Integrating ESG for DC pension schemes – Key Considerations for DC Trustees

The UK defined contribution landscape is evolving rapidly. DC assets grew 25% from £164 billion in 2023 to £205 billion in 2024. The importance of managing these funds responsibly in the context of Environmental, Social and Governance (“ESG”) considerations cannot be overstated. Regulatory expectations around how DC trustees approach ESG issues continue to evolve, as is seen in areas such as more extensive DC disclosure requirements and governance requirements. This article explores some of the key practical takeaways trustees of DC schemes need to consider in relation to their ESG obligations.

Why should DC scheme trustees care about ESG?

It is well-established that trustees have a duty to act in the best financial interests of members. As part of this, ESG factors need to be considered as a “financially material” factor, although ESG issues should not override the overall fiduciary duty of trustees. In very broad terms, trustees need to consider whether and to what extent ESG issues are financially material to the scheme’s investment performance and risk, and then consider them within the scope of the overall fiduciary duty to members. This may require trustees to take a broader view of a pension fund’s investments, beyond pure financial return, and so they need to balance relevant ESG considerations with other relevant factors when making an investment decision.

For DC schemes, the fund’s investment strategy is a fundamental part of the amount of the member’s pot on retirement. The performance of DC schemes is directly linked to the investment choices made by trustees and members alike. Pension funds will be invested for the long term, and it is the long-term nature of scheme investments that makes ESG investing acutely important for pension schemes, particularly given the exposure to climate-change risk and evolving business practices. 

DC trustees must also have regard to the Pension Regulator (TPR)’s General Code of Practice and a core aspect of this is the emphasis on ESG matters within a scheme’s effective system of governance (ESOG). Schemes are expected as part of their governance processes, for example, to consider co-operation with other institutional investors in engaging with investee companies on ESG issues and monitor how investment managers take into account ESG factors in practice. There is also an increased focus on ESG in the context of regulatory developments in the UK more widely, including measures introduced by the FCA such as anti-greenwashing and the Sustainability Disclosure Requirements. We do not consider the FCA requirements for authorised firms in detail here but see our article on “Understanding Greenwashing” for more on this.

Claims are also arising where members feel that ESG factors are not sufficiently considered, as has been seen, for instance, in the 2023 Court of Appeal McGaughey v. Universities Superannuation Scheme Ltd case (this related to a defined benefit scheme but some of the principles of the case can equally extend to DC schemes) where members were challenging the scheme’s decision not to divest from fossil fuels. As set out in our August 2023 article, ultimately, this application was unsuccessful, however McGaughey does show that members with strong views on climate change are willing to bring legal challenges against trustee investment policies with which they disagree (and this can, of course, apply equally to DB and DC schemes). It is imperative for trustees of DC schemes to integrate ESG considerations into their investment strategies to mitigate long-term risks and support sustainable development.

Fiduciary duties - a deeper dive

In a landscape where we are seeing a strong regulatory push to consolidate schemes and to ensure value for members, DC trustees are grappling with a wide array of considerations. With this context in mind, it is helpful to go back to first principles and look at trustee fiduciary duties and where ESG sits within that in some more detail. 

Fiduciary duties underpin the role of a trustee and have themselves been the subject of increasing scrutiny over the past few years, as factors such as ESG considerations, and, more recently, the government’s drive to increase pension scheme investment in productive finance, bring the way in which trustees make decisions under the microscope  For further discussion on the questions being raised, and the case for clarification, please see our November 2024 article.

As noted above, when it comes to investments, trustees have a fiduciary duty to act in the best financial interests of their members and they are required to exercise their investment powers for proper purposes. This may involve differentiating between (i) investments that have social benefits, but may sacrifice financial return; and (ii) those that align with members' financial interests. 

The first category may broadly be characterised as ethical preferences. Trustees may (but are not required to) take purely non-financial factors into account where two tests are met (as was set out in the Law Commission’s report in 2014), namely:

• trustees must have good reason to think members will share the particular view; and
• the decision must not risk significant financial detriment to the fund.

In practice this will be rare given that, whilst certain members might choose an ethical or impact investment fund amongst a range of self-select fund options, this can be difficult to apply to DC default funds. Impact or ethical funds may therefore be an option within a broad range of funds, but they are unlikely to form the default fund. Trustees need to be alive to the fact that most members will never divest from the DC default and so the default needs to focus on meeting the needs of the average member (and accordingly is unlikely to take account of purely “non-financial” factors). 

It is clear, though, that broader ESG factors would usually fall into the second category i.e. they are most likely be “financially material” considerations. This could be with respect to “physical” risks (the direct impacts of climate change, such as supply chain issues from more extreme weather) and “transition” risks (regarding the shift to a low-carbon economy). TPR has made it clear in its “Investment Governance in DC Schemes” guidance that it expects trustees to “take account of risks affecting long-term sustainability of the investments”. TPR’s guidance sets out some helpful considerations for identifying and assessing whether financial factors are “material” or not. This includes, for example, consideration of what proportion of a fund is owned by a particular DC scheme, the demographics of the scheme’s membership and whether a financial factor could have an impact on a higher proportion of the scheme membership where it relates to a default fund.

Practically speaking, this translates to an approach where ESG considerations are integrated into DC default fund solutions. This is likely to require consideration of ESG factors and an understanding of the ESG approach of available fund investments, including understanding the selection criteria used for funds and monitoring how managers take account of ESG factors. The long-term nature of DC schemes means that they are more likely to be exposed to longer-term financial risks associated with ESG, such as climate change, insecure supply chains, and unsound business practices.

Disclosure 

A core aspect of DC disclosure requirements, including in the Statements of Investment Principles (SIP), Implementation Statement and Task Force on Climate-related Financial Disclosures (TCFD), is the emphasis on ESG factors. Trustees must be transparent in how they account for financially material considerations, including ESG factors. Greenwashing, both in the information provided and in evaluating the information received, also poses a tangential risk in relation to meeting those disclosure requirements.

For the SIP, trustees need to say how they have accounted for financially material considerations (which includes ESG and climate change factors). For most DC schemes, this involves publishing a strategy around their default fund and the Implementation Statement requires both a retrospective and a forward-looking approach. DC schemes are therefore broadly required to include additional detail over and above what is required in relation to DB schemes. 

Trustees of schemes with over £1bn of assets under management also need to ensure they meet TCFD disclosure requirements. Whilst this has been in place for some time now, TPR has reviewed scheme disclosures and identified areas for improvement. As such, regulation, governance, and stewardship are ongoing processes - a "one and done" approach is insufficient. According to Mercer, 51% of companies have not reviewed their DC pension provider in the past two years, which can result in a misalignment between a business’s policies and goals and their pension provision.

In recent months, we have seen a shift across the pond, as several US businesses scale back their ESG initiatives, particularly in relation to equality, diversity, and inclusion. Where this results in changes to how US companies are reporting about their ESG credentials, trustees will need to be aware of this. There is currently no specific regulatory guidance on approaching this issue, but we anticipate that pragmatism will be expected. DC trustees should be transparent about any gaps in scheme disclosures and they should be able to demonstrate what steps have been taken to obtain relevant ESG disclosures. Many large DC schemes and master trusts are leading the way on ESG disclosures, particularly in their TCFD reports. Whilst the position on ESG disclosures in the US is potentially more opaque, there is nothing to suggest that this is the case in the UK and Europe. Trustees of DC schemes will therefore need to continue to uphold high standards of disclosure and remain up to date with legal developments as these requirements evolve. 

Practical tips for DC trustees

Below we have set out some key practical steps for DC trustees on this complex and evolving area:  

• Investment Strategy: Trustees need to focus on “financially material” concerns. When considering whether it is appropriate for the default fund to be tilted towards ESG, trustees should ensure that ESG considerations are financially material and align with long-term risk management. This may involve considering the asset mix of the default fund and being mindful of the risks of greenwashing. Regularly reviewing the investment strategy of the default fund will also be essential.
• Member Engagement: Trustees may decide to seek member views and consider the demographics of the scheme and the potential ESG issues that could affect the returns members may receive, rather than making assumptions about their appetite for ESG. Research by Legal & General shows that a significant portion of DC members care about net-zero targets, provided it does not affect their fund's financial performance. 84% even said that they would want to be more involved with their pension if they knew it was being used to drive positive ESG changes - engaging members in understanding how their pensions impact the world could be a powerful tool in encouraging younger generations to engage with their pensions.
• Stewardship: Stewardship can enhance long-term shareholder value and, since October 2020, SIPs must be expanded to address stewardship in greater detail (e.g. how they monitor portfolio companies and how conflicts are managed) and to set out the trustees’ policies in relation to their arrangements with their asset managers. Trustees should consider the extent to which delegation is appropriate, describe voting behaviour by or on behalf of trustees and ensure that ESG considerations are a regular item at meetings.
• Clear audit trails and disclosures: Maintaining a robust documentation trail and clear governance processes on ESG decisions and disclosures continues to be vital. If members disagree with decisions trustees have made, cases like McGaughey highlight the importance of trustees demonstrating that they have followed a proper decision-making procedure regarding investment policy. Detailed and accurate minutes should be kept and ESG policies should be accurately outlined in disclosures, especially the SIP and Implementation Statement. ESG policy statements in documents like the SIP will also continue to evolve – trustees need to review their existing SIP to meet legislative requirements and also to ensure it continues to reflect the investment beliefs of the board. See our article, ‘ESG: What does your Scheme believe?’ for more on the practical steps around preparing an ESG investment beliefs policy and whether members views need to be considered when doing this.
• Ongoing monitoring: It will of course be crucial for trustees to have robust procedures in place to regularly assess the performance of the trustee board and the implementation of the scheme’s investment strategy. Trustees should also review and continue to negotiate contractual arrangements with investment managers and fund providers and monitor ESG funds selection. Schemes will also need to keep a close eye on relevant legal developments and best practice guidance in this area.    
• Trustee training: Finally, trustees will need to prioritise their training on ESG issues. This could involve combining training on trustee legal duties in relation to ESG with any training from the scheme’s investment advisers. As part of this, it is important to understand and crystallise views on the investment beliefs of the trustee board. 

Conclusion

Trustees can play a pivotal role in the future of DC pension schemes by integrating ESG considerations into their investment strategies. 

It is essential for trustees to stay informed and be proactive in their approach, ensuring that their decisions meet both regulatory expectations and the long-term interests of their members. Integrating ESG factors into investment strategies is essential for managing long-term risks and supporting sustainable development. 

While there are challenges, carefully considered and flexible governance structures can ensure that trustees act in the best financial interests of their members while considering the broader impact of their investments.

Burges Salmon is well-placed to advise on all aspects of ESG in relation to pension schemes and can assist with a range of practical matters in relation to ESG. If you would like to explore this topic further, please contact Jack Gillions or Kate Granville Smith.  

This article was co-written by Jack Gillions and Emily Williams.