What do we mean by investing for the endgame?

Endgame is the long-term objective of a pension scheme beyond accumulation and getting to a fully funded level; it is investing in a way that minimises risk and increases certainty of outcome. The outcome is securing the eventual full payment of benefits to scheme members. This may be achieved through a buy-out with an insurer, by maintaining a low-risk, self-sufficient portfolio (with minimal reliance on the scheme sponsor) and running off the liabilities, or indeed by opting for some level of consolidation with other pension schemes (such as DB master trusts or the new superfund vehicles).

In any case, the aim is preservation. If a scheme is entering the endgame and trustees opt for putting in place a self-sufficient portfolio (either indefinitely or with an eventual buy-out or other transfer in mind), the goal will be to ensure that the scheme’s obligations are met both on an ongoing basis – i.e. benefit payments are paid – and in a forward-looking way, by closely managing both liability and investment risk.

An endgame portfolio therefore incorporates, as its main building blocks:

• Buy & maintain credit – to provide contractual income to meet cashflow requirements;
• Alternative assets – e.g. private debt, to increase yield (compared to public debt) by exploiting illiquidity premia;
• Liability driven investing – to hedge residual interest rate and inflation risk; and
• ESG factors.

Why are ESG factors important?

Investing for the endgame is investing long-term. Environmental, social and governance considerations are an important element of this as they help complete, as much as possible, our understanding of the future, which in turn enables us to build a more sustainable portfolio.

Generally speaking, there are two ways that embedding ESG factors in the investment decision-making process can enhance the long-term performance of an asset portfolio.

• First, by expanding the set of factors that have a potential to contribute positively to returns.
• Secondly, by increasing the robustness of the portfolio through providing enhanced risk management.

While the former is important to bear in mind on a general basis, the latter is of crucial significance for our endgame portfolios, whose aim is to preserve capital in the long run.

It is important that every aspect of the investment process incorporates those considerations around sustainability which are most applicable to each asset class.

Embedding ESG factors in endgame investing

ESG matters in the credit research process

ESG analysis is a fundamental ingredient in understanding the risks of a company, alongside traditional credit analysis. ESG analysis needs to be integrated into the investment process – it is additive in the assessment of potential risks debt issuers could face in the future. This is important  because good stock selection in a credit portfolio means avoiding downgrades and defaults which can arise from unmanaged risks.

The contribution broadly comes from two types of research. On the one hand, macro research can enhance our awareness and understanding of the long-term prospects of particular industries and sectors, evolution of consumer preference and many other underlying changes ultimately impacting individual companies. Globalisation, digitisation and automation are transforming our economies and analysis of these trends provides an additional layer to our assessment of a particular investment.

The other layer of research is company-specific, an important element of which is how the company is governed. Both this and macro risk will feed into the overall rating.

Orsted, a Danish operator of offshore windfarms, offers an attractive yield for a strong credit. Bond investors have been able to benefit from an improving ESG rating as the disposal of the company’s oil and gas exploration business has reduced the cyclical risks associated with energy prices. It also removes the risks of the company being left with stranded assets should legislation on oil and gas extraction change

While bond investors do not have a vote (like shareholders do), direct engagement is still effective as it can enhance company research and a constructive dialogue can add value to both parties. Joint company meetings (including fixed income analysts and ESG researchers) provide an opportunity to get a deeper understanding of a company’s plan to future-proof their continued operations – for instance, how a utility company is mitigating any additional costs arising from transition to a low-carbon future. 

Stranded assets are also a risk for miners, auto manufacturers and producers of tobacco, and, while generally low carbon emitters, IT and telecoms companies also need to consider such risks as disrupted infrastructure and operations as a result of climate change.

By clearly setting out information they require to assess ESG risks, bond investors can encourage companies to change their behaviour. Active management can therefore ultimately allow investors to profit from changes to ESG ratings.

ESG matters in private debt

ESG factors in private assets included in an endgame portfolio, such as commercial real estate lending (CREL), infrastructure debt and private placement debt, need to be considered on a deal-by-deal basis, even if they form part of a pooled fund offering. An ESG rating assigned to a prospective investment assesses the likelihood that ESG factors will degrade credit fundamentals – hence informing the decision of whether to include them in a portfolio. Key ESG risk factors for these assets include climate change transition risk and governance considerations, while it also presents opportunities to finance projects with a positive social impact.

ESG matters in LDI counterparty selection and management

The role of ESG considerations is arguably less obvious in the context of counterparty banks, but is important due to the long-term nature of many contracts that asset managers enter into. Taking the example of swap contracts many of which run to several decades, it becomes easier to appreciate that novation risk may become a concern some way down the line. The most relevant factors fall into the governance category; amongst others, stability of business model, strength of franchise and company management are all important for an investment bank’s long-term sustainability. In addition, processes to manage conduct and litigation risk, as well as operational risk factors such as cyber security and money laundering controls need to be in place. From an environmental perspective, it can be useful to examine who the bank lends to and whether this includes companies with heavy reliance on fossil fuels. From a social angle, employee relations as well as the bank’s role in developing the economy (e.g. through lending to small and medium enterprises) are examples of what may contribute to an ESG score.  

Regulation

The direction of travel over the last few decades has been clear, and the reach of regulatory focus has extended to cover an increasing area of investment activity and market participants. However, it was in September of last year, in a paper entitled “Clarifying and strengthening trustees’ investment duties”, that the responsibilities of DB scheme trustees were formally redefined in relation to ESG. In it, the DWP proposes that, when preparing a Statement of Investment Principles (SIP), trustees must show the extent to which the underlying manager is taking material ESG issues into consideration when selecting investments. The regulation, which takes effect on 1 October 2019, also requires trustees to set out their policies in relation to stewardship of investments.

The changes to regulations regarding SIPs present a real opportunity for trustees to improve how they communicate with the underlying investment managers. They are a concrete way for trustees to demonstrate what they expect of their investment managers in terms of how they integrate material ESG considerations into their investment decision-making.

You need an ESG-aware partner for the endgame

When appointing an investment manager, it is becoming increasingly important that the selection criteria includes ESG factors, and that the manager is able to demonstrate that ESG considerations are embedded in the investment process. Partnering with the right manager does not only help evidence this to the regulator, but helps trustees gain comfort that their endgame portfolio is subject to truly robust analysis, and is thus likely to be more resilient in the long term and able to deliver the required outcome.

Trustees’ duty of stewardship requires a meaningful engagement with managers. Members rely on the pension scheme to deliver the benefits promised, which requires the scheme’s assets to be invested in a way that protects these benefits to the greatest degree possible.

Over the time horizon we consider here, the impact can be particularly significant on companies’ ability to deliver and therefore the resilience of the portfolio. Taking full account of ESG factors enables a deeper analysis of the risks to which the investment is exposed. A successful endgame solution therefore needs to meaningfully incorporate these considerations.