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Commercial Question

Doing the right thing: ethical investment by pension schemes

updated on 23 May 2017


Can trustees of UK pension schemes take into account ethical considerations when investing scheme assets, or must they only be concerned with financial factors?


Taking into account ethical factors when making investment decisions, for example, by refusing to invest in an industry which the trustees view as morally problematic, would generally be contrary to trustees' investment duties. By contrast, a "responsible investment" approach which takes into account financially material environmental, social and governance factors would generally be consistent with trustees' duties, although implementing such an approach can be challenging.

The growth of responsible investment

The last few decades have seen the rapid growth of investment approaches commonly known as ‘ethical investment’ or ‘responsible investment’. Although these two concepts are distinct, they are often used interchangeably and the details can vary significantly. When we talk about them here we mean:

  • Ethical investment: making investment decisions which are primarily motivated by an investor's ethical or moral values, such as opposition to a particular sector or business practice. For example, this could involve having a blanket prohibition on investments in the tobacco or gambling industries.
  • Responsible investment: making investment decisions which take into account factors which an investor believes will have a long-term effect on the financial risk and reward offered by particular investments. For example, this could involve taking into account environmental, social and governance (ESG) factors by preferentially investing in companies with environmentally sustainable business practices.

Responsible investing in one form or another is becoming increasingly popular with institutional investors worldwide: the United Nations’ "Principles of Responsible Investing", a set of voluntary responsible investment principles for institutional investors, currently has over 1,600 signatories representing $62 trillion of assets under management.

Defined benefit schemes in the United Kingdom

Occupational pension schemes in the United Kingdom are trust-based, meaning that the trustees of the scheme hold legal title to the scheme's assets for the benefit of the scheme's members. The trustees must operate the scheme in accordance with its trust deed and rules, as well as complying with their duties under trust law and relevant legislation. This article considers the position for trustees of "defined benefit" schemes, which promise members a level of pension on retirement based on their salary.

Defined benefit pension schemes in the United Kingdom currently hold around £1.5 trillion of assets, which is equal to about 75% of UK GDP. The way these assets are invested has a major impact on both the beneficiaries of such schemes and the businesses in which those schemes invest. In recent years there has been increasing pressure on trustees to implement an ethical or responsible investment approach. The question facing trustees is whether either approach can be reconciled with their fiduciary duties when investing scheme assets, or whether they should only be concerned with traditional financial factors.

Trustee duties and ‘best interests’

As noted above, the duties which apply to pension scheme trustees when making investment decisions derive from three main sources: the trust deed, legislation and trust law duties as developed by the courts. As trustees' investment powers are a type of fiduciary power, they must be exercised in the best interests of scheme beneficiaries.

The case of Cowan v Scargill (1985)established that, in the context of a pension scheme investment power, a beneficiary's ‘best interests’ normally means their best financial interests. The court held that trustees' investment powers should be exercised so as to yield the best financial return for the beneficiaries, judged in relation to the risks of the investments in question. By contrast, the trustees' personal ethical views should not be taken into account as part of their investment decisions, as these would be non-financial factors which would not be relevant to the exercise of the investment power, subject to certain very limited exceptions.

The distinction between financial and non-financial factors was central to the conclusions of the Law Commission, which was asked in 2014 to report on "how far those who invest on behalf of others may take account of factors such as social and environmental impact and ethical standards". According to the Commission, the purpose of a pension scheme investment power is "to secure the best realistic return over the long term, given the need to control for risks". Any factor which affects long-term investment risks or returns can be taken into account by trustees. This would permit trustees to adopt a ‘responsible investment’ approach which, for example, takes into account financially relevant ESG factors. The Pension Regulator's guidance on defined benefit investment published in March 2017 supports and expands on the conclusions reached by the Law Commission.

In summary, the law as it currently stands generally prohibits trustees from adopting an ‘ethical investment’ approach motivated by non-financial factors, whereas it could allow trustees to adopt a ‘responsible investment’ approach focusing on factors which the trustees believe are relevant to long-term investment performance.

Obstacles to virtue

Despite the guidance provided by the Law Commission and the Pensions Regulator, there are still significant hurdles for trustees to overcome if they wish to implement a responsible investment approach. These include:

  • Motivation: the motivation behind considering a particular factor is highly relevant to how it should be characterised. If ESG factors are taken into account because of their benefits to society in general, or because they reflect the trustees' ethical values rather than the balance of risk and reward, then they are likely to be a ‘non-financial’ factor.
  • Management: the Law Commission's report suggests that trustees should not take a blanket approach when considering the relevance of a factor, but should instead conduct fine-grained analysis in relation to specific investments. This type of analysis is difficult to reconcile with the trustees' role, as due to regulatory constraints trustees typically only provide high-level strategic direction for investments, with day-to-day decisions delegated to properly authorised investment managers.
  • Measurement: the evidence for a positive link between a ‘responsible investing’ approach and long-term financial returns remains relatively sparse, with academic studies on this issue reaching differing conclusions. This could be due in part to the long-term and diffuse impact of such an approach, but the dearth of evidence suggests that trustees should approach proposals for responsible investment with a degree of caution.

In conclusion, the movement towards pension scheme trustees taking a "responsible investment" approach based on long-term financial factors (such as ESG factors) appears to be gathering pace, although the implementation of such an approach remains challenging.

Alex Economides is a solicitor in the pensions team at Travers Smith.