02 Feb ARC Pensions Law responds to Law Commission’s consultation on social investment
Social investment is an investment which combines financial and social objectives. This idea is that it is possible “to do well and to do good at the same time”.
The Law Commission issued a call for evidence at the end of 2016, inviting views on the possibility for greater social investment by pension funds when selecting DC fund options. The project built on the Law Commission’s 2014 report on fiduciary duties of investment intermediaries, which shone a spotlight on the law of pension fund investment and ESG.
Our view is that social investment by pension funds can benefit members and social projects but, in practice, DC trustees are deterred by obstacles such as low levels of member financial literacy and the law’s focus on protecting saver’s rights.
ARC Pensions Law’s response can be found below, a compilation of all responses is available here. The Law Commission will publish a final report in May 2017.
ARC PENSIONS LAW RESPONSE TO LAW COMMISSION CALL FOR EVIDENCE ON PENSION FUNDS AND SOCIAL INVESTMENT
We are pleased to have this opportunity to contribute to the debate on the possibilities for the greater use of pension fund monies in supporting charities, social enterprises and businesses with a social mission.
ARC Pensions Law is a leading firm of specialist pension lawyers specialising in workplace pension schemes. Our client base consists of Defined Benefit, Defined contribution and Hybrid schemes and their sponsors.
1. Executive summary
We recognise the dual challenges of finding suitable investment vehicles for members’ pensions savings and securing investment in organisations that have a strong social objective. In principle, there are good reasons why it could be beneficial for these two objectives to be combined, provided that appropriate safeguards are also present. However, we believe that notwithstanding the legal protections that are highlighted in the Commission’s paper, there remain legal and practical obstacles that will continue to deter trustees and managers of workplace pension schemes from widespread offerings of such investments.
2. Pensions first
We can appreciate the potential benefits both for members and social projects from widening the breadth of investment opportunities with pension scheme monies. However, from both the legal and social perspectives the starting point for any consideration of this subject must be that pension savings are for the provision of retirement-related benefits. Those savings therefore require a high degree of protection, both from loss, and in respect of investment return until they are deployed for the benefit of the aged member.
The protection issue is therefore an important consideration in respect of this consultation. It arguably has a greater impact potential on members in a DC scheme than in a DB one, since in the DC scheme it is the members who are directly impacted by the investment return from their allocated funds, and carry the full investment risk. The impact of these issues on individual members can be reduced through the use of pooled investment funds, which is commonplace. Nevertheless, any reduction in investment return impacts members.
We agree with the conclusions of the Call for Evidence and the backing extracts from the Commission’s 2014 Report on the legal position, which counter the popular misconception that investing pension fund monies requires that the best available investment return is sought at all times, to the exclusion of all other considerations. It seems clear that trust law allows trustees, in discharging their duties, to take other issues into account, such as the characteristics, needs and desires of the members. It also seems likely that in the case of contract-based pension arrangements the managers are in effect also subject to a similar, if not to the same level, duty of care to members.
This flexibility allows for pension savings to be invested in a manner that enables social and environmental matters to be an aspect of the selected investment vehicles, and accepts the possibility of lower potential returns, subject to there being an appropriate interest in those vehicles from the members whose money is being invested.
3. The potential for member disappointment over outcomes.
The subtext of any discussion of investment that is focused on a factor other than the achievement of the greatest absolute financial return, is that it is more likely to produce a return that is lower than would otherwise be achieved. This would be regarded as the “cost” to the member of following their social conscience. This is not inevitable, since for a number of reasons such investments can produce superior returns and/or offer the potential for counter-cyclical returns that can complement other investments in the portfolio, as the consultation document acknowledges.
However, the possibility of a focus other than on maximum returns diluting performance should not be ignored. If that occurs, even an informed member may be disappointed, so the member with the customary low level of financial literacy is particularly vulnerable. There is potential therefore for a legal challenge even where an investment has been specifically selected, at least in part, on the grounds of its social credentials, even where this fact has been clearly signalled to members.
This presents a risk for DC scheme trustees and managers, in two areas:
- although the member chooses their own investment strategy, they select from a set of options chosen by the parties running the scheme
- the member will be influenced to a greater or lesser extent by information conveyed by the trustees or manager, even where those parties are merely acting as a conduit.
Nevertheless, some trustees or managers may legitimately feel that they are able to construct an environment in which they can safely offer a specific choice of such investment media to members. In that case, social and infrastructure investment may have a future. Despite that, we suspect that for many trustees or managers the legal protections are still not sufficiently precise for them to feel comfortable with following this route.
4. Default funds a particular problem
The risk arguably increases where the investment in question forms part of the default fund, which as the consultation document recognises, is where the large majority of DC members’ funds are invested. The low level of financial literacy of most members makes them susceptible to misunderstanding the consequences of an investment that has been selected at least partially on grounds other than securing the largest absolute return. That increases the risk to trustees and managers, through members arguing that their decision (whether passive or active) was not an informed one.
The financial knowledge issue is well known, and despite attempts to improve it, remains stubbornly low. It is unlikely to improve significantly in the foreseeable future. Consequently, without further legal safeguards, those responsible for selecting funds to offer to members, particularly the content of default funds, will be reluctant to take the risk of moving too far away from the comparative safety of funds selected on the basis of expected absolute financial return. This would frustrate the government’s
policy aim upon which the consultation is predicated.
In the specific context of default funds where the member selects a packaged predetermined blend of funds, the Commission’s own background material makes clear that it is legally permissible for trustees to invest member funds in a way that accepts the possibility of lower financial returns where the compensating trade-off is a social or similar benefit. This applies provided they have good reason to believe that members would have an interest in the wider aspects of that benefit and that the financial detriment, if any, is unlikely to be “significant”. Although these caveats provide the basis upon which trustees might feel comfortable in including such investments in the default fund, the uncertainties around such things as being able to accurately determine member interest in the facet other than absolute return will again make many trustees reluctant to choose them.
On the other hand, where trustees do feel able accurately to identify the interests of members, this may offer a way forward. Wider governance issues are driving a move away from schemes offering a single, generic default fund for members, towards multiple default funds, designed around segregated memberships. This may provide a limited boost for the inclusion of investments containing a social element, where trustees feel able to more accurately match default funds to relevant members (but see below for impact on investing fund sizes).
Nevertheless overall, as noted above, poor member financial knowledge will in practice continue to be a barrier dissuading trustees and managers of DC schemes from investing in social investments.
5. The issue of fund sizes (particularly in respect of infrastructure projects)
Fund size can be an issue. Infrastructure projects of the type for which the government is generally seeking investment from pension funds are too large for any DC pension investor (and indeed, also for most UK DB schemes). In many cases the time lag between the investment and the first returns becoming available is also an issue.
Size per se need not present an insurmountable barrier to investment by smaller investors, provided the project can be packaged and offered on a unitised basis, the individual members’ funds are pooled, or both. In principle this is no different from common current practice across the pensions and wider investment industry.
Even where funds are combined in this way, the proportion of an infrastructure project that can be taken by an individual fund is likely to be relatively small. This makes the task of selling the investment effectively more difficult. Partly driven by this, there has been an upsurge in interest instead in finding ways to increase scheme sizes.
However, that may not be as effective in practice as it might appear in theory. In the context of a DC scheme, a default fund should provide a medium for aggregating individual member funds, but the move towards multiple defaults more closely related to the characteristics of particular member groups dilutes that effect.
That leads to the question of aggregating smaller schemes in order to achieve critical mass for infrastructure investing. There are already models for multiple employer schemes, either involving employers within an employer group, or unconnected employers. There are therefore no absolute insurmountable legal obstacles to mergers between DC schemes. There may however be considerable administrative cost implications, and the disinclination of individual employers to give up their own scheme with its close connection with their employees should not be underestimated.
Furthermore, merging existing schemes is a potentially difficult legal undertaking, where individual member consents would be required. This could occur, for example, where the new scheme would not continue with investment funds in which member monies are currently invested. This would not be unusual, given the universe of funds used across the DC scheme spectrum. A key attraction of consolidation is simplification and a consequent reduction of administration costs. If the aggregated scheme would be required to continue to maintain a plethora of old investment funds from past individual schemes due to an inability to obtain individual member consents to change, that element of incentive to consolidate disappears.
It is not uncommon for scheme rules to require the consent of affected members to any change being made. A practical solution might then be to close the current scheme to future contributions and offer instead membership of the new multiple employer scheme. However, that would provide only a limited solution to satisfying the government’s objectives in the short term, as it would take time for the new schemes to build up the accumulated funds of the size being sought for infrastructure investment.
It would of course be possible to legislate to compel schemes to consolidate. We understand that this is a step that has been taken previously in other jurisdictions. However, there will still be technical and moral issues to overcome, and whether or not to proceed along these lines would be a political decision.
We therefore conclude that, whilst there is potential for matching the government’s desire to source new investment for social and infrastructure projects with access to private pension funds, success may continue to be elusive, due to existing legal and financial knowledge constraints. Success in reducing the negative effect of those constraints may involve legislative and/or regulatory intervention. Any such decision would be a political one. The impact on an individual member may be significant and measurable, and it will be essential to incorporate an element of explicit or at least tacit member consent.