This is our third article in our climate series. In it we explore how climate risk can feature in a scheme’s strategic decision making and suggest actions all schemes can take. First we suggest considerations for schemes that are selecting an insurer and then turn our attention to how to better understand the exposure to climate-related covenant risk when running on. Finally, we focus on schemes with funding deficits. We hope these examples will help you see how you can integrate climate considerations into your own strategic decision making, whatever your circumstances.
For trustees that have decided the appropriate approach for their scheme is an annuity purchase, either through a buy-in or buyout, a key decision is the choice of insurance provider.
The price of the annuity contract has typically been at the top of the list of factors in deciding on the annuity provider but there are a number of other considerations. These include quality of administration, member experience, insurer strength and ESG credentials, including the approach to climate risk. As an increasing proportion of annuity transactions are full scheme buy-in/buyouts rather than partial scheme investments, and with some of these schemes potentially having surplus assets, non-price factors are getting increasing focus.
We would encourage schemes in these circumstances to consider the weighting to place on an insurer’s ESG credentials as part of their selection criteria. For schemes who have their own ESG policies in place, they may wish to consider whether there are aspects within these policies that they would wish their chosen insurer to continue. For example, do they have an automatic investment exclusion policy in relation to businesses involved in thermal coal or controversial weapons? Trustees may also wish to consider the views of their membership and the emphasis they would wish to place on an insurer’s approach to climate risk.
WTW prepares an annual survey of annuity providers’ ESG credentials and can support Trustees considering these topics as part of insurer selection. Beyond the bulk annuity providers, we take a similarly detailed approach in our annual survey of reinsurers which can be an important factor for schemes undertaking a longevity swap.
Importantly, our survey aims not only to assess, but also to raise, the ESG standards of the bulk annuity insurers. In previous years this has involved digging deeper into the depth of the stewardship team, understanding if the insurers are aware of the ESG policies of relevant third parties, and asking questions about their Modern Slavery Policies. Look out for our article on the 2024 survey due in the coming months.
Not all schemes with strong funding positions will be looking to transfer their liabilities to insurance companies; a number will be looking to run on with a portfolio of non-annuity assets.
For these schemes, there are two key areas with a climate focus to consider:
01
The longevity/resilience of the sponsor covenant with respect to climate change is a factor. This will likely be a key consideration in determining whether this approach is supportable in the first place. Where climate poses a material risk to a sponsor, run on may not be suitable. Therefore, it is important that trustees determine the extent of exposure their covenant has to climate risk. See unlock more box below for some recommended questions to begin your process of assessing the employer’s climate exposure.
02
If the scheme is running-on with a view to generating additional surplus for the benefit of its stakeholders, how broad a group of stakeholders should be considered? Members and the sponsoring employer are likely to be the two primary stakeholders, but there are others. Our first article in this series debated the extent to which those responsible for managing pension schemes should consider the climate impact of their actions and perhaps this consideration is most relevant for this group of schemes; if there is a high degree of confidence that the scheme benefits will be paid, perhaps the scheme can “afford” to invest in a way that places additional weight on the (climate) impact of the investments chosen?
The new funding framework requires schemes to work towards a position of “low dependency” on the sponsoring employer; all schemes not yet at this point could be considered to have a deficit to repair.
TPR’s new DB Funding Code of Practice encourages trustees to determine the period of reliability[1] and the period of longevity[2] for their covenant. These assessments will influence the scheme’s funding and investment strategy, most notably any recovery plan period and the time by which the scheme should reach low dependency.
Climate risk can influence both the period of reliability and the period of longevity. For instance, regulatory changes, changes in consumer preference and new products can potentially shorten these periods or introduce uncertainty. Transition costs for employers in more covenant-exposed industries can also be significant, reducing maximum affordable contributions to the scheme.
For those covenants that are most highly exposed to climate, climate could – indeed should – be a significant influencing factor when setting funding and investment strategy.
The questions in the unlock more box “Extent of covenant exposure to climate” are a good place to start in establishing the extent of climate risk to your covenant.
There are clearly some standalone climate tasks that all pension schemes should consider. Most beneficial among these is probably engagement with investment managers and stewardship considerations. But in our view the real value to scheme members and the biggest impact comes from integrating climate considerations into your strategic decision making. We hope this article has given you some ideas how to go about this but contact us if you want to explore any of these ideas further for your scheme.
