Pensions for the planet: balancing sustainability with the right investment

Sustainability knows no bounds in modern Irish business and pensions are no different. Defined contribution and personal retirement savings account investors are gaining increased access to environmental, social, and governance (ESG) options in addition to conventional investment funds.

While we all want to do good for the planet, there’s the more pressing question for pension holders of whether basing a decision on ESG issues can hurt the overall investment.

By and large, the answer is no but it is slightly more complex than that. Risk and strategy, irrespective of what is being invested in, remain the key factors.

“Overall, choosing an ESG pension option does not necessarily involve a substantial performance sacrifice,” says Rav Vithaldas, partner and pensions assurance leader at EY Ireland. “Performance tends to be driven by the underlying asset allocation, investment strategy, fees and manager skill rather than the ESG label itself.

“Well-constructed ESG funds can deliver returns that are broadly comparable to conventional funds over the long term, while potentially offering better management of certain risks such as climate transition risk and corporate governance issues.”

While the returns may be similar in the long-term, it doesn’t mean that each approach works in lockstep on an annual basis.

“Based on our own experience, responsible investment solutions can deliver outcomes that are broadly comparable to more traditional alternatives over the long term,” says Patrick McLaughlin, head of responsible investment (RI) multi asset solutions at Davy.

“That said, there will inevitably be periods when performance diverges. We’ve seen some of this over the last three to five years, where our responsible investment solutions have modestly underperformed our comparable non-responsible strategies, which can be attributed to differences in sector and stock exposures.”

These differences occur for a simple reason. A portfolio focused on ESG is constructed quite differently to conventional funds.

“For example, funds with lower exposure to fossil fuels may lag during strong energy market rallies, as we are currently experiencing with high fuel prices, but outperform when renewable energy sectors are strong,” says Vithaldas.

An obvious point of divergence between ESG-focused and standard funds is how each approaches energy investments but that’s not the only area where differences have been visible.

“For example, our responsible investment strategies have had lower exposure to energy companies, which performed particularly strongly following the invasion of Ukraine in 2022 and again during periods of heightened geopolitical tension in the Middle East,” says McLaughlin.

“Similarly, our responsible investment solutions have had lower exposure to parts of the US technology market, particularly the so-called ‘Magnificent Seven’ companies that have driven a significant proportion of recent equity market returns.”

That’s why those saving for pensions can not allow the short-term divergences in performance to cloud their view on the overall goal.

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“The important point is that these differences can work both ways. A responsible investment portfolio will not look exactly like the broad market, so there will be periods of both relative outperformance and underperformance,” says McLaughlin.

“For most pension investors, the focus should be on long-term outcomes. Think about ‘how am I tracking towards my investment objective?’ rather than short-term deviations from a benchmark.”

Investors should look for the like-for-like financial characteristics when comparing any option, irrespective of the ESG label.

“Investors should therefore compare green and standard funds with equivalent risk ratings, asset mixes and time horizons. Over the long term, a diversified and reasonably priced ESG option can support environmental preferences without requiring a structural reduction in expected pension returns,” says Vithaldas.

He says that fees in particular should be examined, especially as minor differences can add up across decades.

“The comparison should begin with financial fundamentals: risk rating, asset allocation, diversification, benchmark, historical returns after fees and suitability for the investor’s retirement horizon,” says Vithaldas.

“Tracking error shows how far a green fund may deviate from its benchmark. Charges are particularly important because paying 2 per cent rather than 1 per cent annually can reduce the final pension pot by about 20 per cent over 30 years, depending on returns and contribution patterns.”

The choice isn’t between what’s best for the environment and what’s best for your investments. Provided pension savers keep their goals in focus, they should be able to succeed on both fronts.