Pension trustees: evolving approach to ESG

Following the Kay review of 2012 and the Law Commission's report on the fiduciary duties of investment intermediaries in 2014, it has generally been accepted that trustees should only take into account ESG factors in their investments where it would not cause financial detriment to scheme members.

Trustees have a statutory duty to consider financially material factors in their investment decisions. Since 1 October 2019, trustees have been required to disclose in their statement of investment principles (SIP) how they take account of "financially material considerations". These broadly include, but are not limited to, ESG considerations, including climate change. As a result, trustees' investment strategies have been focussed on identifying whether taking account of ESG factors would be financially beneficial to their investment portfolio or, at least, would not cause financial detriment.

Placing ESG factors in the context of financially material considerations aligns with trustees' fiduciary duty to act in the best financial interests of members. To the extent that trustees are ethically opposed to investing in a certain sector or asset class - for example, tobacco or munitions - they would typically need to be able to show there are financial grounds for reducing or disinvesting those holdings. In general, trustees are understandably reluctant to integrate non-financial matters into an investment portfolio without evidence that members share the moral or ethical view, and the decision would not cause financial detriment to the scheme.

Understanding members' moral or ethical views requires a scheme to canvas members' opinions. It is difficult to do this effectively or meaningfully, particularly for defined benefit (DB) schemes which hold an increasing proportion of deferred members. Even where trustees of defined contribution (DC) schemes manage to obtain member feedback that indicates a sizeable proportion of members hold the same views, they have been cautious in aligning default arrangements with member feedback and tend to restrict members' views to self-select funds.

At present, therefore, trustees tend to consider ESG factors from a strictly financial viewpoint and treat members' views as non-financial factors.

However, this dynamic has become more nuanced with the new investment reporting changes from 1 October 2020. The changes affect the way trustees should be engaging with their investment managers and consultants, and will indirectly influence their approach to sustainability of the companies in which they invest.

Trustees now need to disclose their policies with asset managers in the SIP. Disclosure should cover all aspects of their relationship including remuneration, performance, costs and how they incentivise managers to align investment strategy and decisions with their own policies. Crucially, trustees need to show how they incentivise managers to make investment decisions based on assessments of the medium to long-term non-financial, as well as financial, performance of investee companies. See our template SIP for more detail.

At first sight, the requirement to assess non-financial performance of companies seems to potentially conflict with trustees' considering ESG factors through the lens of financial performance. The concept seems to go beyond what is generally understood to be trustees' strict legal duty. 

However, we are starting to see a blurring of the lines between financial and non-financial ESG factors and, arguably, it is no longer possible to ignore non-financial factors altogether. This is already evidenced through the increasing sophistication of climate-related data disclosure, metrics and measurement, scenario analysis and the evolving analysis of investment risks and opportunities. At a policy level the UK government's green finance strategy; climate-related amendments to the Pension Schemes Bill; and consultation into mandatory reporting in line with the Task Force on Climate-Related Financial Disclosures (TCFD) recommendations reveal a wider government move towards assets being assessed in a more holistic manner by asset owners.

From a legal perspective, we think it is important for trustees to separate what they consider to be financially material ESG factors at a strategic level - that is, those factors that have a financially material impact on investment and drive investment strategy - and those factors which are more granular and determine the due diligence parameters set with investment managers.

Many managers already incorporate non-financial aspects into their investment due diligence. For example, they may assess a company's approach to diversity, corporate governance, equal pay and sustainability, all of which could be viewed as 'non-financial' factors forming part of the due diligence process. The role of trustees is to challenge and monitor this process and ensure it reflects their own investment policies, approach to ESG and investment beliefs more widely. Trustees need to understand what non-financial factors managers take into account in their assessment of investee companies; to check that they are comfortable with these factors and the way in which they are used; and to ensure that the weight attributed to non-financial factors is proportionate and in line with their fiduciary duty to members.

Increasingly, we are seeing trustees of large schemes such as DC master trusts adopt investment beliefs that target long-term sustainability, the transition to a zero carbon economy and a holistic approach to ESG. As these schemes start to develop their approach to TCFD reporting in line with the UK government's proposals, we expect trustees' approach to climate change will be driven by ESG policies championing ever-closer alignment of financial and non-financial factors.

Co-written by Michael Jones and Jack Gillions of Pinsent Masons, the law firm behind Out-Law.