Welcome to our winter edition of Investor Agenda.
It has been a busy year on the investment front with the CMA order to implement and a focus on ESG and stewardship in new legislation. In this edition we pick up on the new requirement to have defined objectives for investment consultants by 10 December 2019, and describe what we are seeing trustees do in practice to comply. We also include a summary of the new UK Stewardship Code and how trustees might respond in practice.
We have continued to watch developments with the Woodford funds and include a couple of updates (including how the FCA has responded); and finally with all this activity in specific areas it is easy to get distracted – so we have included a “back to basics†article as reminder of the fundamentals of the law relating to pension fund investment.
We hope you enjoy this edition of Investor Agenda – if you have any queries or topics you would like to suggest, please do get in touch.
In the meantime, best wishes from the Linklaters team for the festive season and a successful New Year.
Rosalind Knowles Partner
Pensions Investment Practice: Investor Agenda
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Revised UK Stewardship Code
The Financial Reporting Council has now published its revised UK Stewardship Code, which sets out more rigorous reporting requirements and higher expectations for investor stewardship policy and practice.
In the last edition of Investor Agenda, we mentioned that, from 1 October 2020, the new SIP requirements following the Shareholder’s Rights Directive II will kick in, requiring trustees to report on their arrangements with asset managers and their policies in relation to capital structure, conflicts of interest and other stakeholders.
The Stewardship Code is a voluntary Code to which trustees can decide to sign up, and its best practice requirements sit on top of the new changes coming in on 1 October 2020. It is published by the Financial Reporting Council and is intended to set high stewardship standards for asset owners (including pension scheme trustees).
The FRC first published the Code in 2010, and last revised it in 2012. The new Code takes effect on 1 January 2020, with the first reports due in 2021. The Code is structured around 12 principles, and it explains how signatories are expected to report against their application of each principle.
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Principle 5 Internal assurance
Principle 1 Investment beliefs
and strategy
Principle 9 Engagement
Principle 6 Beneficiary views
and needs
Principle 2 Governance
resources and incentives
Principle 10 Collaborative engagement
Principle 7 ESG issues
Principle 3 Conflicts of
interest
Principle 11 Escalating activities
Principle 8 Monitoring managers and service providers
Principle 4 Identification
of risks
Principle 12 Exercising rights
and responsibilities
The UK Stewardship Code 2020 is available in full here.
The Stewardship Code is a voluntary Code to which trustees can decide to sign up.
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> Signatories will be expected to take ESG factors, including climate change, into account and explain what processes they have used to integrate stewardship and investment, including material ESG issues, to align with the investment time horizons of beneficiaries (Principle 7).
> Signatories are now expected to explain how they have exercised stewardship across asset classes beyond listed equity, such as fixed income, private equity and infrastructure, and for investments outside the UK (Principle 12).
Do I need to be a signatory?
As mentioned above, the Code is voluntary and sets a standard higher than UK minimum legislative requirements on stewardship. There is no requirement to be a signatory to the Code, however, many large pension schemes who have more complex investment structures do decide to sign up to the Code.
What’s new?
The changes to the Code are broadly summarised as follows:
> The Code’s focus has been extended to include explicitly asset owners, such as pension funds and insurance companies, and service providers as well as asset managers. Service providers have their own separate principles in the Code; however, the main 12 principles are those likely to be applicable to pension scheme trustees.
> Signatories are required to report annually on stewardship activity and its outcomes in a Stewardship Report which should be publicly available.
> Signatories are required to explain their organisation’s purpose, investment beliefs, strategy and culture and how these enable them to practice stewardship. They are also expected to show how they are demonstrating this commitment through appropriate governance, resourcing and staff incentives (Principles 1 and 2).
> Signatories must explain how they have taken into account beneficiaries’ needs and sought beneficiaries’ views; how the needs of beneficiaries have been reflected in their stewardship; and what they have communicated to beneficiaries about their stewardship and investment activities (Principle 6).
Rebecca Fellas
Pensions Investment Practice: Investor Agenda
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CMA Order: setting objectives for investment consultants
We have previously reported on the requirements coming out of the Competition & Markets Authority’s (“CMAâ€) investigation into investment consultancy and fiduciary management services to pension scheme trustees, which led to an Order being published in June 2019. This update focuses on the requirements under the CMA’s Order to set objectives for investment consultants by 10 December 2019. We also take a look at developing practice amongst trustees and investment consultants as to what an appropriate set of objectives might look like.
What are the requirements under the CMA Order?
The Investment Consultancy and Fiduciary Management Market Investigation Order 2019 (the “CMA Orderâ€) came into force on 10 June 2019 and states that trustees must not continue to obtain investment consultancy services unless they have set strategic objectives for their investment consultant by 10 December 2019. The objectives must be defined by reference to the investment consultancy services being provided. The CMA Order defines these services as the provision of advice to trustees on one or more of:
> investments that may be made by the trustees;
> matters which trustees are required by law to seek advice in relation to their Statement of Investment Principles (“SIPâ€);
> strategic asset allocation; and
> manager selection.
As a minimum, trustees must set several strategic investment objectives for their investment consultant on this basis by the 10 December deadline. We comment further below on how we are seeing this applied in practice.
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Trustees are not required to take the DWP’s consultation into account when setting the objectives for their investment consultant for the 10 December 2019 deadline. However, trustees should be aware of the key points, as these will need to be factored in when the objectives are reviewed in 2020. In addition to the basic CMA Order requirements, DWP suggests that trustees should consider the following points when setting their objectives:
> objectives should have regard to the SIP;
> trustees should review performance of their investment consultant against the objectives at least every 12 months;
> trustees should review objectives every three years and without delay if any material changes to investments have been made;
> objectives can include service-related objectives and should not just be limited to investments; and
> objectives should define outcomes and performance which is measurable.
The Regulations will also require trustees to confirm compliance annually through the scheme return.
The DWP’s consultation is supplemented by draft guidance from the Pensions Regulator on setting objectives. The guidance suggests that trustees should set multiple objectives for their investment consultants to reflect the services received, that short and long-term objectives are appropriate and objectives can be quantitative and qualitative.
Who do the requirements apply to?
The requirement to set objectives applies to all trustees of UK based DC and DB occupational pension schemes who receive investment consultancy services.
We are aware of some concerns in the industry about the requirements applying to any third-party providers or advisers who provide advice to trustees which could amount to “investment consultancy servicesâ€. High-level commentary from the scheme actuary with regard to the link between a scheme’s investment approach and its funding objectives is explicitly excluded from the definition of investment consultancy services in the CMA Order. Any other investment-related advice from a scheme actuary should be tested against the definition of investment consultancy services above and legal advice sought if needed.
We do not consider that legal advice on investment matters would be caught by the definition of investment consultancy services. This is because such advice usually focuses on trustees’ investment duties and/or the implementation of an investment once a decision has been made to make the investment.
Is there any additional guidance that trustees should bear in mind?
The DWP published a consultation on draft regulations in July 2019 to integrate the CMA Order into pensions law. These regulations are due to come into force on 6 April 2020, at which point the CMA Order is intended to fall away.
The requirement to set objectives applies to all trustees of UK based DC and DB occupational pension schemes who receive investment consultancy services.
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scorecard†approach in line with the Regulator’s draft guidance, as there is insufficient time to agree such detailed objectives by the 10 December deadline (and it is not a legal requirement). In addition, we expect to see more detailed templates developed over the next 12 months by the pensions industry as the draft regulatory guidance is finalised.
Where objectives are being discussed and agreed at trustee meetings where investment consultants are present, trustees should be mindful of potential conflicts – a point flagged by the Regulator in its draft guidance. Trustees should of course seek input from their investment consultants to ensure objectives are realistic and achievable but may wish to agree them without consultants being present. Trustees may also want to seek independent professional advice on how their objectives comply with the CMA Order and developing best practice.
We suggest that trustees timetable a review of the objectives for their investment consultant from mid-2020 onwards, once the DWP regulations have come into force.
Gareth Craft
Perhaps the most useful aspect of the draft guidance is two case studies on DB and DC scheme objectives. The Regulator suggests objectives are grouped into categories which are given a scoring weighting depending on their importance to trustees and an investment consultant’s performance is then scored against these objectives (what the Regulator calls a “balanced scorecardâ€). We are seeing many investment consultants use the Regulator’s case studies as a starting point for their template objectives for trustees.
What are we seeing in practice?
It is still too early to identify definitive best practice for setting objectives so there is no consistency yet around what “good†looks like. Given timing is relatively tight, what we are seeing many trustees do for the 10 December 2019 deadline is put in place high level objectives which satisfy the minimum legal requirements under the CMA Order and looking to revisit during 2020 as more evidence of best practice emerges.
Trustees are tending to use investment consultants’ template objectives as a starting point for agreeing objectives for their schemes and these templates in turn tend to borrow heavily from the case studies in the Regulator’s draft guidance. The objectives we are seeing typically include investment and service-based objectives and include language around reviewing the objectives and testing performance in line with the draft DWP regulations.
We are not seeing many trustees (or consultants in their templates) attempting to adopt a more detailed “balanced
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Update on the Woodford funds
We reported in our Autumn Investor Agenda the closing of the Woodford Equity Income Fund to redemptions on 3 June 2019, and the ensuing news coverage. Following a sharp fall in the value of the fund, investors have had their cash trapped in the fund for the foreseeable future, and it is unclear how much their investment will be worth when (or if) they are able to withdraw it.
There have been a number of updates on the future of the affected Woodford funds, and we explain these below.
The Woodford Equity Income Fund closed to redemptions in June 2019, and the fund manager had announced that the suspension was likely to continue at least until December 2019. There have been three updates since the date of our Autumn Investor Agenda:
Winding up the Woodford Equity Income Fund
On 15 October 2019, Link Fund Solutions (the authorised corporate director of the Equity Income Fund) announced that the Woodford Equity Income Fund is being wound up. They also announced that they have been in discussions with the FCA in relation to the winding up, which is expected to commence in January 2020.
If a fund winds up, it will usually realise its assets, and less liquid assets will be sold over time on a gradual basis. The fund manager will settle any liabilities owed, cover the costs of winding up, and then investors will receive their share of the proceeds after covering costs and liabilities. Link Fund Solutions has said that it expects investors to receive their first payment of proceeds by the end of January 2020, but this could be subject to change. It is unclear how much of their original investment shareholders will receive back.
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Second Woodford fund frozen
The LF Woodford Income Focus Fund has also suspended dealing, after Woodford Investment Management Limited resigned from its role as investment manager on 15 October 2019. There is no current deadline for this suspension to end.
Woodford Investment Management resigns
On 15 October 2019, Woodford Investment Management Limited resigned from its role as investment manager for the Woodford Patient Capital Trust plc. It will work out its three-month notice period and will then be replaced.
Rebecca Fellas
Pensions Investment Practice: Investor Agenda
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On 30 September 2019 the FCA confirmed new rules which apply to certain types of open-ended funds investing in illiquid assets (eg property).
The new rules are set out in the FCA’s policy statement, available here.
The FCA comments in its policy statement that, following the suspension of the Woodford Equity Income Fund, it has a “renewed focus on illiquid assets held in open- ended fundsâ€, and is concerned about the levels of investor awareness around liquidity risks.
The FCA’s new rules reinforce the need for clear disclosure to investors regarding the implications of investing in illiquid (or less liquid) assets through open-ended fund structures. These rules apply to NURS (non-UCITS retail schemes), a type of open-ended vehicle which generally can invest in a broader range of asset classes than a UCITS and, as the name suggests, is not subject to the UCITS regime.
The FCA’s new rules require three main changes to the FCA Handbook for NURS:
> Risk management: fund managers must maintain plans to manage liquidity risk where they invest in inherently illiquid assets, and depositaries will have a duty to oversee the process for management of liquidity of the fund.
FCA confirms new rules for open-ended funds investing in illiquid assets in wake of Woodford suspension
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> Suspension of dealings: NURS holding property or other immovables must suspend dealing if there is a “material uncertainty†about the valuation of at least 20% of the property held, unless the depositary and authorised fund manager agree that to continue to deal is in the best interests of investors.
> Disclosure: there will be additional disclosure requirements on funds to set out their liquidity risk strategies, and a standard risk warning for promotional material.
The FCA is also introducing a new category of “funds investing in inherently illiquid assets†(FIIA). Funds that fall into this category will be subject to additional requirements, including those above, and will have to identify themselves as FIIAs.
These changes will directly affect the managers and parties involved in administration of these kinds of funds. However, trustees considering investment in an open-ended fund where the underlying investment is inherently illiquid, particularly property funds, should be aware of the new requirements, and the new FIIA designation, when different fund options are proposed.
Rebecca Fellas
Pensions Investment Practice: Investor Agenda
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Back to basics: pensions specific investment restrictions for trustees
Most trustees will be aware of the restrictions on pension scheme investments contained in the Pensions Act 1995 and underlying regulations. Now and again we like to do a “refresher†on the basics of pension scheme investment law.
The main restrictions on the types of investments trustees can make are contained in the Pensions Act 1995 and the Occupational Pension Schemes (Investment) Regulations 2005.
Trustees also have common law duties regarding their investment of pension scheme assets (eg the duty to invest trust assets, to act with prudence, to review investments periodically and to take advice).
Certain investment activities cannot be carried out by pension scheme trustees unless they are authorised by the FCA, pursuant to restrictions under FSMA 2000. We focus on the Pensions Act and Investment Regulations restrictions in this article to keep it brief.
In short, the main requirements are:
> To invest within the restrictions in the Investment Regulations.
> To prepare, maintain, and invest in line with, the Statement of Investment Principles.
> To obtain proper advice before investing in any manner.
> Not to invest in employer-related investments.
Breach of any of the statutory requirements can lead to civil penalties (or, in the case of certain employer-related investment activity, criminal sanctions).
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Statement of Investment Principles (SIP)
Trustees must prepare, maintain and review a SIP – a written statement of the investment principles governing investment decisions, and trustees must invest in line with the principles set out in the SIP.
The SIP must be reviewed at least every three years and without delay after any significant change in investment policy. Before preparing or revising the SIP, the Trustee must obtain and consider written investment advice and consult the employer. This advice may often be given by a different consultant or advisor to the person providing the “section 36 advice†– see below.
The SIP must set out the Trustee’s policy in relation to:
> securing compliance with the statutory requirements for choosing investments (described above);
> the kinds of investment to be held and the balance between different kinds of investments;
> risks, including the ways in which risks are to be measured and managed;
> the expected return on investments and the realisation of investments;
> how they take account of financially material considerations, including ESG factors (including climate change) in the selection, retention and realisation of investments;
Restrictions on types of investments: Investment Regulations
The Investment Regulations (made under the Pensions Act 1995) restrict how trustees invest scheme assets. In brief, trustees (and any fund manager to whom they delegate investment discretion) must:
1. invest assets in the best interests of members and beneficiaries;
2. exercise their power of investment in such a way as to ensure the security, quality,liquidity and profitability of the portfolio as a whole;
3. invest assets in a way that is appropriate to the nature, timing and duration of the expected benefits payable;
4. not borrow or act as a guarantor (except on a temporary basis for the purposes of providing liquidity);
5. make sure investments are predominantly admitted to trading on regulated markets;
6. properly diversify investments; and
7. only invest in derivatives to reduce risk or for efficient portfolio management.
The restrictions in 4, 5 and 7 most commonly come up in the context of discretionary management mandates or individual investments which have to be considered in light of the restrictions.
As mentioned below, trustees’ investment advisers or consultants will need to provide advice on individual investments in light of these restrictions.
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Delegation and duty of care
Trustees cannot exclude or restrict liability for failure to take care or exercise skill in the performance of any investment function, with one exception: a trustee can exclude itself from liability for acts or default of a fund manager when it has properly delegated its investment decisions under section 34 of the Pensions Act 1995.
Under section 34, a trustee can delegate “investment decisions†to either an FCA-authorised fund manager; or someone who acts as a fund manager but who does not need to be FCA-authorised.
If a trustee delegates under section 34 to a fund manager, the trustee is not responsible for the act or default of that fund manager to whom they have delegated investment decisions if the trustee has taken reasonable steps to satisfy themselves that:
> the manager has appropriate knowledge and experience for managing investments of the scheme and is carrying out his work competently; and
> is complying with section 36 (i.e. acting in accordance with the SIP and investing in accordance with the Investment Regulations).
Trustees should carry out suitable due diligence of their fund managers, discuss any appointments with their investment adviser and regularly review manager performance for competence.
> their policies in relation to the stewardship of investments, including engagement with investee firms and the exercise of the voting; and
> a statement on the extent to which (if at all) members’ views will be taken into account in preparing the SIP.
See our Autumn Investor Agenda for details on the requirements for the content of the SIP which changed from 1 October 2019, and new requirements applying from 1 October 2020.
Proper advice
Before investing in any manner, trustees must obtain and consider “proper advice†on the investment. That advice should confirm whether the investment is satisfactory having regard to the Investment Regulations and the SIP (both above). This advice is required by section 36 of the Pensions Act 1995, and as such this advice is often referred to as “section 36 adviceâ€.
Advice is usually sought when trustees are considering a particular investment, or when entering into a discretionary investment management arrangement, in addition to any legal advice being obtained. This advice will usually be provided by the trustees’ investment consultant, and sometimes by an investment manager where they are retained to do so. The person advising on the SIP and general investment strategy may be different from the person providing “section 36 adviceâ€.
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> Investment management agreements usually include an obligation on the manager to comply with its obligations under the Pensions Act 1995 and the Investment Regulations and to ensure managers act in good faith and with due skill, care and diligence. It is important to make sure that any investment management agreement contains an effective delegation of the trustees’ responsibilities.
> It is important that any delegations to fund managers and any investments are made in line with the SIP. Updates to the SIP should ideally be communicated to discretionary managers, if they are not already, to try to make sure that investments are aligned.
> When trustees are considering a specific investment structure, care should be taken to make sure that the restrictions in the Investment Regulations are complied with (i.e. that the investment does not constitute long- term borrowing or an employer-related investment). Investment advisers and legal advisers can help trustees take a view on this.
In practice, trustees usually delegate decisions they cannot make (i.e. day to day decisions) to a discretionary investment manager.
Employer-related investment/ERI
Section 40 of the Pensions Act 1995 restricts employer- related investment (i.e. double exposure to a scheme employer). Breach of the restrictions may lead to prosecution.
An “employer-related investment†can capture a wide range of investments, from shares or securities, loans, guarantees, land, and some collective investment schemes. Depending on the type of investment, the restriction on the investment may be absolute or it may be restricted to no more than 5% of scheme assets.
ERI issues tend to crop up most where a sponsoring employer is a bank, a publicly traded company or an insurer. The trustee will need to take legal advice on the risk associated with any investment and whether there is a risk of breach of the ERI restrictions.
Actionable tips for trustees
The above restrictions and requirements demonstrate why it is important to undertake a legal review of investment documentation, in particular, discretionary management mandates, as well as obtaining the usual “section 36†advice.
Rebecca Fellas
Pensions Investment Practice: Investor Agenda
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Rebecca Fellas Managing Associate Tel: +44 20 7456 5464
Rosalind Knowles Partner Tel: +44 20 7456 3710
Anna Taylor Counsel Tel: +44 20 7456 3743
Philip Goss Partner Tel: +44 20 7456 5604
Garath Craft Managing Associate Tel: +44 20 7456 4265
Contacts
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This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors.
© Linklaters LLP. All Rights reserved 2019
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