Pension allocations to climate funds – including in the private assets sphere – are likely to increase dramatically, with potentially vital consequences in the real world.

Pension funds represent around $54 trillion – a little over a third – of the entire $154 trillion global asset management industry. The vast majority of that $54 trillion is in just the seven largest pension fund markets in the world. Wherever pensions direct their attention, change follows.

We think the next phase for the pension industry may be defined by the rise of the “climate allocation”. Here’s why.

It’s all adding up to (net) zero

In recent years, there have been three key trends in pensions.

Source: Schoders Capital, For illustrative purposes only

Looking forward, there are both economic and policy drivers likely to emphasise these trends.

Cost will always be a concern for both pension members and regulators. Securing sources of return from the private markets is, however, more expensive as a rule. We expect there to be industry consolidation which will assist scale economies, and create room for private assets to be used more without impacting overall cost.

Technology must further assist in driving down costs, but it can simultaneously play a role in member engagement, communication and in the mass customisation of offerings. However, adding rigorous reporting on sustainability and impact targets (such as Co2 footprints) will naturally weigh on the already tight margins. Proprietary tools will be a distinguishing criteria and require significant investments for asset managers that strategically decide to lead in sustainability.

Finally, sustainability will become a mainstream concept. Governments and regulators are already assisting in industry evolution, by promoting new structures that make investing towards social and environmental benefit more straightforward. The newly-announced Long-Term Asset Fund (LTAF) in the UK is a case in point. These vehicles have extended minimum redemption requirements and a focus on long-term, illiquid assets. As the ability to measure impact improves the prevalence of so-called “green washing” will fall.

In addition, the impact and longevity of the assets will naturally converge. This is because private assets will change their investment processes so that they achieve “measured” impact, and are likely to set the bar higher for themselves than what is required by regulators.

Why investors can expect to see more private asset focused climate allocations

Today the UK DC market is around £500 billion in size, and is forecast to top £1 trillion by the end of the decade. We expect significant consolidation into master trusts, which manage the schemes of numerous employers under one roof.

With that will come evolution. Greater interaction with members, more education and much greater sensitivity to ESG. According to Willis Towers Watson there has been a “step change” in the importance of ESG with 50% of schemes likely to offer ESG as part of their default option in the short-term.

Crucially, there is also a significant mismatch between those expressing specific interest in climate friendly funds, and the number that have yet acted upon it. The Defined Contribution Investment Forum found that 74% of UK savers were either ‘very interested’ or ‘somewhat interested’ in climate friendly funds. However, the same survey found that just 9% have actually invested in climate friendly funds via their pension. We strongly argue that after COP 26 this desire has increased, but there is a need to provide appropriate solutions for savers, if they are to act.

Private assets can directly contribute to investors’ climate ambitions

There is a clear desire and willingness to progress towards climate friendly pensions both from the members and the investment industry. But a number of challenges are proving stubborn to overcome.

We mentioned cost earlier. For pensions, cost has two factors.

The first is the regulatory cost cap that UK pensions have to act under. The cost cap is a real hurdle, which many seem to tackle with a private markets budget. The solution to this must come from operating efficiency and perhaps some regulatory relaxation.

The second is what we call the “value paradigm”. We have had a lengthy period of strong public market growth that can be bought at a very low cost. Why pay more for private market exposure?

We believe there are clear answers to the latter question. The most glaring is the diversification that private assets bring. As we head into choppier waters, it will become much clearer how much of the return in the private markets is generated from the asset’s fundamentals as opposed to market direction.

Another strong rationale, especially as we come on to talk about impact, is the ability to get much closer to the asset you are financing. While ESG is rising in prominence, consistent and repeatable measurement remains a key challenge, made all the more difficult the further away an investor gets from an asset. Verification of the measured impact being the ultimate goal.

If we think of proximity as a spectrum, index trackers would be at the far, most-removed end. Private assets are at the other. As owners and operators of the asset it is arguably as close as investors can get to seeing the real-world implications of their finance decisions.

The Schroders’ 2021 Institutional Investor Study identified data fragmentation as a major obstacle in private asset investment, with 58% citing a lack of transparency as key challenge. On this we believe the industry must do a much better job in communicating with investors.

It is certainly the case that assets revalue less frequently, but when they do it is on the basis of their fundamental worth, as opposed to what’s going in the market. However, private funds are usually comprehensive in disclosing all of the assets within the portfolio as opposed to, say, the biggest five positions. This perhaps is not so well understood.

ENDS