Clare Keeffe explores the new fiduciary duty guidance from the Financial Markets Law Committee (FMLC), and how it looks to help pension schemes incorporate sustainability concerns into their investment decision-making process.

Driven in large part by our greater understanding of climate change and its impacts on our lives, over the last decade there has been an increased focus on sustainability in all walks of life. This has not escaped pension schemes, helped by a raft of regulatory changes that require sustainability to be considered, principally in investment decision-making.

On the whole, trustees of pension schemes have risen to the challenge, increasingly considering sustainable investment opportunities and challenging asset managers on their management of sustainability issues.

However, there have been pockets of resistance, with one often cited barrier to the consideration of sustainability being confusion over the definition of ‘fiduciary duty’. To help address this barrier, the FMLC have produced new guidance on decision-making in the context of sustainability and the subject of climate change. 

Decision-making on sustainability – what has been the issue?

A key area of confusion to date has been whether sustainability factors are financially material. 

In 2014, the Law Commission of England and Wales issued what has since been considered as the authority on fiduciary duty. In their 2014 report, the Law Commission set out a distinction between financial and non-financial factors: 

  • Financial factors are defined as “. . . any factors which are relevant to pension fund trustees’ primary investment duty of balancing returns against risks”. 
  • Non-financial factors are defined as “. . . factors which might influence investment decisions that are motivated by other (non-financial) concerns, such as improving members’ quality of life or showing disapproval of certain industries”. 

Criticism to date has been that the distinction between financial and non-financial factors using the definitions above is not clear-cut, resulting in confusion. In addition, our understanding of sustainability has progressed considerably since 2014. There is a question mark over whether existing legal guidance has evolved to take account of this pace of change.

That is where the latest guidance from the FMLC comes in.

How FMLC helps 

In our view, the FMLC guidance helps to break down existing uncertainties by highlighting the following legal positions:

Financial and non-financial factors

FMLC highlights that today, financial factors are broad. What at first may appear to be a “non-financial factor” is actually “financial” when properly understood (we give an example of this below).

FMLC also highlights that what distinguishes a financial factor from a non-financial factor is the motive underlying its consideration, rather than the nature of the factor. For example, if as a trustee board you are considering the exclusion of a specific investment based solely on your beliefs, then this would not necessarily be a financial factor.

“Numbers and Narratives”

FMLC notes that pension fund trustees will need to expect that the reasons for their decision, made with regard to financial factors, should involve both numbers and words. 

Sometimes financial factors cannot be quantified but it does not follow that they lack weight.

Example to show different thinking under FMLC

Let's take modern slavery as an example. Firstly what is the motive for the consideration? Likely there is a view from trustees that modern slavery could have an impact on the financial return achieved by the scheme, as well as concerns about the wider implications of being associated with such practices. 

On discussion, the trustees agree that modern slavery could detract from financial performance, as any firm undertaking such practices could be subject to sanctions, as well as loss of earnings from consumers moving away from firms associated with such activity. 

The trustees recognise that their conclusion is largely based on words that reflect the severity of the potential situation rather than concrete numbers. In this situation, it is worth noting that the trustees need not take any moral position themselves on modern slavery – rather they are reflecting on the financial implications of other people taking a moral position (amongst other factors that may detract from financial performance). Subsequent actions may be to consider sectors particularly exposed to modern slavery and increase stewardship activity relating to the topic.

Other key highlights

There are several other helpful points raised by the FMLC guidance as follows:

  • The guidance gives a helpful overview of why a trustee is considered to be a fiduciary and what this means in practice, including that “pension fund trustees are, broadly speaking, not judged in hindsight, nor are they expected to have perfect foresight when making complex investment decisions.”
  • Before approving any advice, trustees should be able to articulate the basis of the advice - demonstrating understanding, rationale, data and assumptions on which the advice is based - and the scope of the advice, covering both the areas the advice covers and (equally as important) the areas that it does not.
  • FMLC highlights the role advisers play, but reaffirms that pension fund trustees continue to have ultimate responsibility for decisions. The importance of trustees, advisers and investment managers not working in “silos” is recognised, to ensure open dialogue.
  • Trustees are not expected to be experts in the field of sustainability. When seeking professional advice, trustees should not be “rubber stamping”.
  • “Sustainability may reduce risk or improve return . . . the relevant entry point for consideration for sustainability in the context of pension is as a financial factor.” 
  • It may be necessary to forgo short-term gains as they may create longer-term identifiable risks to the sustainability of investment returns. The trustee should be aware that they may still be complying with their fiduciary duties in the scenario of accepting reduced short-term returns as this may create long-term value for the scheme.
  • With reference to climate change specifically (but noting this could apply to many factors), FMLC notes that whilst it may not be difficult to accept that the overall direction of travel over time will be away from activity that could have adverse climate change consequences, it is important to note that material developments may sometimes be sudden.
  • Legislation requires trustees to make informed and reasoned decisions and to ensure that all relevant factors have been discussed and considered. So long as trustees act within their powers and the above has been considered and can be demonstrated, trustees should not need to fear liability.

Driving forward change 

Whilst the FMLC are quick to highlight that their guidance is not legal advice, it is clear to see already that this update will help to drive forward change. 

Following the publication of the guidance, several expert witnesses recommend to the House of Commons Work and Pensions Committee that the guidance be captured by wider trustee guidance produced by the Pensions Regulator (TPR). Watch this space for further developments.

If you would like to discuss how fiduciary duty could be applied to your pension scheme decision-making, please contact us.

This article features input from Erhan Reyman, Pension Management Consultant at BW.

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