In the October 2014 edition of Pensions Pieces we gave an update on the Law Commission's consultation on fiduciary duties of investment intermediaries and outlined the key findings in its report following that consultation. The Department for Work and Pensions ('DWP') has now focused on two key themes emerging from that report, namely:
- The difference between financial and non financial factors when taking decisions about investments; and
- The role that a 'stewardship' approach can play when making decisions about investments and has now issued a consultation on proposed changes to the Investment Regulations1 to cover these areas.
Investments – 'financial' and 'non financial' factors
Trustees are, subject to certain exceptions, legally required to set out their investment strategy in a statement of investment principles. The DWP is consulting on amendments to the required content in relation to each of these issues in such statements aimed at focusing trustees' minds and providing some clarity as to what trustees should be considering in this regard.
As discussed in our previous articles on the Law Commission's review referred to above, the question as to what should be considered when making pension scheme investments (and the weighting that can be given to financial and non financial factors) has traditionally been a difficult one for trustees, particularly where an investment may appeal e.g. for ethical reasons but may not have the prospect of producing the best returns. The Law Commission in its review concluded, amongst other things, that
- Trustees should take into account factors which are material to the performance of an investment, including over the long term and where the trustees think that ethical or environmental, social or governance ('ESG') issues are financially material they should take them into account.
- even though pursuing financial return should be trustees' predominant concern, the law was sufficiently flexible to allow other non financial concerns to be taken into account as long as trustees have good reason to think that scheme members share this view and there is no risk of significant financial detriment to the pension scheme.
The Law Commission recommended (amongst other things) that the Government should review certain areas including the reference to ESG as one of the matters to be included in the statement of investment principles to ensure it accurately reflects the distinction between financial and non financial factors.
The consultation picks up on this and is seeking views on how the Investment Regulations should be amended in light of the Law Commission's recommendations. More particularly one of the questions raised is on the extent to which trustees should be required to state their policy on:
- how they evaluate their long term investment policy, including ESG and other factors which may be financially material to the performance of scheme investments; and
- determining whether and in what circumstances it would be appropriate to make investment decisions on the basis of non financial factors.
Perhaps thankfully the DWP agrees with the Law Commission's view that the general law of fiduciary duties should not be codified (as this would likely to be a lengthy and complex process with possible unintended consequences and undermining the inherent flexibility in common law). However, the consultation says that it wants trustees to feel empowered to consider a wide range of factors when forming their investment strategies in line with the Law Commission's findings.
Trustees are already required to disclose, in their statement of investment principle ('SIP'), the extent (if at all) to which social, environmental or ethical considerations are taken into account in the selection, retention and realisation of investments, but the disclosures proposed go further in the detail that would be required of trustees. The extent to which this will affect trustee behaviours in the investments they make is questionable, particularly given their primary duty still being to administer the scheme by acting in its best financial interests. Indeed, trustees might be nervous of giving any inference in their disclosures that there are circumstances in which non financial factors would carry more weight which would open them up to censure if the investments in question failed.
Stewardship – to what extent should trustees be getting involved in the companies in which they invest ?
The consultation mentions that the Law Commission review (and indeed the Kay Review which preceded it) commented on the value of investors having a meaningful relationship with the companies in which they invest. On this question, the Government is consulting on whether or not trustees should be required to state, in their statement of investment principles :
- that they have signed up to the UK Stewardship Code or explained why they thought it was not relevant to them; and
- if they have signed up to the Code, how they comply with its principles or explain on what grounds their approach departs from these principles.
The UK Stewardship Code sets out principles of effective stewardship by investors and is directed at asset managers and asset owners. The code is primarily directed at investment managers who act on behalf of asset owners, but asset owners, such as pension funds are also strongly encouraged to report if and how they have complied with the Code's principles. Signatories to the Code are required to explain how they implement the seven principles and guidance of the Code which apply on a 'comply or explain' basis – i.e. any non compliance needs to be explained. The Code explains that effective stewardship includes engaging with companies on very direct issues affecting the company such as strategy, remuneration, corporate governance and capital structure. It does not apply to schemes that have no direct investments in equities such as those invested entirely in an insurance policy.
The consultation asks whether or not amending the Investment Regulations to require trustees to comply with the current requirements of the Stewardship Code (or explain why they have not done so) is the most appropriate way of implementing the Law Commission's recommendations that trustees should be encouraged to consider whether and how to engage with companies in which they invest to promote their long-term success and whether there should be a specific requirement for the SIP to contain a statement of the trustees' policy (if any) on stewardship. While the sentiment of such proposed trustee engagement is worthwhile, there could be some practical difficulties, such as whether or not trustees have sufficient resources and skills to be able to engage with the companies in which they have invested and any voting rights are often with the investment managers to whom investment duties have been delegated in any event. Requiring trustees to confirm whether or not they have signed up to the Code may lead to a box ticking type culture without implementing the spirit of what the Code is trying to achieve, which is better engagement and influencing behavioural change where that is felt necessary to improve standards.
The DWP also picks up on some other issues which the Law Commission's review raised. On these:
- Currently trustees of schemes with fewer than 100 members are exempt from certain requirements relating to how they choose their investments (under regulation 4 of the Investment Regulations). Following the Law Commission's suggestion that the Government should review this, the DWP has decided that removing this exemption is not necessary as its discussions with stakeholders suggest that such schemes appear to be complying with all or most of these requirements in any event, including as a result of general trust law. It also believes that the new DC governance standards2 introduced from April this year should improve behaviours in that context and particularly in relation to default funds which are specifically addressed in those provisions.
- The Law Commission also recommended that the Pensions Regulator should consider how the Law Commission's guidance on fiduciary duties should be given more prominence to assist trustees in their investment decisions. On this the Regulator has already updated its Trustee Toolkit in light of the Commission's findings and it is also updating its investment guidance as part of its review of DC publications to reflect the new DC governance and charges requirements and to supplement the Defined Benefit Code of Practice with more detailed guidance on investment strategy and integrated risk management.
The Government is keen to encourage the growth of new markets which allow investments to be made on the basis of financial and social returns. The consultation refers to the Law Commission's guidance as being useful for trustees when considering the range of factors they need to consider, including social factors, when determining what is financially material to the fund and on how trustees may make investment decisions based on non-financial factors.
The Consultation period closed on 24 April and we are waiting for the DWP's response in relation to the issues raised above. Clearly the Government, in light of the Law Commission's findings, is trying to find a more satisfactory way of clarifying the position in relation to financial and non-financial factors and stewardship in the context of trustee investment duties, without being overly prescriptive in attempting to codify the law of fiduciary duties which underpins pension scheme investment duties. We wait with interest to see how the DWP chooses to tackle these areas and whether or not what is proposed will give trustees enough clarity and confidence to be more actively involved in these areas.