What are my compliance obligations?

Pension scheme trustees are subject to various trusts law and fiduciary duties that they owe to their scheme beneficiaries.

These duties require trustees to:

  • exercise their investment powers for their “proper purposes”, namely the provision of members’ pensions
  • take account of factors that are “relevant” to that purpose – usually those that are financially material (this may be consideration of risks as well as returns), and
  • do so in accordance with the “prudent person” test. Broadly this is the principle that trustee investment powers must be exercised with the care, skill and diligence a prudent person would exercise when dealing with investments for someone who they feel “morally bound to provide”.

Debate and commentary on the issue of fiduciary duty has continued ever since the Law Commission’s 2014 report, Fiduciary duties of investment intermediaries (the Law Commission Report), with increasing focus in some quarters on the need for reform and what that might look like.

Relevant factors: ‘financial’ and ‘non-financial’

It is trite law to say that trustees must take account of all “relevant” factors in their investment decisions. Factors that are “relevant” in this context may include those that could either enhance or detract from expected returns, as well as those that may increase or decrease risk. Such factors are typically referred to as being “financially material”.

With regard to ESG, it is now widely recognised that the physical risks of climate change and the UK’s transition to a lower-carbon economy could pose significant financial risks to pension schemes. When these risks are financially material to a scheme, trustees should take them into account in their investment decisions, in line with their fiduciary duties.

The distinction between financial factors which trustees are legally able to take into account and “non-financial” factors (which they generally cannot) can become blurred. Trustees cannot make investment decisions solely to express their disapproval of unethical behaviour by a company. However, in some cases that same conduct may be considered to impact the longer-term financial prospects of the company in question and so could become a relevant financial factor to consider.

A checkpoint for trustees is to ask themselves what their real motive is in deciding whether to take a factor into account in their investment decision-making. This will be instructive as to whether trustees are acting on a financial factor or something else.

The grey area

Where things can become particularly tricky is when trustees start to consider broader issues such as systemic market risks and the quality of life of beneficiaries. Arguably, both of these could be relevant factors in investment decision-making.

Well-functioning markets and a stable global environment ought to be in the best financial interests of pension funds and their members. And many will argue that this alone should legitimise trustees adopting strategies such as rapid de-carbonisation or impact investment, even if there’s some negative financial impact in doing so.

But there’s a problem of causality. Is it really credible for one board of trustees to base their investment decision-making on a premise that the external impact of investments will bring about a tangible benefit to the scheme and its members in ways other than the direct financial performance of the investments themselves? What if each trustee board is just too small to make a difference with its own investments?

This question was partially addressed in the Law Commission Report, but the view expressed was that for a decision to be justified on financial grounds, the anticipated benefits to the portfolio should outweigh the likely costs to the portfolio. In other words, the financial benefit must not be “too remote and insubstantial” and must accrue to the fund itself, not to the social good in a more general way.

This was referenced by the Financial Markets Law Committee (FMLC) in their report, Pension Fund Trustees and Fiduciary Duties – Decision-making in the context of Sustainability and the subject of Climate Change (the FMLC Paper). It stated that while some “wider economic or systemic climate change-related issues may have been characterised as ‘too remote and insubstantial’ in the past, pension fund trustees will need to reappraise this in a context where, for example, physical, transition and litigation risks are now apparent and material”.

But the FMLC stopped short of saying that trustees might be able to prioritise external impact over more direct risk and return considerations.

Parallel areas of the financial system

It’s fair to say that the pensions industry has generally been cautious of tinkering with trustee fiduciary duties, but one does not have to look too far to see developments in parallel areas.

Suggestions have been raised in relation to company law in the proposed Better Business Act. This act sets out a reform to UK legislation aimed at changing the way companies operate by integrating social and environmental responsibilities into their core duties.

The initiative, led by a coalition of over 500 businesses, organisations, and individuals, seeks to amend s.172 of the UK Companies Act 2006 to ensure that companies not only prioritise shareholder interests but also consider the needs of stakeholders such as employees, communities, and the environment. Could a similar wider duty be imposed on pension trustees?

In addition, on the continent, amendments to the Institutions for Occupational Retirement Provision Directive (EU) 2016/2341 (IORP II) have also included updating the prudent person rule to ensure the consideration of sustainability preferences of members and beneficiaries in the investment decisions for institutions for occupational retirement provision. Although now not directly applicable to the UK, it’s interesting to see how the issue is developing elsewhere.

Productive finance is a concept firmly on the Government’s agenda. In general terms it relates to providing equity and funding to UK businesses in order to grow the economy. The Mansion House speech led to a package of reforms focused on bolstering investment in the UK, with pension schemes playing a key role in achieving this aim. The reforms seek to “increase returns for pensioners, improve outcomes for investors and unlock capital for our growth businesses”.

How more investment in productive finance is going to materialise is still to be seen but it raises the question of how does such investment interplay with a trustee’s fiduciary duty to invest in the best interests of scheme members?

Elsewhere various civil society groups have noted the obligation under regulation 4(2)(a) of the Occupational Pension Schemes (Investment) Regulations 2005 that pension scheme assets “must be invested in the best interests of members and beneficiaries” and questioned whether it is really in members best interests that their pension savings be channelled in businesses that will degrade the environment into which they hope to retire.

It is perhaps not too big a leap to envisage further legislation prescribing additional factors that trustees might consider when determining what is in scheme members’ best interests.

For details on how fiduciary duty thinking is developing and where reform may be heading, see Fiduciary duty – evolution and reform