared with alternatives that carry lower management and administrative costs”. 

“Pension schemes and their advisers will need to weigh any higher costs against the value provided to members through mitigating future risks,” it added. 

Schemes and their advisors should also be wary of the growing risk of climate litigation, the new guidance cautions. It is a warning the IFoA previously made in 2018 – the same year Australian super fund REST was taken to court by a beneficiary over its alleged failure to manage climate risks. Late last year, REST agreed to settle the pioneering lawsuit. As part of that settlement, REST committed to align its portfolio with Net Zero by 2050. 

The IFoA’s new guidance also points to the growing regulatory risks for schemes as the UK Government increasingly seeks to address climate risk in the financial system. 

For instance, as of this month larger occupational pension schemes and authorised master trusts with assets of more than £5bn are required under the Climate Change Governance and Reporting Regulations 2021 to set climate-related targets. 

Moreover, trustees of such schemes are also required to undertake “governance activities” relating to each of the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD) and report annually on it.

In relation to this evolving regulatory landscape, the IFoA guidance writes: “Actuaries must address climate risks and opportunities when providing advice. Put simply, doing nothing is no longer an acceptable position for those running pension schemes, or for actuaries in providing advice.”

Sandy Trust, Chair of the IFoA Sustainability Board and one of the authors of the report, told RI: “Schemes must now manage the material financial risks related to climate change on behalf of their members and this means making appropriate changes to default investment strategies.” 

“It is hard to see how any default investment strategy that isn’t managing these risks can be appropriate for members and it will be interesting to see how Independent Governance Committees and Trustee Boards report on this,” he added. Trust is also Director, Sustainable Finance at Ernst & Young.