Responsible investment: our approach and our legal obligations as a pension fund

In light of the horrific events that have been unfolding over recent weeks in the Middle East, we know that members and employers may have questions about our investments. Simon Pilcher, Chief Executive of USS Investment Management, sets out our approach to investing responsibly and in the best financial interests of the scheme’s members and beneficiaries, in line with our legal duties.

USS is a long-term, responsible investor with a legal duty to invest in the best financial interests of the scheme’s members and beneficiaries, so we can pay pensions now and long into the future.

Being a responsible investor will mean different things to different people but, for USS, the key element here is best financial interests.

That’s because trust law requires that this must be our over-riding consideration when it comes to deciding how, and where, to invest the scheme’s money – because we have a duty to ensure the benefits promised to members can be paid when they fall due, now and decades into the future.

We appreciate that, across society, ethical and religious beliefs are hugely important. They can be intensely personal and part of people’s identities. For example, some might not want to invest in companies that extract fossil fuels, produce nuclear energy, provide gambling services, manufacture weapons, or sell alcohol – regardless of whether they are legal and financially sound investments.

We know from member surveys¹ that they hold a diverse range of views on different issues. That is perhaps unsurprising given we have more than 500,000 members and the one thing they all have in common is that they have links to the UK’s Higher Education sector – a sector that champions freedom of speech, critical thinking, and constructive debate.

How do we decide where to invest?

With £75bn worth of assets to manage (as at 31 March 2023), our size and scale means we need to run a globally diversified portfolio to protect against adverse events at a particular company or in a particular market or region.

So, our investments represent a small slice of the global economy.

Some of those investments may not align with the views, perspectives, and principles of some members. But trust law is clear that we would only be able to take non-financial factors (such as ethical preferences) into account if they did not pose a risk of significant financial detriment to the scheme and we had good reason to think that the scheme’s members shared each other’s concerns about the non-financial factors.

Legally, there is more flexibility when members can choose their own investments. That’s why members with Investment Builder savings (the defined contribution, or DC, part of the scheme) can choose to invest in funds that may reflect their personal beliefs and preferences (despite any potential impact on financial risks and returns).

For example, we provide a Sharia-compliant fund into which around 2,000 members actively choose to put some of their pension savings.

We also offer two ethical self-select options – the USS Ethical Lifestyle Option, for members who want us to manage their DC investments over their lifetime, and the USS Ethical Equity Fund, for members who want to choose a specific fund. Currently, around 6.2% of active members with Investment Builder savings elect to put at least some of their pension savings into these funds. You can read more about how we go about designing them.

That is not to say our other investments in the Investment Builder are, by extension, unethical. We do assess environmental, social and governance (ESG) issues across the piece. Where we consider these to be financially material factors, we will incorporate them in our investment decisions.

While it’s not feasible for us to offer members the ability to choose exactly how their funds are invested, we put a lot of effort into understanding the breadth of views members hold and try to reflect them in the choices we are able to provide to members in the DC part of the scheme.

Per the trust law point above, the position is (legally) more restricted in the Retirement Income Builder, the defined benefit, or DB, part of the scheme. And, unlike the DC part, all members of USS build up benefits in this part of the scheme – so the investment decisions we take for the DB part of the scheme affect all members.

Our approach

We think very carefully about the financial risks around all our investments, including those that might arise from ESG issues.

Our latest Stewardship Code Report provides more detail on this.

We believe that when a company, state or country is run effectively, and appropriately manages its environmental and social risks, like climate change or health and safety, investment risk can be reduced over time and returns may be positively impacted.

We integrate financially material ESG factors into our investment decisions and, where possible, engage with the companies we invest in to encourage positive change. We do this for both our equity and debt investments across both the DB and DC parts of the scheme.

We assess countries based on a range of indicators, such as human development, economic freedom, and corruption, as well as market and insurance-based risk metrics. The prospects of an investment being adversely affected by changes in government policy, increased regulation, or other geo-political factors (such as the introduction of sanctions) could also be relevant financial considerations.

We review our assessments regularly, and in response to events. Companies, sectors, or countries may be considered for exclusion or divestment at any time – where we have control over the ultimate asset allocation.

Exclusions and divestments

For example, in June 2020, we announced scheme-wide plans to exclude and, where necessary, divest, from companies in sectors deemed financially unsuitable for the scheme over the long-term. These included tobacco manufacturing, thermal coal mining (specifically where this makes up more than 25% of revenues), and companies that may have ties to controversial weapons, such as cluster munitions, white phosphorus, and landmines (largely because they aren’t legal in many jurisdictions).

You can read more about the financial reasons behind these decisions.

And, following Russia's invasion of Ukraine, it was hard to see how Russian assets could be deemed a sound financial investment against a backdrop of sanctions and detachment from international trading relationships and the global financial system – so we acted accordingly. While we noted the moral context of that event, our decisions were based on the best long-term financial interests of the scheme, rather than that context itself or the views of individual members.

However, Russia’s invasion of Ukraine also reinforced the role the defence industry sadly has to play in protecting freedoms and supporting geo-political stability. It is a sector that might not align with some of our members’ views, but (noting the exclusions given above) it is part of the investible universe.

The importance of diversification

The trustee is under a specific statutory duty to ensure the appropriate diversification of the scheme’s investment portfolio. Even if we could feasibly reflect all of the disparate views held by USS members, we would risk concentrating our investments in a way that we do not believe would be in the best long-term financial interests of the scheme. That is, it could amplify the financial impact of adverse events at a particular company or in a particular market or region.

If we were, for example, to start excluding government debt on the grounds that it (directly or indirectly) funds activities some members disagree with, we could substantially restrict our ability to diversify and invest.

The same would be true if we were to exclude or divest from companies or countries with implicit links to armed conflict. The Geneva Academy’s Rule of Law in Armed Conflict Online Portal (RULAC) currently monitors more than 110 armed conflicts across the world. We must instead look to individual governments, and the international community as a whole, to protect freedoms, support geo-political stability, and – more than anything – ensure peace prevails.

Engagement vs divestment

When it comes to exclusions or divestments, we need to strike a careful and considered balance. And, as an active, responsible steward of the scheme’s investments we believe engaging with companies and governments can be a far more effective tool for effecting positive change.

The reaction of the international community to the military coup in Myanmar, and the resultant change in investment outlook, prompted us to engage with relevant companies in our portfolio. Initially, we encouraged them to protect and assist local workers and withhold money from the junta. Ultimately, we encouraged them to withdraw entirely from the country.

The climate challenge is another case in point.

We believe the financial risks of not addressing climate change are legion. We have set out our ambition (and interim targets) for our investments to be Net Zero for carbon generation by 2050, if not before.

But we also believe that divesting our way to Net Zero would make no difference to the actual carbon emitted to the atmosphere and therefore would not address the climate challenge. In contrast, proactive engagement with the companies we invest in to drive positive change and shift their business as usual models does make a difference. We would rather be an investor with a seat at the table than have no influence.

While we recognise that fossil fuels have a role to play in the near term, they won’t have a role in the long term, so we must encourage the assets and markets we invest in to make the transition to a low-carbon future. We also know that some members hold strong views about investing in nuclear energy, but we recognise that it arguably has a part to play in achieving the transition to Net Zero.

Governments and regulators set the framework within which both businesses and individuals must operate. So, investors like ourselves, who have a long-term investment horizon have a responsibility to engage with governments and regulators, encouraging them to adopt policies and regulation that will benefit us all over the long-term.

Our legal duty

Given the diversity of views held, we recognise that the scheme won't invest as each individual member might choose to invest their own money if they wished to reflect their personal ethical views. But we are committed to being a responsible steward of the scheme’s investments and, true to our legal duty, will continue to invest in what we consider to be the best financial interests of the scheme’s members and beneficiaries, so we can pay members’ pensions now and long into the future.

¹We last surveyed USS members specifically to inform our approach to the ethical Investment Builder funds in late 2020 and early 2023. We ask about investment matters, including responsible investment, more often (at least annually) through our quarterly general surveys. In March 2023, USS asked a sample of active members (1,183 responses) how much they thought their pension fund should invest in a sustainable way, even if this potentially lowered the pension they would get in retirement. On a scale of 1 (not at all) to 7 (to the full extent) - 17% of members chose 1-2, 53% chose 3-5, and 30% chose 6-7.