Welcome to our latest briefing on topical issues facing occupational pension schemes in the risk and investment spheres.
A key theme for the past six months since our previous briefing has been the growth of ESG investing. This issue explores the growing influence of climate change on the industry, and the relevance of members’ views.
We also investigate some key recent developments in the bulk annuities space and how insurers are grappling with GMP equalisation.
CMS Pensions Investment and Risk Briefing October 2021 Briefing Note prepared by London Cannon Place | Investment and Risk 2 Welcome to our latest briefing on topical issues facing occupational pension schemes in the risk and investment spheres. A key theme for the past six months since our previous briefing has been the growth of ESG investing. This issue explores the growing influence of climate change on the industry, and the relevance of members’ views. We also investigate some key recent developments in the bulk annuities space and how insurers are grappling with GMP equalisation. Contents: GMP equalisation – recent developments in the bulk annuity market .................................................... 3 Member engagement on investment – what does it mean for Trustees? ............................................... 5 Butler-Sloss and ethically-motivated investing for charities .................................................................... 7 Also in the news....................................................................................................................................... 9 Please get in touch with one of us or your usual CMS contact if you would like to discuss anything further. Dominic Harris Partner – Solicitor Advocate T +44 20 7367 3361 E [email protected] James Parker Partner T +44 20 7367 3316 E [email protected] Pete Coyne Partner T +44 20 7367 2748 E [email protected] Laura McLaughlin Senior Associate T +44 20 7367 3316 E [email protected] Chris Ransom Senior Associate T +44 20 7524 6189 E [email protected] Alexander Waters Associate T +44 20 7524 6272 E [email protected] Briefing Note prepared by London Cannon Place | Investment and Risk 3 GMP equalisation – recent developments in the bulk annuity market The Lloyds Bank case in 2018 and subsequent hearings clarified key elements of trustees’ duties in relation to GMP equalisation. Broadly, two types of methodology were found to be lawful: ‘dual records’ approaches where members’ benefits need to be checked year-on-year against an opposite-sex comparator’s, and one-off approaches where members receive a one-off adjustment calculated by the scheme actuary. The Lloyds Bank judgments have given schemes and insurers some level of certainty regarding the lawful approaches to GMP equalisation and the market has continued to develop to accommodate this. As more and more schemes are preparing to approach the insurance market, understanding how your GMP equalisation project might interact with a buy-in and any subsequent buy-out has never been more important. From a trustee/sponsor perspective, showing that you have thought about the issue of GMP equalisation, have taken advice on it and have a plan to deal with it is going to put you in a much better place when approaching the buy-in market. Timing Immediately following the first Lloyds Bank case, schemes who were purchasing insurance typically completed GMP equalisation exercises during the ‘data cleansing’ period after buy-in – i.e. after the trustees had a scheme-wide insurance policy in place and as part of the process of reconciling benefits with the insurer. Now that there has been more time for the industry to assimilate the judgment we are increasingly seeing schemes carrying out all or some of their GMP equalisation project before purchasing a buy-in insurance policy; insurers may be able to accommodate either approach. The advantage of completing the project before obtaining insurance can be that the ‘data cleanse’ process may be more straightforward, but it is essential to get appropriate legal and actuarial advice on the best way to approach the project if this is being done. Many schemes continue to complete equalisation during the data cleansing period, so trustees shouldn’t be concerned if it has not been completed before then. The GMP equalisation project must be completed before benefits are bought out (when individual insurance policies are issued to members and the pension scheme no longer provides those insured benefits). Key points to note: ― Many schemes are now completing a GMP equalisation exercise before approaching the market for buy-in and buy-out; this will yield practical advantages to schemes provided that they have had appropriate legal and actuarial advice. ― The method of equalisation could affect schemes’ attractiveness to insurers and schemes with a simpler benefit structure are likely to be looked on more favourably. ― Wide-ranging insurance cover can provide comfort to trustees for potentially unforeseen liabilities, but the exact terms of the insurance should be carefully checked. Briefing Note prepared by London Cannon Place | Investment and Risk 4 What method will insurers accept? A scheme is more likely to be attractive to insurers if the methodology chosen is more straightforward to operate and, in the case of GMP conversion, results in more straightforward benefits to price and administer. In general insurers have previously preferred to insure schemes where a ‘one-off’ approach to equalisation has been taken using GMP conversion, which is a statutory method that also allows other adjustments to benefits in some instances. However, we are seeing insurers increasingly able to insure benefits that have been equalised using a dual-records method, as insurers’ capability to deal with the more complex administrative aspects of dual-records methods has developed. Residual risks insurance Residual risks’ (also known as ‘additional risks or ‘all risks’) cover may be offered by the insurer as part of the buy-out to cover trustees for certain liabilities following the buyout and winding up of the scheme. The cover is typically focussed on liabilities relating to benefit payments after buy-out, such as missing beneficiaries or incorrect benefits having been insured. A number of insurers can insure the risk that the GMP equalisation methodology chosen by the trustees is later found to be invalid – for example because of a future change of law - and/or that the way in which GMP equalisation has been implemented is incorrect. Insurers will want comfort that the trustees have taken appropriate advice, including legal and actuarial advice, in relation to the GMP equalisation project and considered their fiduciary duties, and may ask to see copies of any advice received and records of decisions made by the trustees and (where sponsor approval is needed as part of GMP equalisation) the scheme sponsor. If implementation risk is being insured the insurer will want to carry out its own independent checks of any calculations carried out by the trustees’ advisers. Residual risks insurance is unlikely to cover anything relating to past liability. For example, back-payments due to members for past underpayments due to not having carried out GMP equalisation and the requirement to correct past transfers out are unlikely to be covered. Run-off insurance purchased from a non-life insurer may cover some aspects not included as part of any residual risks insurance. Briefing Note prepared by London Cannon Place | Investment and Risk 5 Member engagement on investment – what does it mean for Trustees? The continued focus on ESG issues for pension schemes has raised a secondary and arguably broader issue around the extent to which Trustees should be engaging with their members in relation to investment issues. The answer to this is by no means straightforward. There is no specific legal requirement for Trustees to engage with members and actively seek views on investment issues. Nevertheless, a number of recent developments have put the spotlight on this, meaning member engagement in investment issues is an area requiring increasing consideration by Trustees. Where are we now? The past few years have seen the introduction of various new mandatory reporting requirements for pension schemes’ investment activity. Regulations now require defined benefit and defined contribution pension schemes to publicly report on a host of new areas including: (1) the Trustees’ approach on the extent to which “non-financial matters” (including the views of members and beneficiaries) are taken into account in investment, (2) the Trustees’ policy on “undertaking engagement activities” in respect of investments including engagement with investee firms and the exercise of voting rights and (3) an optional policy on a separate ‘statement on member’s views’ in the scheme’s statement of investment principles. Despite that, there is still no legal requirement for trustees to take into account members’ views when making their investment decisions. Nonetheless, these recent changes point in one direction; greater visibility of investment issues and bringing the membership of a pension scheme closer to the investment of its assets. However, what this means in practice for Trustees will depend heavily on the nature of their scheme and, in particular whether the scheme is defined benefit (where members are not directly exposed to investment risk) or defined contribution (where they are). Issues to think about Ensuring that members are engaged and aware of the value of their pension is a positive for all. However, facilitating direct engagement with members on their views in relation to investment and then accommodating those views raises a number of legal issues. Briefing Note prepared by London Cannon Place | Investment and Risk 6 To what extent are Trustees legally able to take into account non-financial matters when determining investment strategy Trustees should take into account financially material factors when making investment decisions (and ESG issues often are financially material), but there are limited circumstances where a nonfinancial factor can be determinative. Our previous Investment and Risk briefing earlier this year discussed the Palestine Solidarity judgment and the 2-stage test the court focussed on here (based on one suggested by the Law Commission) for Trustees to make a decision based on nonfinancial matters - (1) Trustees should have good reason to think that scheme members would share the concern; and (2) the decision should not involve the risk of significant financial detriment. However, in our view this case is not good authority for the trustees of occupational schemes to start using non-financial factors, and even if it were the practicalities of using the test do not make it an easy hurdle for trustees to jump. As such, trustees need to take care in allowing any non-financial factors to influence or determine an investment decision, particularly in a defined benefit scheme where the role of any employer in supporting the scheme should not be overlooked. How can Trustees be clear that the views being presented are representative of the membership? One of the practical issues with the 2 stage test, outlined in 1 above, is how can Trustees be sure that all scheme members share a particular concern? Trustees are unlikely to be able to gauge the views of all of the scheme membership and need to ensure that opinions of more vocal or impassioned members do not dominate the agenda. What about voting rights? This is an area of increasing focus. The report from the Taskforce on Pension Scheme Voting Implementation recently published by the DWP sets out a number of recommendations for overhaul in pension scheme voting and we are already seeing changes in the market through providers such as Tumelo, which facilitate a forum for members to submit views on how they would like asset managers holding their pension scheme assets to vote. It is clear that we are likely to see increased activity in this particular aspect of engagement in investment issues but as the Taskforce’s report acknowledges there are a number of challenges here particularly given the structure of the ownership of investments. Allowing members greater input in investment may raise expectations around information that will be provided Facilitating member engagement may create further expectations around the information schemes provide. Schemes may come under pressure from members to release more detailed information about the investment approach being taken. The Pensions Ombudsman’s decision in the Shell Contributory Pension Fund (PO-27469) is helpful in confirming that pension schemes need only provide the information that they are required to disclose under the legislation. Care should be taken with the content and tone any communications to members Trustees should ensure that they consider any data protection issues in relation to using member data for the purposes of surveying views on investment. It’s worth particularly being aware of the Privacy and Electronic Communications (EC Directive) Regulations 2003 where communications are being sent electronically, as the very broad concept of what constitutes marketing under these Regulations means they could apply to these sorts of communications. There’s certainly lots to think about here and this is an issue that seems likely to only gain greater prominence. This is particularly given the reference in the current draft of the Pension Regulator’s single code of practice to the fact that when preparing their statement of investment principles, Trustees “should….take into account the types of investments scheme members prefer”. If this wording is carried over into the final form of the code this could move the dial further by introducing what looks much more like a requirement for Trustees to accommodate members’ views when considering investment strategy. Briefing Note prepared by London Cannon Place | Investment and Risk 7 Butler-Sloss and ethically-motivated investing for charities In May, the High Court granted permission to the trustees of two environmental charities to ask the courts for declaratory relief on whether they could adopt an ethical investment approach. We are now awaiting a substantive decision which could alter trust law investment duties. The proceedings This was effectively an interim application, but it foreshadows what could be some significant developments around trustees’ investment duties. Here, two charities needed to get the Charity Commission’s consent to apply to court to approve an ethical investment approach. The charities wanted to adopt investment policies aimed at excluding investments that did not align with the Paris Agreement on climate change. The concern about doing so without the court’s permission was that it might be an unlawful breach of their investment duties to pursue a policy that was likely, in the short term, to result in lower investment returns. The Charity Commission did not give their consent to the court application (they said that they were going to bring forward new guidance on the topic which might mitigate the need for it), so the charities proceeded to make the application. The judge granted the application. During the course of the judgment, he said the leading case in the field for charities - The Bishop of Oxford Case – was thirty years old and things have considerably moved in terms of ethical investment policies and the severe impact of climate change. Trustee duties in this area could therefore be ripe for review. The Paris Agreement The Paris Agreement was drawn up in 2015 and signed in 2016 by over 190 countries. The overarching aim is the limit the rise on mean global temperature to below 2 degrees centigrade and preferably limit it to 1.5 degrees. The charity trustees in this case were looking to fall in line with the Paris Agreement; pension scheme trustees could be faced with similar concerns in due course. As of October 2021, the largest pension schemes have been under obligations to make climate-related financial disclosures (as well as other climate-related obligations). These obligations do not currently include the requirement to measure how aligned a scheme’s portfolio is to the Paris Agreement by reporting on its implied temperature rise, or ‘ITR’, as the government has recognised methodologies for producing the data are insufficient. However, the government have expressed an intention to consult on ITR in future, so this could form part of trustees’ disclosure duties in the medium-term. Briefing Note prepared by London Cannon Place | Investment and Risk 8 How Could the law change? Trustees currently have to be circumspect about taking into account non-financial factors when investing, for fear of breaching their fiduciary duties. Currently: ⎯ In a pensions context, the case of Cowan v Scargill indicates the financial interests of beneficiaries are overriding, and ⎯ only in exceptional cases can beneficiaries’ views be taken into account. For charities, the Bishop of Oxford Case held that the position is very similar, and the circumstances in which trustees could make financially disadvantageous investment decisions for ethical reasons were extremely limited. The Charity Commission are currently consulting on guidance for charity trustees, which indicates a relatively broad set of considerations (appearing to take into account non-financial factors) are relevant for trustees’ investment decisions. Interestingly, in the Butler-Sloss case the charities queried whether this guidance would conflict with the current law. In its 2014 report on pension funds and social investment, the Law Commission indicated it thought the law allowed trustees to take into account non-financial factors when there was good reason to think members shared trustees’ concerns about non-financial factors, and there would be no risk of significant financial detriment to the scheme if acted on. However, the Law Commission’s report is not a definitive statement of the law as it stands. This case could decide whether the Law Commission’s “2 stage test” is good law, and how it should operate in practice. Key point to note: Although this case stemmed from an application from charity trustees, it could have implications for pension schemes as well. The decision could prompt future changes in investment duties and permit trustee to adopt ethical investment approaches in keeping with their beliefs and their membership’s beliefs, even if it could result in lower returns. Briefing Note prepared by London Cannon Place | Investment and Risk 9 Also in the news CMS Pensions LawCast We continue to add new content to the CMS Pensions LawCast video and podcast series. Click here to view our latest LawCasts (Pension Schemes Act: information sharing and pensions disputes resolution) as well as earlier topical episodes including equality, diversity and inclusion and ESG issues. The Pension Schemes Act 2021 The Pension Schemes Act 2021 is perhaps the most significant piece of UK pensions legislation in the 17 years since the Pensions Act 2004. It broadens the powers of the Pensions Regulator even further, introduces certain criminal offences that are drafted in a very broad manner and sets in motion a whole host of other initiatives. Many of these new powers, but not all, came into force on 1 October 2021. To coincide with the implementation of the Pension Schemes Act 2021 we have updated our Interactive Guide which you can access here . Your free online legal information service. A subscription service for legal articles on a variety of topics delivered by email. cms-lawnow.com The information held in this publication is for general purposes and guidance only and does not purport to constitute legal or professional advice. CMS Legal Services EEIG (CMS EEIG) is a European Economic Interest Grouping that coordinates an organisation of independent law firms. 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