Herbert Smith Freehills' Michael Aherne and Richard Evans
What exactly are pension funds here to do and could they be doing more?
Most lawyers will answer confidently that pension trustees must use their powers for their "proper purpose" and that overriding purpose is, in most cases, securing and paying the promised pension benefits – the right amount, to the right person, at the right time.
However, is this too limiting? Should a pension trustee invest solely with a view to securing member benefits or maximising returns at an acceptable level of risk? Should there be the option to use surplus assets in a defined benefit (DB) context to serve some wider purpose, provided that members' promised benefits are already suitably secure and the sponsor of the scheme is supportive?
With £1.7trn of DB assets, and ESG high on the political and social agenda, the answer to these questions should be clear. But trustees find themselves grappling with a legal framework which, truth be told, has changed little since the nineteenth century.
What is a fiduciary's duty?
The challenge lies in reconciling ESG factors with the fiduciary duty of trustees, and in particular their duty to invest the assets of the trust which they administer. The leading case, re Whiteley, dates back to 1887. The late Mr Whiteley had set up a trust for his infant children. The trustees invested in a speculative venture – a brickfield. The trust lost money as a result. Finding against the trustees, the court laid down the golden rule for investment decisions – trustees should take as much care as a person would take when investing on behalf of someone "for whom he felt morally bound to provide". On the back of this, it is sometimes said that trustees should seek the best returns compatible with an acceptable level of risk.
Where does ESG fit in? The Law Commission looked at this question nearly a decade ago and suggested that ESG factors should be divided into two types. "Financial" factors are those which go to risks or return, for example climate change impacting insurer profits. "Non-financial" factors are those which do not go to risks or returns but reflect wider concerns, for example as to quality of life or a moral attitude. Recently the Financial Markets Law Committee (FMLC) published a paper which builds on the Law Commission's conclusions.
The FMLC paper concluded that climate change and sustainability are financial factors affecting risk and returns. Accordingly, such factors can and should (consistently with the Whiteley principle) be considered in trustee decision-making. Decisions should be supported by information and advice, but trustees should be willing to make judgment calls: "sometimes financial factors cannot be quantified but it does not follow that they lack weight".
Regarding non-financial factors, the FMLC paper quotes the view of the Law Commission. Such factors may be considered (the Commission felt) if two conditions are met. These are that trustees are satisfied that the relevant concern is shared by scheme members and that the relevant decision does not involve a risk of significant financial detriment.
The FMLC paper goes on to note that some lawyers have questioned the soundness of the Law Commission's conclusions on this topic. This is putting it politely. In 2020 a committee of the Association of Pension Lawyers (APL) concluded that trustee investment duties are more stringent than the Law Commission suggested and would in practice prevent most trustees from taking any non-financial factors into account. The APL paper did suggest that most factors, properly analysed, could likely be characterised as financial factors – something the FMLC paper supports – but this does not remove the central uncertainty around the issue of what trustees can and cannot consider as part of their decision making.
Serving a wider purpose
At the time of writing, the government evidently believes that pension schemes can and should serve a wider purpose – witness its "productive finance" initiatives, most recently in the guise of Jeremy Hunt's Mansion House reforms. The broad aim is to enable "more to be done" with pension assets, such that "the high-growth businesses of tomorrow" can access capital, ultimately promoting growth and benefiting the City and UK economy as a whole.
With this in mind, the government has established and promoted fund products such as long-term asset funds (LTAFs) , the Long-Term Investment for Technology and Science tweaked the new DB funding regime to ensure that private sector schemes can invest in "a wide range of assets" even when fully mature and announced measures to promote productive investment by the Local Government Pension Scheme.
The government is also considering reforms to the DB surplus regime and consolidation of the pensions sector with similar motivations. It is still to be seen how Labour will take these initiatives forward if they come to power, but the direction of travel is consistent with the pro-business "growth" message that Rachel Reeves has been keen to promote.
The aims of the Mansion House reforms are laudable but may be hampered if trustee investment powers and duties remain unclear or unused. Trustees need to know whether and when they can invest with an eye to something other than providing pensions (and what if any limits apply).
If the uncertainty cannot be resolved by trustees and their advisers, the government may need to legislate to clarify the position. This is important not only for productive finance, but also for ESG. By clarifying that trustees can, in certain circumstances and with appropriate safeguards, use their investment powers for wider purposes than the security and provision of member benefits, the government could help facilitate investment to address the climate crisis and sustainability issues, as well as promoting the growth of UK plc.
Some may say that such a change would be to fundamentally alter the purpose of the pension schemes and the role of the trustees, but what would the judges in re Whiteley have made of it? One suspects they would have approved. Investment in the brickfield was deemed inappropriate because the business was "of necessity of precarious duration" and would involve "such an excavation and destruction of the soil as must eventually leave what remains nearly useless for agricultural and other purposes". In that sense, sustainability lay at the heart of the case. And, to modern eyes at least, it would seem odd if trustees who felt "morally bound" to provide for an infant child did not have regard to matters such as climate change and quality of life.
Michael Aherne is partner and Richard Evans a professional support lawyer at Herbert Smith Freehills
