Summary and implications

The Law Commission has issued its report on the fiduciary duties of investment intermediaries (the Report). The focus of the Report is on pension scheme trustees but it also includes some recommendations in relation to contract-based schemes.

The Report contains specific guidance (with the title "Is it always about the money?") for pension scheme trustees on their duties when setting their investment strategy (the Guidance). It recommends that the Guidance should be disseminated to trustees, endorsed by the Pensions Regulator and, in the longer term, included in a Code of Practice. The Guidance particularly focuses on the extent to which environmental, social or governance (ESG) factors should be taken into account. Key points in the Guidance include the following:

  • The primary purpose of pension trustee investment powers is "to secure the best realistic return over the long term, given the need to control for risks".
  • Trustees should always take into account financial factors. Not simply to maximise returns but to balance risk against return.
  • Non-financial factors may be taken into account where trustees have good reason to believe that this reflects the view of the members and there will be no significant financial detriment. This raises the possibility of trustees consulting with members on certain aspects of their investment strategy.  

Although not legally binding, the Guidance does give trustees a helpful structure to follow when considering investment strategy, particularly where ESG factors come into play, and trustees should not be criticised for taking it into account. Trustees may wish to discuss with their investment advisers whether, in the light of the Guidance, they should be reviewing their Statement of Investment Principles (SIP) or any aspect of their investment strategy.

A brief reminder of trustee investment duties 

Trustees must act in the best interests of the beneficiaries and in accordance with the purpose for which the trust was created. In a DB pension scheme, this means generating sufficient returns from the assets to provide the promised benefits (or in a DC scheme to maximise each member's pension pot). Most trust deeds will include an express power of investment which may set restrictions on how trustees can fulfil their investment duty.

Legislation also prescribes certain investment requirements, including one that trustees exercise their investment powers in a manner "calculated to ensure the security, quality, liquidity and profitability of the portfolio as a whole".  

Within the confines of trust law, the trust deed and legislation, trustees should exercise their discretion over investments, balancing risk against return, to achieve the purpose of the trust. Trustees must not fetter their discretion by applying a rigid policy, must consider all relevant circumstances and must take appropriate advice.

The vast majority of pension scheme trustees will delegate day-to-day investment decisions to fund managers but it must be the trustees who set the overall investment strategy.

Financial factors: always relevant

The Guidance confirms that trustees must always take into account financial factors when formulating their investment strategy. This is not just a question of maximising returns. They must balance risk against return. Relevant risks will include questions about a company's long term sustainability. It is in this context that ESG factors may be financially material and so should be taken into account.

An ESG factor may be financially material where the controversial nature of the company's business (for example the nature of its products or the manner in which it treats it suppliers) or the manner in which the business operates (a poor safety record or a bad reputation for customer service) is sufficient to raise questions over its long-term sustainability. If this is the case then the Report concludes that "there is no impediment to trustees taking into account ESG factors where they are, or may be financially material". It is at the trustees' discretion, acting on proper advice, to evaluate which risks are financially material and how to take them into account. 

Non-financial factors: may be relevant

Non-financial factors are described in the report as "factors which might influence investment decisions motivated by other concerns, such as improving members' quality of life or showing disapproval of certain industries". The improvement in quality of life might include general ESG considerations, not just factors relating to a particular group of members.

The Guidance considers that non-financial factors should always be subordinate to financial factors but that trustees may take them into account where:

  • they have a good reason to think members would share the concern; and
  • the decision should not involve a risk of significant financial detriment to the fund.

The first of these points raises perhaps the most interesting issues about how trustees should decide whether members would share the concern (or welcome the lifestyle benefit). There is no single test laid down in the Guidance. Trustees must apply their minds to the particular issue and come to a decision in a reasonable way.

In some extreme cases – for example, where the activities of a company contravene international conventions – trustees may make assumptions about the members' views and could conclude, in the absence of any express objections, that the members would not welcome an investment being made. In other less clear-cut cases trustees should consider consulting members directly. The Guidance states that there does not need to be 100 per cent agreement – where a "majority agree while the rest remain neutral, that may be enough" although where there is a vocal minority then trustees should focus on the financial factors alone.

There is no legal requirement for trustees to consider member views but they should only take non-financial matters into account if they reflect the views of the members rather than the trustees.

The Guidance allows two exceptions where a decision is permitted which puts the scheme at risk of a financial detriment. First, where it is allowed by the trust deed. This might be where the trust deed expressly prohibits investment in a particular asset class. Second, in a DC scheme where the member has chosen the fund as long as there was a clear understanding that the investment choice could lead to a lower return.

Stewardship and engagement

There is currently no legal duty on pension scheme trustees, or on their investment advisers (although they do have some obligations under the Stewardship Code), to undertake stewardship activities in relation to the companies in which they invest.

The Report concludes that it is in the interests of pension schemes to promote the long-term success of the companies and one way to do this is by direct engagement with the company. It proposes a new requirement that the SIP should include a statement on the trustees' policy on stewardship. Trustees should disclose whether they intend directly, or through their investment managers, to exercise voting rights and how this will be done.  

Practical steps for trustees

As mentioned above, trustees may take the Guidance into account with immediate effect and discuss with their investment advisers whether they should be reviewing SIP or any aspect of their investment strategy, particularly in relation to ESG factors. As part of this review, trustees who wish to rule out any particular investment or asset class will need to consider what the views of the members are and what, if any, steps they should be taking to canvass those views.   

There is no requirement, based on the Guidance, to undertake an immediate review of current investments. 

DC schemes

The Guidance does not make many specific recommendations in relation to DC schemes. The Report does however refer with approval to the Government's proposals for improved DC governance which were published in March and outlined here.

The Law Commission sees no reason, in principle, why members' interests in contract-based default funds should differ from those in DC trust-based default funds. It recommends that the independent governance committees to be established by pension providers under the Government's proposals from April 2015 should owe a non-excludable statutory duty to scheme members to act, with reasonable care and skill, in members' interests.

Suggested changes to legislation

The Report itself recommends that the Government considers three changes to legislation in order to facilitate its proposals:

  • Revising the provisions in the Investment Regulations on social, environmental or ethical considerations to take account of the Report's recommendations on financial and non-financial factors.
  • Widening the general investment duties in the Investment Regulations to schemes with fewer than 100 members.
  • Requiring trustees to state their policy (if any) on stewardship.

 The Report and Guidance can be found here.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.