The Law Commission’s report highlights the ever greater role of environmental, social and governance factors in investment. Trustees will increasingly need to engage with members on these issues.
The extent to which pension funds should invest purely for profit has been on the political agenda for decades. In recent years this has moved away from traditional moral concerns (e.g. alcohol and gambling) into the environmental and social impact of investments.
The accepted legal position has long been that trustees' overriding concern must be the financial interests of their scheme’s members. That is increasingly changing and the Law Commission's latest report (June 2017) continues this trend.
The traditional view – investment return is the bottom line
The incorporation of “Environmental, Social and Governance” factors (ESG Factors) into trustees’ investment obligations is not new. The Regulator’s “Code of Practice” for defined contribution pension schemes includes guides for trustees on compliance.
The investment guide specifically requires trustees to consider ESG where they believe it is “financially relevant”. This ties in with the Law Commission's view in a previous report on the issue from 2014 – trustees could invest according to ESG principles where there was an underlying financial incentive to do so.
The financial consequences of ESG factors can be keenly felt through risk to the sponsoring employer where investment information enters the public domain. An obvious example would be a health charity’s pension fund investing in tobacco - news of this would likely cause a decline in donations.
A change of climate – ESG factors coming into their own
The Law Commission’s role is to review the law on particular areas and make recommendations for improvement. However, the Regulator explicitly refers trustees to the Commission’s 2014 report on the issue of factors in investment decision-making, giving it extra weight. The recent 2017 report may well receive similar treatment in due course.
It was acknowledged in the 2014 report that trustees could make an investment decision based on “non-financial” (e.g. ESG) factors if:
- they were confident that a majority of members supported such a decision and none were opposed to it
- it would not involve a risk of significant financial detriment to the scheme.
It was thought this would apply where the majority of members oppose an investment on ESG grounds and the rest remain neutral. There was no real guidance on how members’ support might be gauged in practical terms, especially since many members have no notion of how their pension fund is invested. Even obtaining a response from a majority of members could prove arduous.
The 2017 report represents a subtle, but significant move away from this position. It states that if trustees consult members on whether to prioritise an ESG factor, a simple majority of the responding members in favour and an absence of explicit opposition, will be sufficient to justify an investment.
The implications for trustees
The implications of this development are worth considering. It further opens up pension scheme investment in a range of social enterprises, particularly infrastructure, and much of the report is devoted to the practicalities of how pension schemes would go about this.
However, the key concern of the 2017 report is to increase member engagement with schemes on questions of ESG and investment. Its proposals to involve members will have a major impact on trustees if they come into force. Trustees may be required to develop a full policy on long-term investment risk relating to ESG factors, as part of their Statement of Investment Principles. Even if this proposal is not taken forward, it might still be best practice. The ability to point to a formal policy will provide some protection from activists opposed to certain investments seeking to undermine relations with scheme members.
Possibly the most significant proposal is an obligation on trustees to ascertain members’ views regarding social investment, which would then shape investment strategy. The precise details of how this would be implemented remain to be seen. However, it is likely that trustees would need to maintain an ongoing dialogue, regularly seeking members’ input. Given how difficult some schemes find it to engage the interest of members, this could prove challenging in practice.
These proposals further increase the importance of ESG. Rather than looking for financial justifications to make an ESG-focussed investment, trustees may soon need to consider whether there are financial reasons not to.