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What do pension schemes need to say about ESG, climate change and stewardship?

  • United Kingdom
  • Pensions

17-06-2019

Trustees and providers of pension schemes face ever increasing and changing legal duties to have policies on and disclose how they deal with stewardship and environmental, social and governance (ESG) issues.

This article pulls the new rules together and sets out what trustees and providers will need to do differently and where and when they will need to do it.

It also explains how these steps are relevant to how trustees and providers communicate with members more generally and how they engage with members keen to present their own views to the scheme.

Updates to statement of investment principles

By 1 October 2019, most pension trustees will need to include in their scheme’s statement of investment principles (SIP) their policies on:

  • “financially material considerations” over the “appropriate time horizon” of investments
  • the extent (if at all) to which they take into account “non-financial matters”
  • the exercise of rights (including voting rights) attaching to investments
  • undertaking engagement activities in respect of investments

“Financially material considerations” are matters which the trustees consider as financially material, including ESG considerations (including but not limited to climate change).

An “appropriate time horizon” means the length of time that the trustees consider is needed for the funding of future benefits by the scheme’s investments. This means that trustees need to reflect the profile and maturity of their own scheme when considering whether a factor is financially material - for instance, taking into account their endgame planning, such as targeting buy-out.

“Non-financial matters” means the views of the members and beneficiaries including (but not limited to) their ethical views and their views in relation to social and environmental impact and present and future quality of life.

Engagement activities include the methods in which, and the circumstances by which, trustees would monitor and engage with “relevant persons” about “relevant matters”. By 1 October 2020, trustees will need to disclose a wider range of engagement activities as new rules will extend the matters that their policy needs to cover to include the capital structure of an issuer of debt or equity and the way in which the trustees will manage actual or potential conflicts of interest arising out of their engagement activities. The list of people that the trustees will have to consider engagement with is extended to cover “other stakeholders” (for example those with an interest in an issuer of debt or equity who are not other holders of that debt or equity).

However, given that many trustees already need to update their SIPs to disclose their policy on certain engagement activities by 1 October 2019 anyway, some are aiming to comply with this duty in full by then.

There are limited exceptions for schemes with fewer than 100 members and public sector schemes.

Arrangements with asset managers

Just as many schemes were updating their SIPs to comply with these new rules, the DWP laid a further set of requirements dealing with stewardship before Parliament. These are intended to implement the second EU directive on Shareholder Rights which needed to be incorporated into UK law by 10 June 2019. Presumably, Brexit had meant that the Government was uncertain whether it would need to implement these requirements or not.

These latest rules will require trustees to include in their SIP their policy in relation to their arrangement with ANY asset manager, setting out (or explaining why they are not setting out):

  • how the arrangement incentivises the asset manager to align its investment strategy and decisions with the trustees’ own core investment policies
  • how the arrangement incentivises the asset manager to take decisions based on assessment of the medium- to long-term performance (financial and non-financial) of debt / equity issuers, and to engage with those issuers to improve that medium- to long-term performance
  • how the remuneration for asset management services and the method used for, and the time period over which, the trustees evaluate the asset manager’s performance, are in line with the trustees’ core investment policies
  • how the trustees monitor portfolio turnover costs incurred by the asset manager and how they define and monitor targeted portfolio turnover (i.e. expected frequency of asset purchase / sale transactions) and turnover range (i.e. the expected minimum and maximum frequency of such transactions)
  • the duration of the trustees’ arrangement with the asset manager

Larger schemes, with active investments and segregated mandates, may already have arrangements in place (e.g. performance fees) which deal with some aspects of their investment strategy. However, smaller schemes, or those which invest mainly in pooled funds may find these new rules onerous. In addition, “asset manager” is not defined for these purposes and is not a term generally used in pensions legislation so trustees may have to give some thought as to which arrangements they need to document in the SIP.

Fortunately for trustees, these are issues which asset managers will already be considering as new FCA requirements will mean that they need to disclose information to trustees on how their investment strategies contribute to the medium to long term performance of the assets. Life insurers have been subject to equivalent rules since 10 June 2019 (see Comparison with contract based schemes, below). Trustees who are developing their policies in this area may therefore want to look to their contract-based counterparts.

Disclosure on website and implementation statements

The vast majority of trust based schemes (both defined benefits and defined contribution) will need a SIP that complies with the new rules outlined above.

DC schemes

Further obligations will apply to the trustees of defined contribution (DC) and hybrid schemes (excluding those where the only DC benefits are AVCs).

From 1 October 2019 trustees of such schemes will be need to:

  • publish the SIP on a publicly available website, free of charge, and inform scheme members of this in their annual benefit statement and
  • if there are 100 or more members in their scheme, state their policy on engagement in their default investment strategy

From 1 October 2020, trustees of DC schemes will need to include in their annual report and on a publicly available website information on how they acted on the principles in their SIP. They will need to signpost members to the website in their annual benefit statement. This information will need to be updated to set out information on the trustees’ voting behaviour over the year and the updated information will need to appear on the website by 1 October 2021.

DB schemes

The requirements for trustees of DB schemes are slightly less onerous. They will need to:

  • publish their SIP on a website from 1 October 2020 and
  • report on their voting behaviour and how they followed their policy on engagement activities during the scheme year in their annual report from 1 October 2020 and publish the information on a publically available website by 1 October 2021

Comparison with contract based schemes

The FCA has also issued new rules intended to improve shareholder engagement and increase transparency around stewardship (and presumably also to deal with requirements under the second Shareholder Rights Directive). The FCA intends that this “should over time encourage the emergence of a market where firms in part compete based on their effective stewardship”.

The new rules took effect from 10 June 2019 and apply to both life insurers and asset managers. Under these rules:

  • life insurers and asset managers will need to publish their engagement policy and annual information on how it has been implemented, or explain publicly why they are not doing so
  • life insurers must also disclose, on an annual basis:
    • their arrangements with asset managers
    • how the main elements of their equity investment strategy are consistent with the profile and duration of their liabilities
    • how these elements contribute to the medium to long term performance of their assets
  • asset managers must provide information to asset owners, including on how their investment strategies contribute to the medium to long term performance of the assets

The rules came into effect within weeks of publication. The FCA has therefore suggested that firms will be able to comply by explaining what they are doing to develop an engagement policy – or that they are still considering whether or not to have one.

As noted above, trustees may find it helpful to look to the information disclosed by both life insurers and asset managers when updating their SIP to comply with the new rules on engagement.

The FCA is also consulting on whether to expand the remit of Independent Governance Committees (IGCs) to report on the ESG policies of firms that provide workplace pensions. IGCs were set up by the FCA in 2015 with a view to providing independent oversight of the workplace pensions of insurers.

The FCA has proposed that the duties of IGCs will be expanded to include a duty to report on the firm’s policies on ESG issues, consumer concerns and stewardship for the products covered by the IGC. Coupled with this, the FCA is proposing guidance for providers of workplace pension products and investment-based life insurance products on how those firms should consider ESG risks and opportunities when making investment decisions on behalf of customers.

Trustees of DC schemes may well be interested in the FCA consultation and its outcomes given the large number of members who will likely move towards drawdown products with firms covered by the consultation. If these rules are introduced, trustees may find IGC reports on these issues a useful point of comparison when preparing their own disclosures.

The consultation closes on 15 July 2019.

Member views

Trustees and providers will need to consider how the steps they are taking to comply with the new disclosure rules reflect how they communicate with members more generally.

The Government dropped its more controversial proposals, which would have required trustees to prepare a standalone ‘statement on member’s views’. This statement would have set out the extent to which trustees took into account members’ views on non-financial matters and would have been issued alongside the SIP.

This was generally welcomed because of the potential problems of determining what member views are and whether they reflect the views of the majority of the members. In addition, it is clear that as a matter of trust law, trustees do not have to take member preferences into account when investing scheme assets. Their primary concern should be the financial return generated by investments.

Trustees may, nevertheless, decide that they do want to take member views into account as part of their investment strategy. If so, they will need to include that policy in their SIP. They will also need to consider how to determine member views and ensure that taking them into account will not result in any financial detriment to the scheme.

The Law Commission suggested in its report on “the Fiduciary Duties of Investment Intermediaries” back in 2014 that trustees could determine member views using a member poll – albeit the success of this would depend on whether enough members take part. They also proposed that in some cases trustees could make assumptions of member views – e.g. that they are likely to oppose practices that contravene international conventions on landmines and cluster bombs. Other options for gathering member views, put forward by the Pensions Regulator, include using workshops, an annual general meeting for members, focus groups or a member panel.

In DC schemes, providers and trustees may also want to offer members a range of investment options (as an alternative to the default fund) which tilt towards addressing ESG, climate change and/or ethical issues. These options may need to be accompanied by additional risk warnings to make clear where non-financial factors are given priority over financial factors.

Anticipating a response

Institutional investors face ever greater public scrutiny on how they handle ESG and climate change.

Trustees need to consider how information disclosed in their SIP could be treated when it is made public:

  • trustees currently have a duty to provide a copy of the SIP to any member, prospective member or beneficiary who requests it within two months of the request being made
  • trustees of DC schemes will need to disclose their SIP on a publicly available website from 1 October 2019 – and a number of other trustees adopt this approach already
  • trustees of DB schemes will need to do this from 1 October 2020

Only last month Extinction Rebellion, a climate change activist group, targeted a Pensions and Lifetime Savings Association (PLSA) conference to advocate that local authority pension funds divest from certain companies for environmental reasons.

Last year the House of Commons’ Environmental Audit Committee wrote to the 25 largest UK schemes to ask how they manage the risks that climate change poses to pension savings. ClientEarth, a legal environmental campaign group, also wrote to various pension scheme trustees, warning them of possible legal challenges if they fail to take account of evolving market standards and legal duties.

Trustees and providers need to consider how public bodies and industry groups could respond to any statements they make on ESG and climate change.

Upcoming developments

In addition to the FCA publishing its final rules on the remit of IGCs, the pensions industry is also awaiting a new code of practice from the Pensions Regulator (TPR) on internal controls.

The updated code will reflect changes to the Pensions Act 2004 made in January this year following the new European pensions directive (IORP II). It will outline TPR’s view on how trustees should consider ESG factors and other risks in their governance systems and arrangements.

TPR is expected to issue the new code and consult on it later this year.

TPR may also issue additional guidance in relation to investment.

Next steps

Trustees should review their SIP and consider whether it needs updating ahead of October 2019.

Trustees can also take further steps to address ESG, climate change and stewardship as part of their investment strategy, governance arrangements and how they communicate with beneficiaries. For instance they could:

  • get some training. We tend to see trustees asking their current consultant, an ESG specialist consultant and their lawyer to give this
  • engage with members and the employer sponsor to understand their views on ESG
  • think further about how to build these issues into investment strategy and governance arrangements – e.g.
    • obtaining additional reporting at trustee and sub-committee meetings
    • preparing / reviewing a statement on their approach to responsible investment
    • reviewing how they, investment managers and any proxy voting advisers take account of ESG issues when selecting, retaining and realising investments or exercising voting rights
    • engaging with companies in which the scheme invests on the areas to be improved

If you would like any more information about how this might apply to your scheme, please contact your usual Eversheds Sutherland contact those below.

For more information contact

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