Willem Schramade, Head of Sustainability Client Advisory at Schroders

Strategic Asset Allocation (SAA) is of paramount importance to achieving pension funds’ risk-return objectives and hence to their decision making. The same increasingly applies to sustainability integration into investments. Yet, the two topics have so far hardly been connected.

That is strange. After all, if sustainability considerations are taken seriously, then it logically follows that they flow into investment beliefs; into expectations on the risk, return and sustainability outcomes of asset classes and sectors; and ultimately into their SAA.

Of course, we see sustainability integrated in specific mandates within asset classes, for example shifting from global equities to low carbon global equities. But sustainability can also be integrated across asset classes, for example shifting from public assets to private assets with strong sustainability outcomes.

We are beginning to see some signs of this amongst sustainability minded investors. Pension funds are increasingly articulating their sustainability-related investment beliefs.

Mostly, this is done by stating that environmental, social and governance (ESG) issues are relevant to financial risk and return. We would describe this as single materiality. For example, US pension fund LACERA[1] says: “LACERA recognizes that environmental, social, and corporate governance factors (ESG) may present financial risks and opportunities for the Fund. LACERA seeks to identify, evaluate, and manage financially relevant ESG factors in its investment process—including portfolio construction, investment due diligence, and stewardship strategies—to safeguard and enhance Fund performance.”

Quite a few pension funds take a double materiality approach in their investment beliefs, saying that they also aim to improve the way their investments affect outcomes for nature and society – see a previous blog: Why invest for “sustainability outcomes”?

For example, Dutch pension fund PFZW[2] says “as a long-term investor we can make a valuable contribution to a more sustainable world. We call this 3D investing, a new way of investing that will take further shape in the coming years.” With 3D investing, they mean adding impact as a third dimension in addition to risk and return. And in fact, we do see some pension funds asking for such 3D investment strategies.

It is encouraging to see such aspiration, whether expressed as single or double materiality. From what we have so far found, it is not always clear how pension fund investment beliefs might alter the pre-existing long-term risk-return assumptions and asset allocation choices.

Roor, Maas and Schoenmaker (2024) wrote an interesting article on how to do this. At the Schroders Amsterdam office we organized a seminar with the authors and with pension fund representatives, discussing the challenges of integrating sustainability into SAA. The paper gives strong guidance, but serious bottlenecks remain.

One such bottleneck is the use of models: long-term models on climate risk are far from perfect, as they are shown to underestimate climate risks, and it will take years to make them work well. But we cannot wait for perfection. Instead, pension funds will need to make assumptions. A Nordic client told us that it is doing this by means of stress testing of extreme events; by considering which countries are hit harder; and then adjusting exposures if it doesn’t hurt in other respects.

This is all doable but approaching it at a strategic level is crucial. Manager selection teams often find themselves stuck in a narrow remit. The initiative must be taken from the top – board, CIO or head of SAA. Selection teams are bound by the mandate they are given by their Board. Fulfilling this mandate will require the appropriate mindset as well as the models required. These may take some time to adopt and develop.

In the meantime, integrating sustainability considerations in investment beliefs is a great start, but the proof of the pudding is in the eating: we would like to see these sustainability considerations flow from investment beliefs into long-term assumptions and SAA.

ENDS