Will Fiduciary Fog Clear for Trustees?

The thorny question of whether impact should be considered as a part of fiduciary duty is being revisited in the UK with another review by the Financial Markets Law Committee.

Despite many words written on the topic, along with regulatory and legal reviews and reports, there is still confusion and caution among some pension fund trustees about how ESG factors affect their fiduciary duty obligations. Further clarification may be on the way as the UK government’s updated Green Finance Strategy 2023 includes a commitment to review pension trustees’ fiduciary duties and stewardship activities.

“The issue of ESG and fiduciary duty is ground that has been gone over on several previous occasions,” says Paul Lee, Head of Stewardship and Sustainable Investment Strategy at independent investment consultancy Redington. “But there is still hesitancy among some trustees and boards when thinking about these factors, which are not a traditional part of the investment process.”

The UK’s Law Commission published reports on the issue in 2014 and 2017. The 2014 report distinguished between trustees’ ability to take ‘financial factors’ and ‘non-financial factors’ into account in their investment decision making. The 2017 report recommended that legislation be amended to require pensions trustees to “[evaluate] risks to an investment in the long term, including risks relating to sustainability arising from corporate governance or from environmental or social impact”.

Today, says Lee, it is “undeniable” that climate change is having an impact in the real world and in the financial world. “Very few would disagree that this is a material financial issue, but that doesn’t necessarily mean that everyone thinks every ESG issue is material. Not every factor within ESG will be relevant for every investor, but if investors ignore these issues, they risk missing the key drivers of long-term financial and business performance. These issues will come to value over the time line of pension schemes and they are very much tied to fiduciary duty.”

Oscar Warwick Thompson, Head of Policy and Communications at the UK Sustainable Investment and Finance Association (UKSIF), says discourse has been shifting in recent years. “A number of our members, alongside ourselves, are seeking further clarification to fiduciary duty from the government,” he says. “There has been a relative lack of clarity among market participants, including pension scheme trustees, on the extent to which consideration of ESG factors, impacts, and stewardship across all sustainability factors (including social) is consistent with fiduciary duty.”

In addition to the Green Finance Strategy, which “very much acknowledged this shift”, Warwick Thompson notes that the Department of Work and Pensions’ Taskforce on Social Factors (TSF) has also been exploring this area. “We think it warrants attention, given a particular lack of focus on the extent to which social issues, such as diversity, human rights, and a fair transition, could be appropriately treated within the parameters of these duties.”

Many investors are looking beyond the impacts of ESG factors on portfolios to understand and manage the impacts their portfolios have on the world around us, says Eliette Riera, Head of UK Policy at the Principles for Responsible Investment (PRI). “However, there remains a (mis)perception that pursuing sustainability impact goals represents a departure from prioritising an investor’s financial purpose. Not only is this a false assumption, it also overlooks the fact that in some cases investors need to address sustainability impacts to preserve financial returns, and are already legally required to consider doing so,” she says.

Dr Anna Tilba, Associate Professor in Strategy and Governance at Durham University Business School, says the question is not so much what has changed, but about what hasn’t. “Since the Law Commission’s 2014 report on fiduciary duties, nothing really has changed significantly,” she says. “The report itself was given very little attention at the time. I assume that the aim of the latest review is to examine ongoing issues around fiduciary duty, especially in the context of the revised UK Stewardship Code 2020, to see what obstacles (real or perceived) remain.”

Current obstacles to clarity

An issue that often arises when trustees consider ESG factors is assessing their financial materiality, says Maria Nazarova-Doyle, Head of Responsible Investments and Stewardship at Scottish Widows. “While in recent years the pensions industry has become better in assessing and quantifying the effects of climate change on investments, there is still a large list of material ESG factors that is not so easy to assess precisely.”

For cross-cutting and systemic issues, the modelling becomes overly complicated and potentially spurious, she adds. “Can we really reliably calculate in basis points the effects of an unjust transition, deteriorating public health, biodiversity collapse or spiralling social inequalities? And yet, these are extremely material for pension scheme decision-making given how long-term these investments are. As trustees usually make investment changes on the basis of modelling, and with systemic issues not fitting neatly into the models being used to assess risk and return, this leads to these factors often being omitted from consideration.”

Redington’s Lee agrees, noting that ESG factors are “almost impossible” to build into traditional financial models because of uncertainty over what money is at risk and when the risk will hit. The long-term nature of pension investments is also a factor as the “average fund manager’s outlook tends to be shorter”.

Nazarova-Doyle says it is important that impact, risk and return are considered together. “In fact, it’s extremely hard to separate them, particularly with the 30, 40, 50 years’ outlook that pension funds have. There is no free lunch for pension funds – if they try to make a quick buck now by ignoring or even exacerbating impacts of their investments on society, climate and nature, these externalities will only come back to get them later.”

Dr Tilba, who has co-written a paper on fiduciary duty that addresses the problems with the current definition, says the key problem is that trustees still interpret their fiduciary duty of loyalty as acting in the best financial interests of the beneficiaries. “In addition, although the general law concept of fiduciary duty is sufficiently flexible to allow ESG concerns to be taken into account, it does seem to conflict with the regulatory framework within which pension fund trustees operate.”

As a principle of general law, a person acting as a trustee has to act in accordance with the terms of the trust, which typically is set out by the creator of the trust in the trust deed. The paper notes that as a relatively new concept, stewardship has not been explicitly included in the terms of many pension fund trusts. The paper notes that the UK Stewardship Code is “guidance and not a legal obligation”. A trustee who has reservations about a particular investment decision can apply to the courts for a direction as to whether it is proper; indeed a decision can be challenged in some cases by other trustees or the beneficiaries of the trust.

The widespread adoption of the Stewardship Code since its 2020 reiteration suggests the outcome of the current review may be different from previous examinations of fiduciary duty, says Dr Tilba. “The Code has moved away from requiring signatories to commit to stewardship ‘on paper’ with policies, to actually demonstrating what tangible or meaningful outcomes have been achieved as a result of stewardship and engagement. This puts greater emphasis on stewardship commitment in practice, which may be even harder to achieve for pension funds that solely focus on generative financial returns as means for trustees to act in savers’ ‘best interests’.

“The key issue to look at would still be around clarifying in law what it means for trustees to act in savers’ best interests and to what extent this could or should include stewardship and ESG engagement.”

Ideal outcomes

Lee believes clarity can be achieved via better advice to help the pension fund trustee to be more confident that they are not breaching their fiduciary duty by thinking about ESG. “I think this is the direction of the Financial Markets Law Committee (FMLC) – it wants to help with the interpretation and understanding of what the law is already and give people better advice around it.”

A challenge may be the difference in definition of fiduciary duty between US and UK fund managers, however. “. US-based fund managers and those coming from the US tradition believe fiduciary duty requires thinking only about the money and financial returns. In the UK, fiduciary duty encompasses a greater range of long-term issues, including ESG factors,” says Lee.

UKSIF hopes the UK government’s work will lead to new supporting guidance for trustees, says Warwick Thompson. “One proposed avenue for change we recommend is for detailed guidance to be issued for UK occupational pension schemes from government departments, including the DWP, and financial regulators such as the Financial Conduct Authority and the Pensions Regulator.”

At a minimum, UKSIF would like to see non-statutory guidance published that could assist trustees and provide a clearer expectation of the extent to which they can, and should, take account of social and other sustainability considerations. “Our view is that while changes are not needed to the law, the core issue is around interpretation and supporting trustees and others to better fulfil their fiduciary duty,” he adds.

The more policymakers shine a light on the issue, the more ‘acceptable’ it will become in the minds of trustees, says Dr Tilba. “Some pension funds, such as Railpen, stand out as asset owners who are both willing and able to do so. Smaller schemes who delegate their scheme and investment management to external providers could still influence their asset managers to be signatories to the Stewardship Code at the stage of awarding their mandates and also require their fund managers to report on what has been achieved with stewardship. There are also collaborative stewardship options available.

“The key challenge is, of course, to be able to balance between short-term financial and broader long-term interests of the members, in order to have intergenerational fairness when it comes to pension fund investments.”

A few years ago, says Nazarova-Doyle, ESG considerations were “largely theoretic” whereas now many trustees have come up against practical challenges relating to materiality assessment of ESG factors and their experiences can help contribute to the review. “Also, with more schemes now finding ways to exercise more responsible investment approaches, the government can look at discrepancies and find outliers who do not take these factors fully into account, and understand whether this is because they need more help or, indeed, enforcement action.”

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