In the world of sustainable finance policy, “billions to trillions” has become the rallying cry of efforts to finance the United Nations’ Sustainable Development Goals (SDGs) and tackle climate change.
In reality, the anticipated deluge of capital remains a mere trickle – and UK pension funds are contributing particularly little.
In a new study for ODI, the global development think-tank, my co-authors and I found that pension funds – unlike insurance providers – do not face major regulatory constraints to investing in emerging markets, but rather hold back for cultural reasons.
They’re missing out on potentially lucrative returns, as well as the chance to channel their sizeable holdings into crucial development and climate financing in regions that need it most.
UK pension funds allocated a paltry £14.2bn to emerging market and developing economies (EMDEs) in 2022, representing 0.5% of their assets under management. Their investments outside the UK were overwhelmingly in the US and other developed economies.
UK pension fund overseas portfolio allocation, by region, 2022
Source: ODI, Office for National Statistics
Emerging markets provide risk diversification and are an attractive option for investors seeking growth. Our analysis of representative equity indices shows that emerging markets performed just as well as US markets between 2002 and 2021, and outperformed non-US developed markets.
Moreover, emerging market equity far outperformed the US in the first half of that period, whereas the US outperformed emerging markets in the second half. Emerging market bonds have also outperformed developed market bonds in most years since 2008. On this basis, a more geographically balanced allocation would appear to be prudent, with each element hedging the other in certain scenarios.
Performance of respective equity market indexes, 2002-2021
Source: ODI, Umland and Wren (2022)
Emerging market and developed market bond index performance, 2008-2024
Source: ODI, Bloomberg
Cautious thinking
Pension trustees and asset managers often adhere to the cautious counsel of advisers, whose interpretation of fiduciary duty tends to focus squarely on financial returns.
Where environmental, social and governance (ESG) factors do feature, it’s through the prism of the direct risk they can pose to investment returns, known as first materiality ESG. Second materiality ESG, which looks more broadly at the environmental and social impacts of investment decisions, is not a significant part of advisers’ thinking, we found.
This narrow view is at odds with the idea of sustainable investment, which seeks to harmonise financial performance with positive long-term outcomes for people and the planet.
Greater investment in emerging markets would contribute to this goal, since it is there that funds can have the greatest positive impact on the climate, poverty, and social progress.
As public interest in sustainable investment grows, including among many UK pension policyholders, providers are falling behind by failing to offer plans that take it into account.
Defined contribution opportunity
Pension providers have an opportunity to move past outdated ways of thinking, as the UK market moves away from defined benefit (DB) schemes and towards defined contribution (DC), with DC assets projected to surge sixfold and surpass DB assets by 2030.
DC schemes prioritise return enhancement, which aligns with the growth potential of emerging markets. This translates to a higher tolerance of investment risk, potentially opening the door for increased emerging market allocation.
Moreover, these plans offer beneficiaries a more direct say over how their pensions are invested, enabling investment in line with their sustainability preferences.
Within this framework, there is a lot the industry can do to channel more funds towards sustainable investments.
A subtle yet impactful shift lies in altering the default investment option. Currently, 90% of DC policyholders meekly invest their contributions in default funds, the Law Commission has found. Emerging market allocations in these funds are low, reflecting their low share in global market indices.
Development finance institutions (DFIs) such as the International Finance Corporation and British International Investment can act as catalysts by developing investment products that reconcile investors’ desire for low-cost, liquid investment options with the imperatives of sustainable finance.
The government and the pensions regulator, meanwhile, could empower pension funds to integrate sustainability preferences into their investment decisions without compromising on prudence by providing clearer guidance on fiduciary duty that encompasses second materiality ESG factors.
Dutch example
Inspiration can be drawn from Dutch pension funds, which our study found to hold more than 60% of the funds allocated to emerging markets among Europe’s top funds.
For instance, leading Dutch fund APG has invested $750m in the ILX fund, which provides exposure to a portfolio of emerging market loans originated by DFIs. Government policies that align with beneficiary demand for sustainable investment greased the wheels.
The Dutch example demonstrates that with the right framework, pension funds can be catalysts for sustainable growth and social progress, and that there is a viable alternative to the UK industry’s conservative approach to emerging market allocation.
The urgency to act is palpable. It is time for a paradigm shift that recognises the multifaceted nature of fiduciary duty and the transformative power of sustainable investment. Only then can UK pension funds unlock the full potential of their capital, fostering a future that is prosperous, equitable, and resilient for all.
Samantha Attridge is a senior research fellow at ODI
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