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Pension fund trustees will soon have to demonstrate that they not only assess investments from a risk and return perspective, but also look at ‘financially material’ sustainable investing factors. Importantly, the rules resolve a key fiduciary conflict between investment performance and environmental, social and governance (ESG) by integrating sustainable investing approaches into the set of relevant considerations. We aim to help trustees navigate these new rules in an easy-to-use checklist of the main issues.

An added burden or a welcome clarification?

In September 2018, the UK Department for Work and Pensions (DWP) announced plans to implement new rules on the fiduciary duties of pension scheme trustees into statute. The new regulations are expected to become law in October 2019 and clarify that ‘financially material’ considerations include ESG-related issues. They also make a distinction between issues relevant to ESG and those which are based on ‘personal ethics and optional extras’.

With these changes, the government is implicitly indicating that ESG-related themes can make a difference to the performance of investments and that not incorporating ESG matters because they fall in to the realm of individual investor ethics is no longer acceptable.

The clarification also helps resolve the conflict between the fiduciary duty of trustees and ESG. While it was previously legally uncertain where ESG fell into the scope of fiduciary obligations, it is now clear that ESG is an extension of the duties and sits firmly within it, not outside. Consequently, trustees of all occupational pension schemes with over 100 members will have to update their SIP (Statement of Investment Principles) accordingly.

Financial materiality and personal ethics

‘Financially material’ relates to any considerations which can affect the performance of investments over the appropriate time horizon. Pension funds will have to consider what their time horizon is given the profile of its plan members. And over time, this horizon will change along with the relevant risk factors to consider.

Thinking about financial materiality is best done through the lens of risk and reward. ESG factors, which have a bearing on protecting against risk or providing a potential source of outperformance, are clearly important to consider because they affect outcomes for pension scheme beneficiaries.

The DWP draws a distinction between ESG and personal ethics. The difference can be subtle, but a good way to separate the two comes from using the financial materiality clause. ESG-related factors can have a material impact on the outcome of the investment whereas its conceptually much harder to draw a link between investment outcomes and personal ethics.

For example, a decision not to invest in tobacco companies because of beliefs around health is not directly based on financial outcomes and falls into personal ethics, whereas a choice to not invest in a specific tobacco company because it is potentially liable to consumer health litigation is an ESG concern and can make a significant difference to the expected performance of the investment.

Whilst the regulatory change clarifies that ESG issues must be considered, each pension scheme now needs to think about how it addresses this. Working through the following checklist may help.

Checklist for UK pension trustees

For illustration purposes only. Source: Fidelity International, April 2019

Reformulating the Statement of Investment Principles (SIP)

UK pension funds will have to update their SIPs to reflect their approach to ESG. The SIP defines the governance structure of the scheme and should detail the pension fund’s investment beliefs and how ESG is incorporated into the decision-making process. For example, is there an internal team responsible for considering ESG or will that be outsourced to an external asset manager?

In the government’s guidelines it specifically warns against using ‘identikit boilerplate explanations’. The regulations are intentionally ‘unprescriptive’ with the goal of encouraging schemes to develop their thinking around ESG and review their policies.

In addition to deciding where the day-to-day responsibility for considering ESG issues will lie, schemes should also have policies on stewardship, including voting and engagement with other parties (e.g companies, asset managers, other shareholders), and on any other relevant ESG issues such as climate change. This is a step up from the previous requirements where trustees only had to report on the exercise of rights related to investments such as voting.

Ultimately, trustees should aim to have formed their philosophy around ESG and be able to communicate it. This doesn’t need to be an overly detailed, granular approach with an answer to every ESG issue, but it should provide a framework through which ESG issues can be considered.

Part of that is likely to involve engaging with scheme holders to understand how best to represent their ESG views. What does ESG mean to plan beneficiaries and how will the issues impact them? This could involve thinking about what the world could look like in two or maybe 20 years depending on the profile of the body of beneficiaries.

Choosing investment strategies and asset allocation

Picking strategies and allocating capital to asset classes is the first step in applying the ESG principles from the SIP. It’s important to recognise at the outset that some asset classes are just easier to address than others and at different stages of the ESG process.

The nature of equities for example, lends itself to ESG analysis. Publicly published and comprehensive financial statements allow analysts to make informed judgements about listed companies, which enables ESG-informed stock selection in an active approach. For passive strategies, ESG-tilted benchmarks can guide the process. For both disciplines, voting and engagement play important roles.

Fixed income investors do not have a natural mechanism through which to vote on corporate events but they can engage with issuers to influence credit agreements and monitor covenant terms. Investors can also look at how proceeds from bond issues are spent and whether that meets their ESG criteria.

Alternative assets such as real estate and infrastructure often require in depth due diligence because projects are inherently heterogenous. Factors such as energy efficiency, carbon footprint and the role of the project in the community are important considerations.

Asset allocation should not only consider asset classes and strategies, but also regions and sectors as regulations, cultures and practices vary. For example, European companies are on average more ESG-aware than global peers, and within Europe, Nordic countries and the Netherlands tend to lead.

Selecting asset managers

Pension schemes can allocate directly to investments, but many employ external managers as well. While this moves pension funds one step away from the end investment, ESG analysis can still be applied. If we think about ESG as risks to the sustainability of an investment’s cash flows, this can be translated to external managers as risks to the sustainability of the manager’s underlying performance.

An asset manager’s ESG approach can fall into a broad spectrum from ESG unaware to ESG integration. Each level has its pros and cons, and should be considered with reference to the scheme’s wider objectives so that trustees can pick the application(s) that best suits their needs.

ESG terminology overview

For illustration purposes only. Source: Fidelity International, April 2019

How to judge an asset manager's ESG integration

To better understand a manager’s ESG processes and judge whether they align with their own SIP, trustees can investigate the level of a manager’s ESG integration:

  • How is ESG incorporated in the manager’s asset allocation, establishing the investment universe, portfolio construction, industry/sector analysis and stock selection?
  • What resources does the manager have internally and externally? Is there a dedicated ESG team or do they use third-party agencies? Do they produce independent ESG ratings on potential investments?
  • What incentives are there in place for analysts and portfolio managers to consider ESG issues?
  • What is their proxy voting and engagement policy? Can they provide a voting record and investment case studies? How much do they rely on proxy advisers? Do they partner with other investors to drive changes?
  • Is the manager a signatory to UN PRI (Principles of Responsible Investment)? Are they part of the UK SIF (Sustainable Investment and Finance Association)? Do they engage with regulators and take part in industry groups?
  • What sustainability metrics can they provide on specific funds? How regularly are these tracked?

This is not an exhaustive list and will change over time as ESG analysis develops. In some cases, a manager may not currently completely fulfil all the criteria a trustee is seeking but can adjust their process to accommodate it. Here, trustees should be explicit in their ESG instructions to managers.


The new rules mean trustees will have to monitor their managers to ensure they are implementing ESG considerations as expected. This is an extension of the current process which most trustees follow but includes additional disclosures on ESG matters.

Formats that asset owners use for monitoring include annual questionnaires to the manager, onsite due diligence, third-party opinions and meeting with the portfolio manager and ESG representatives. Many of the questions which were asked before investing with the manager can be followed up to ensure standards are being maintained.

If there have been personnel or structural changes at the manager, it’s important to find out how will this affect their ESG policies and implementation. If ESG analysis is developing, managers should account for it by changing their process or adding resources.


The reporting requirements on pension schemes have become stricter. By 2020, pension schemes must produce a public report on how the SIP is implemented, an added burden compared to previously just reporting cases of a breach. Reports should of course be regular, transparent and independently verified where appropriate.

Trustees can also think about establishing metrics to help quantify how the SIP is being implemented. For example, emissions reduction numbers or tracking error against ESG benchmarks. Case studies can be useful tools to bring to life the benefits of ESG awareness to scheme holders.


The new guidelines around ESG have increased the burden on trustees but they have also added clarification on the role of ESG analysis in the investment decision making process, which shouldn’t be underestimated.

Pension funds must now explicitly address ESG issues, treating them as a critical part of the investment workflow, which could help improve outcomes for beneficiaries. The industry adoption of ESG factors is also another step in the standardisation and development of investment practices.

For trustees, implementing the new DWP guidelines should ease the path to implementing future regulations and initiatives such as the new stewardship code currently being considered by the Financial Reporting Council (FRC) which will include ESG factors.

The DWP regulations are part of a longer-term trend within the investment industry to develop the understanding and incorporation of ESG - it is not a one-off event. In this vein, it’s important to remember that asset owners are partnering with asset managers, not actively trading those managers. This long-term relationship works best when it is cultivated by both sides, and ongoing ESG discussions will help align expectations with each party relying on and influencing the other.

Important links

UK DWP clarification report

Law Commission report

Pensions Regulator Investment Governance guidance

Proposed UK stewardship code

Matthew Roberts

Matthew Roberts

Corporate Governance Analyst

Adnan Siddique

Adnan Siddique

Investment Writer