Clarifying fiduciary duties in pension investments

The deceptively simple question: “what are a trustee’s fiduciary duties” is one that pension trustees frequently put to their legal advisers when considering how to invest a pension scheme’s assets responsibly. The answer, however, often ends up leaving trustees more confused than when they started. 

Pension trustees are subject to a bundle of different statutory, trusts law and fiduciary duties to their scheme beneficiaries. However, there continues to be considerable debate amongst lawyers and other industry professionals as to how these duties might apply in practice to emerging investment themes, including environmental and social matters.

This article looks at where the law currently stands on fiduciary duties and whether this is sufficient to allow trustees to make investment decisions that fully reflect both the increasingly sophisticated assessment of investment risks and opportunities that is developing in the financial markets and the long-term well-being of pension scheme members. This includes consideration of beneficiaries’ standards of living in retirement, the state of the planet they will inhabit, and the wider systems on which their futures depend.  

Arguably, “systems-level” considerations could be made easier with a clarificatory change in the law. As Parliament considers the forthcoming Pension Schemes Bill, there is an opportunity to bring such clarification.

What are pension fund trustees’ investment fiduciary duties?

In the past, pension trustee duties were often misdescribed as simply being about “maximising returns” based on wording in the 1984 case of Cowan v Scargill [1985] CH 270 However, at best, that is an oversimplification. It is also not how most pension funds are invested in practice, with defined benefit scheme investments in particular being more focused on matching liabilities rather than maximising growth. 

Properly understood, pension trustee duties can really be thought of as comprising three core components when it comes to investing trust assets:

• To exercise trustees’ investment powers for their “proper purposes”, namely the provision of members’ pensions and not for any ulterior motives unconnected with that, such as making moral or political statements.

• To take account of all factors which are relevant to that purpose (and not irrelevant factors). This will usually mean giving proper consideration to all factors that might be financially material (including consideration of risks as well as returns).

• To act in accordance with the “prudent person” principle. Broadly this is the principle that trustee investment powers must be exercised with the “care, skill and diligence” a prudent person would exercise when dealing with investments for someone else for whom they feel “morally bound to provide”.

The case law in this area is surprisingly historic and limited, although the Financial Markets Law Committee endorsed this approach to fiduciary duties in its guidance for pension fund trustees published in 2024 and, whilst it was a charity law (rather than pensions trust) case, the principles were similarly applied in the Butler-Sloss v Charity Commission [2022] Ch 371. Consequently, the practice of giving legal advice in this area relies heavily on interpreting of the authorities. This has given rise to a diversity of potential legal views.

Is there a problem to be fixed?

A generally orthodox interpretation of the law currently holds that for most large asset owners, including pension funds, certain environmental, social and governance (“ESG”) factors can be financially material to investments and may therefore be relevant factors to be taken into account in trustees’ investment decisions. For example, both the physical risks of climate change (e.g. prolonged heat waves, drought, rising sea-levels etc) and transition risks (essentially risks to company business models from de-carbonising the economy) can create direct financially material risks (and opportunities) to investment portfolios. 

The more difficult question arises when considering whether trustees can, or should, take other, potentially wider or less direct, issues into account. For example, in relation to climate change, both physical and transition risks can also affect financial institutions through increases in claims paid by insurers, or decreases in the creditworthiness of borrowers and liability arising from litigation or regulatory change or intervention. These shocks can pose a systemic threat to the financial stability of entire markets if they occur simultaneously. This “system-level” risk can level down whole portfolios for asset owners and cannot easily be diversified away from.

From an asset-owner perspective this might be considered at two levels: 

• the effect that systemic risk could have on a scheme’s investments (the “outside-in” risk); and

• the effect that the asset owner’s investments may themselves have in contributing to systemic risk (the “inside-out” risk). 

From a fiduciary duty perspective, it is not always easy to reconcile the investment decisions that trustees might want to take in response to such system-level considerations - particularly the inside-out risk - with some narrower interpretations of fiduciary duties. This is because, even where the relevance of factors such as systemic market risks and beneficiary standards of living is accepted, it may be challenging for trustees to demonstrate the causal link between their investment decisions and economic benefits (or avoidance of economic harms) ultimately delivered to the scheme’s beneficiaries in retirement. However, if all pension trustees think like this then these wider economic benefits are never delivered to anyone because each individual trustee board considers itself too small, and its own asset-owner clout too insubstantial, to make a difference.

The current reality, therefore, is that practical action across the industry is impeded, depending in part upon how broadly each trustee board and their legal advisers are prepared to interpret their legal duties.  There have been numerous attempts to clarify the position through non-binding but official guidance and influential commentary, particularly in the last decade, yet the debate continues unabated.  In the authors’ view, this is evidence that the law is fundamentally unclear in key respects.

A proposal for legislative clarification

The authors have been assisting ShareAction, the Impact Investing Institute, together with other key partners and stakeholders, in advocating for a more permissive legal environment to unlock some of these issues by clarifying that trustees may properly consider broader systems-level considerations in their investment decisions. 

Regulation 4 of the Occupational Pension Schemes (Investment) Regulations 2005 already set out a series of basic criteria that occupational pension schemes must, by law, take into account when investing. These include, for example, that assets must be invested in the best interests of members, be properly diversified and invested in a manner calculated to ensure the security, quality, liquidity and profitability of the portfolio as a whole.

We believe that some relatively short drafting could be added to the current legislation to make it clear that it is legally safe to adopt certain wider considerations alongside this. These would be optional factors that trustees may take into account, amongst other matters, when they are considering what is in the best interests of a scheme’s members and beneficiaries. The proposed new factors would be:

• system-level considerations, being those risks and opportunities relevant to the scheme that cannot be fully managed through diversification alone and which arise at the level of one or more economic sectors, financial markets or economies;

• the reasonably foreseeable impacts that the scheme’s investments have upon financial systems, the economy, the community and the environment (the “inside-out” risk referred to above;

• the reasonably foreseeable impacts that the scheme’s investments have upon beneficiaries’ standards of living and their health and social and economic well-being;

• the views of the members and beneficiaries of the scheme.

These proposed amendments would not dilute trustees’ obligations to act prudently and for the proper legal purposes of the pension scheme.  Rather, they would make it clear that considering a wider range of relevant issues is permitted as consistent with, and part of, the fiduciary duty. Reinforcing the existing fiduciary duty to take account of all factors that are financially material, the regulations would also make clear the trustees’ duties to consider and manage all such issues that are financially material. 

Without the proposed amendment there remains, in the authors’ view, a risk of a “tragedy of the commons” where individual groups of trustees remain reticent to pursue investments delivering wider economic benefits or minimising negative externalities, leading to a worse outcome in retirement for all beneficiaries. 

Working with industry figures and others, the authors have developed potential draft legislation along the lines outlined here. The draft is being shared in various industry settings and with policymakers.

With the Government currently considering the forthcoming Pension Schemes Bill, it seems to us that the time for a legislative clarification of fiduciary duties is now.