Introduction
Environmental, Social, and Governance (ESG) factors have emerged as critical considerations in investment strategies for all asset managers, including pension trustees. However, for pension trustees, the challenge lies in balancing these considerations with their fiduciary duties and the pension scheme’s purpose. This shifting landscape raises a key question for trustees: what practical and legal leeway do they have to incorporate ESG factors into their investment decisions?
Fiduciary duties and the purpose of a pension scheme
When considering the extent to which trustees can take into account ESG factors and broader issues, two key aspects must be examined: the purpose of the pension scheme and the trustees’ fiduciary duties.
Trustees are expected to exercise their powers for the proper purpose of the scheme; to provide pension benefits as they fall due, subject to the specific terms of the establishing deed.
Trustees are also required to act in the best interests of the members. The term “best interests” has been interpreted in various ways, but is generally understood as the best financial interests of the beneficiaries. However, trustees should also consider the risk of an investment over the appropriate time horizon, not just the returns.
Fiduciary duties are not set in stone and there is scope for them to evolve. We have seen this in respect of charitable trusts and we understand that the Department for Work and Pensions is seriously considering amending fiduciary duties to support trustees investing in ESG positive and wider productive finance initiatives.
Legal considerations for trustees
Further, there are some legal considerations to which pension trustees must abide. The legislation governing pensions investments has been updated in recent years to create clear scope for ESG investing. However, in practice the key consideration for trustees will be distinguishing between “financial” and “non-financial” factors.
Financial factors are broadly defined as "including but not limited to environmental, social, and governance considerations that trustees deem financially material". .
Non-financial factors relate to the views of the members and beneficiaries such as their ethical views, their views in relation to social and environmental impact, and present and future quality of life.
As a general rule, where a Trustee can tie a decision to a financial factor and demonstrate it is in the best financial interest of member and in line with the purpose of the Scheme, trustees have power to act on that decision.
However, for trustees to consider non-financial factors in investments, they must comply with the following two stage test:
1) Trustees must have a good reason to think that all scheme members share the concern; and
2) The decision must not involve a significant risk of financial detriment to the fund.
This is a very high bar which in practice means many trustees are deterred from considering non-financial factors. However, a recent survey we carried out suggested 40% of schemes questioned were considering non-financial factors to a certain extent. Perhaps this suggests that the pensions industry is heeding the calls for it to support the ESG agenda.
Stewardship
When considering ESG in the context of pensions, it is important to consider both investment selection and stewardship.
Stewardship, in this context, refers to the responsible management and oversight of pension scheme assets to ensure long-term value creation and sustainable benefits for the economy, the environment, and society.
Stewardship is crucial for managing risks and supporting returns over the long term, and comprises the following activities; Monitoring, Engagement, Intervention, Reporting, and Collaboration & Advocacy.
The Department for Work and Pensions (DWP), along with the Taskforce on Pension Scheme Voting Implementation, has suggested several options available to trustees in respect of stewardship. However, in exercising these options, Trustees must comply with their fiduciary duties, act in line with the proper purpose of the Scheme and where they are motivated by non-financial factors, and satisfy the 2 stage test above.
Picking the right ESG investment
In order to navigate this complex challenge, Trustees should begin by defining a set of 'ESG beliefs'.
In our experience, an effective way to do this is by determining areas of focus or interest. This will vary from each scheme but things to consider could include: employer activity, stated views of members, the local environment in which the scheme and its employers operate.
An example may be wanting to identify investments in industries with a strong track-record of meeting net-zero targets or looking to improve the local area through investing in local businesses.
Once these beliefs have been established, they can be brought together into a strategy that can guide trustees as they consider their investments. However, the application of an ESG investment strategy can be either inclusionary or exclusionary.
An inclusionary approach seeks to identify and invest in assets that align with your beliefs; an investment will only be considered if it meets some or all of your investment criteria. Conversely, an exclusionary approach will see investments ruled out of consideration if they conflict with the beliefs or values of the investors.
ESG strategies in practice
Although trustees may have a defined ESG investment strategy, there are some practical considerations that may hamper their ability to apply it when considering investments. For example, investments must align with the time horizon of the scheme, the strength of the covenant, and the current investment strategy in order to be fit for investment by the scheme.
Another crucial consideration for pension schemes considering ESG investments is the liquidity needs and how this affects the availability of appropriate assets. When it comes to sustainable investments, liquidity can be a challenge. Many ESG investments, such as those in renewable energy projects or green infrastructure, tend to be less liquid compared to traditional investments like stocks and bonds. However, the market is evolving, and there are now more illiquid funds available that will purchase investment grade ESG investments relatively quickly without a significant haircut.
Risks and opportunities
Deciding to invest in ESG investments presents new risks and opportunities for pension trustees. However, whilst the opportunities can lead to strong financial performance and returns for members, the risks must be appropriately managed to ensure trustees meet their fiduciary duties and act in line with the purpose of the scheme.
ESG investing was primarily born out of investors spotting a correlation between strong financial performance and active consideration of E, S and G factors. The innovation, competitive advantage and technological advancement that is synonymous with ESG can lead to quick capital growth.
However, ESG investments can rapidly fluctuate in value due to the amount of innovation in the market. These shorter-term time horizons mean trustees may require more active oversight that they are used to in order to ensure they exit an investment in a timely manner to avoid a loss in value.
The risk of an integrity gap is also significant, with greenwashing and social-washing claims presenting a real financial and reputation risk for schemes. Trustees must perform thorough due diligence to ensure their ESG investments are genuine, and failing to do so can lead to serious consequences. For instance, Mercer Superannuation (Australia) Limited was fined $11.3 million for misleading statements about the sustainability of its investment options. This case highlights the importance of accurate ESG claims.
Another risk that has begun leading to fines for trustees is complying with ESG reporting regulations, such as the Taskforce for Climate-related Financial Disclosures. However, whilst this is a risk, the standardised data and metrics provided by these reports also present an opportunity for trustees who can more readily compare different ESG investments.
Conclusion
While trustees have significant leeway to incorporate ESG factors into their investment strategies, it is crucial to align these decisions with their fiduciary duties, the scheme’s purpose, and relevant financial and non-financial factors.
Integrating ESG factors into pension investments is not only a matter of regulatory compliance and ethical responsibility but also a strategic imperative for long-term success. By adopting a proactive and informed approach to ESG, trustees can enhance the resilience and performance of their portfolios, while contributing to a more sustainable and equitable financial system.
However, in order to do so effectively, trustees must develop a robust ESG investment strategy that considers the risks and opportunities, and the practicalities of investing member funds in light of the time horizon and liquidity needs to pay benefits as they fall due.
For further guidance on integrating ESG into pension investments, please contact Liz Ramsaran and Kurun Bhandari.
