Out-Law Analysis | 28 Feb 2017 | 3:46 pm | 4 min. read
The result is a 'herd' mentality with very few small- or medium-sized funds willing to invest in a way that is out of step with the market.
Asset pooling provides a potential means of addressing this. However, there is no clear legal route to such transfers, leaving lawyers to pick through a series of challenges and issues created by a web of historic legislation and guidance from HM Revenue and Customs (HMRC).
For this reason, the Law Commission's recent call for evidence into social investment by pension funds, particularly defined contribution (DC) pension funds, is to be welcomed. What emerges from the call for evidence should be a good starting point towards enabling trustees to develop a broad-based investment strategy for the longer term, and invites the possibility that small- and medium-sized funds will see these issues moving up their agenda.
Trustees and pension funds are coming under increasing pressure to think more widely about the range of issues that affect the long-term performance of the assets they invest, and to reflect on whether social investment is necessary to ensure the proper exercise of their fiduciary duties rather than just being an issue for the largest funds or a 'nice to have'.
However, under the current legal framework, the law can act as a barrier to social investment for a number of reasons.
Trustees of occupational pension schemes must act in the best interests of the scheme beneficiaries. This has been interpreted by the courts in a way that means normally acting in their best financial interests.
This means that, when deciding how to invest, trustees will look to their investment managers, or to evidence of financial returns. If there is little evidence to show that 'social' investments produce the required returns, trustees may be reluctant to invest in these products. They may feel that to do so would open themselves up to criticism, or even claims from the sponsoring employer or scheme members if they produce poor returns.
Social investment refers to investment which combines financial and social objectives. As definitions go, this seems pretty vague and is likely to have different meanings to different people. Any future framework to encourage social investment must start with a clearer definition of the concept.
The quality and diversity of social investments available may also act as a bar to investment. Funds that are illiquid, or difficult to understand, may be off-putting, particularly to smaller schemes with fewer resources. While larger schemes with more resources may be more willing to allocate time to consider social investments, small to medium schemes are more likely to invest in step with the market.
The UK government has been keen to encourage investment into infrastructure by pension funds. Its thinking is that the infrastructure sector would benefit from an alternative source of private finance, while pension funds would benefit from a stable investment asset that delivers long-term returns.
The problem is that investing directly into infrastructure assets is a significant step up for any institutional investor, but even more so for trustees – who are essentially volunteers. Even with the increasing number of professional trustees entering the market, none have the time, experience or budgets to source infrastructure investment opportunities and conduct the necessary due diligence, let alone project manage and monitor the assets.
Even investing in pooled funds specialising in infrastructure would require trustees to 'scale up' their in-house resource by ensuring they had individuals within their team with the relevant skills and experience to evaluate and monitor infrastructure investment offering from fund managers. The initial cost and administrative hurdles of building up these specialist resources may dissuade trustees from considering new asset classes such as infrastructure investment funds, particularly for mid-sized or smaller pension funds which will only have a relatively small allocation to invest.
Liquidity is another potential issue. With most defined benefit (DB) schemes closed to accrual and DC schemes under trust experiencing an upsurge in transfer requests given the new DC flexibilities, cash flow is an increasing issue for schemes and the illiquidity of infrastructure assets makes them unattractive as investments. Anecdotally, we are seeing a reduction in property holdings due to 'gating' restrictions by property funds following the Brexit vote.
Current legislation on pension scheme transfers discourages asset pooling by smaller schemes. This legislation is clearly designed to protect the interests of members of DB schemes, and is simply not fit for purpose for DC to DC transfers.
Specifically, the requirement for actuarial certification based on comparing the rights transferred with the 'transfer credits' obtained in the new scheme is extremely challenging to apply in the DC context, and there is little certainty on what elements should be included in such a comparison. Should this include investment choice? Tax protections? Fund charges? Liquidity?
To make asset pooling easier, and ultimately enable infrastructure or social investment on any meaningful basis, the Law Commission should consider: