Investing “to do well and to do good”: what can pension trustees do without personal liability for breach of trust?

Trustees of occupational pension schemes have wide investment powers under English law. However, their primary duty is to invest in the best financial interest of members and to secure the best return over the long term while managing risk.

This means that trustees should take into account all financially material factors when making investment decisions. The Government has identified some “confusion and misapprehension” about how trustees assess the impact of environmental, social and governance risks (ESG) on financial performance and is currently consulting on legislative changes to clarify the position.  

The changes are intended to strengthen trustees’ investment duties in relation to stewardship (engaging with companies on risk, performance, governance etc as a means to effect change) and consideration of members’ concerns about investments and to require pension trustees to consider and document (and in some cases make publicly available) how they consider ESG factors will financially affect performance when deciding on an investment strategy[1].

One of the key messages from the consultation is that each of the ESG factors should be considered in a financial context when deciding on an investment strategy. For example, when considering whether to invest in a company with a poor environmental record the trustees should question the long term viability or profitability of the business. The trustees should not ignore ESG factors.

However, some trustees may wish to go further and consider non-financial issues when deciding on an investment strategy. They may wish to make investments with a positive social impact (or avoid investments with a negative impact) (SII) and this note considers the issues they must consider, the risks they run and the steps they could take to reduce those risks.

What are the risks?

Many investments with a positive social impact will also generate competitive market returns. In this instance, the considerations for trustees are the same as for any other investment if they can be justified on a financial basis. Indeed, such investments may help improve diversity of the pension schemes investment portfolio.

However, if pension trustees want to take into account non-financial matters when making investment decisions, there is an established two stage test under English case law:

• The trustees must have good reason to think that the scheme members hold the relevant concern; and
• The decision should not involve significant financial detriment.

If either of these tests is not met then trustees run the risk of a breach of trust claim from the scheme members. While pension schemes will ordinarily contain an indemnity and perhaps exoneration from liability for trustees, this will not extend to any act wilfully carried out in breach of trust. Taking into account non-financial matters could therefore, in certain circumstances, result in personal liability for trustees.

Establishing if scheme members hold the relevant concern

Obtaining and interpreting the opinions of a large number of pension scheme members about their views on investment is not a straightforward exercise. There may be gradations of members’ opinion.  Trustees are expected to assess whether there is a consensus from members in order to avoid the risk of personal liability.

The most obvious way to establish whether members share a consensus will be to engage with them directly. However, in the absence of the sponsoring employer underwriting the costs of the member engagement exercise, any engagement with members should be appropriate to the particular membership and the costs should be proportionate to the size of the scheme.

As a first step then, it may be sensible to carry out a preliminary questionnaire to gauge member engagement and level of interest. If there is interest, Trustees could consider running workshops or presentations to give members an opportunity to hear about the scheme and ask questions, holding a member AGM with ESG or SII as a specific topic, setting up focus groups or forums or even setting up a members’ panel that is representative of the wider membership, perhaps with elected positions. It should be borne in mind that different categories of members (active, deferred and pensioner) may have a diversity of views.

In less controversial matters, the government’s current consultation and previous Law Commission reports suggest that formal consultation may not always be necessary. Knowledge of broader public opinion may be relied on in some circumstances. For example, if the UK has ratified an international convention it may give trustees reason to believe most people would support a particular investment stance. Equally, where an organisation pursues a particular aim, such as cancer research, it is likely that conclusions can be drawn about investments that should be avoided.

However, these assumptions can be challenged by members, so trustees need to be careful making them.  Case law[2] is clear that “powers must be exercised fairly and honestly for the purposes for which they are given and not so as to accomplish any ulterior purpose, whether for the benefit of the trustees or otherwise”. In almost all cases, an investment power will have been granted to ensure the best financial return to help members save for retirement and case law states that “trustees may even have to act dishonourably (though not illegally) if the interests of their beneficiaries require it”.

Very careful thought must therefore be given to the motivations of the trustees and any decision to rely on public policy or assumptions based on the employer’s business, where there is a risk of financial detriment. In addition, while current employees of an organisation, such as a charity, can perhaps be assumed to share a common ethic, this may no longer be the case for employees who have left and who are deferred members of the scheme.

By analogy, the Government faces a legal battle about the scope of statutory powers to determine the investment approach of authorities running the Local Government Pension Scheme (LGPS). The Government made it a statutory requirement (through binding guidance) that LGPS investment decisions cannot be used to give any support to activist groups for boycotts or disinvestment unless they reflect accepted UK foreign policy. The Palestine Solidarity Campaign argued this falls without the powers granted by statute and won at the High Court but lost on appeal to the Court of Appeal[3]. This may go to the Supreme Court.

No significant financial detriment

What constitutes financial detriment should also be considered by trustees. This should not be interpreted narrowly. Some risk is acceptable and is the nature of investment, but trustees should be particularly careful where the risk-adjusted rate of return is significantly less than that available from other investments.

If the investment is expected to be equally financially beneficial the trustees can choose the investment they consider members would prefer. This is known as the “tie-break” principle.

Where there is a risk of financial detriment (i.e. a lower rate of return or greater risk for the same return when compared to another form of investment, or a loss of liquidity) a clear consensus of the membership is essential and the “burden would rest, and rest heavy, on him who asserts that it is for the benefit of the beneficiaries as a whole to receive less by reason of the exclusion of some of the possibly more profitable forms of investment[4]”.

In such cases where there is a dissenting minority, who have actively stated their disagreement to a proposed investment, then trustees cannot safely proceed. However, where there are a majority of members in favour of a particular ESG or SII approach with a minority who are neutral, the picture is not so clear. In these cases, the trustees will need to consider the evidence they have and carefully document the reasons they have for believing the membership hold the relevant concern.

Defined benefit and defined contribution schemes

For trustees of defined benefit schemes, these issues crystallise with every investment decision because pension scheme funds are held for the benefit of all members and so the difficulties of obtaining member agreement pertain. It is likely to be a rare set of circumstances that permit trustees to take non-financial factors into account when setting investment strategy.

In seeking consent to such a step, trustees must also bear in mind that the assets must be used to secure benefits for deferred members and so accurate records will be needed to ensure they can communicate with persons who are deferred members and no longer employed by the schemes’ sponsoring employer.

For trustees of defined contribution schemes there is perhaps more latitude to offer funds that are motivated by SII. This is because members of defined contribution schemes will commonly be able to actively choose between a number of different funds in which to invest their money and may choose to favour non-financial factors over financial concerns. The individual member ordinarily bears the risk in this circumstance, not the membership as a whole.

Trustees in this situation will want to understand if there is sufficient interest among the membership before incurring any cost (unless there is a socially motivated sponsoring employer willing to meet the costs) and then ensure their statement of investment principles is sufficiently broad to permit the relevant funds to be offered.  If there is a risk of significant financial detriment then this will need to be clearly communicated to members. Trustees may wish to obtain some form of disclaimer from members who enter into the funds to reduce the risk of future liability.

However, offering defined contribution members the opportunity to select a fund which prioritises a social impact agenda is qualitatively different from taking non-financial factors into account when choosing a default fund for members. Particularly as many pension trustees will be aware that the majority of members do not exercise a choice once put into a default fund. If this was under consideration all of the matters of member consent and the need to be sure that the members share the relevant concern will apply in the same way as they apply to a defined benefit scheme.

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For more information, please contact Lee Colgate, Michael Jones or Melville Rodrigues.

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