The Law Commission’s recent investigation* into the fiduciary duties of investment intermediaries is the latest initiative to improve pension scheme governance.
“One of the focuses of the Law Commission’s investigation was to consider how fiduciary duties apply to different persons in the investment chain – such as fund managers, custodians and consultants as well as trustees,” notes Simon Tyler, legal director at Pinsent Masons.
The Law Commission admits that the law relating to fiduciary duties is confusing. This, it explains, is because it derives from a variety sources, including “the trust deed, legislation, duties which attach to a power and duties of care, as well as ‘fiduciary duties’ as understood by lawyers”. As a result, pension trustees have no point of reference to tell them the right way to make decisions. But the Commission does not advocate legislation to codify the law, believing this could lead to a loss of flexibility, nor does it recommend that fiduciary duties be extended to other people in the investment chain.
At a glance
• The Law Commission says any attempt to codify fiduciary duties could make the system less flexible and to lead to unintended consequences.
• Fiduciary duties should not be extended to others in the investment chain it says, but members of independent governance committees (IGCs) should have a statutory duty to act in members’ best interests.
• Providers should be required to indemnify IGC members.
• The Commission did not recommend that investment consultants should be more tightly regulated, but said the government could commission further research to establish whether the current system poses any risks.
The Commission’s report follows the recent OFT market study and DWP Command Paper, both looked at the quality and governance of DC schemes, especially those used for automatic enrolment. One key outcome of these reviews is the requirement that all providers of contract-based pension must establish an independent governance committee (IGC) by April 2015. The Law Commission’s review considered the role of these committees, saying that it sees no reason in principle why members’ interests in contract-based default funds should differ from those in DC trust-based default funds. Accordingly, it has recommended that the Financial Conduct Authority (FCA) consider whether IGCs need guidance in interpreting the interests of members in default funds.
It made two further recommendations:
• That IGCs embedded within pension providers owe a statutory duty to scheme members to act, with reasonable care and skill, in members’ interests and that this duty should not be excludable by contract; and
• That pension providers should be required to indemnify members of their IGCs against any liabilities they incur in the course of their duties.
While IGCs are considered a good thing, there are differing views on how the level of governance they will provide will compare with trust-based schemes. For example, Tyler says: “This should give members of contract-based schemes some of the confidence that members of trust-based schemes derive from knowing that someone is acting in their best interests.”
James Double, scheme manager at PS Independent Trustees, supports the view that contract-based schemes have not had the same levels of oversight as trust-based schemes and observes that IGCs will provide a ‘trustee-like’ oversight for contract-based schemes. But he questions how truly independent IGCs can be, saying: “An IGC set up at provider level can’t move a default fund to another provider or shift the administration away if it isn’t up to scratch – there’s a conflict of interest. In an ideal world this oversight would be at employer level – we’ll have to see what comes out.” He adds: “The government is fully aware that one reason why small employers have taken the contract-based route is cost savings. It would be a challenge for smaller employers to have their own governance committees so the compromise is to do this at the provider level.”
Should investment consultants be regulated?
As part of its review, the Law Commission looked into how investment consultants are regulated. Currently, investment consultants do not fall within the scope of FCA rules if the advice they provide is considered to be “generic”. This includes advice on strategic asset allocation and advice to become the client of a particular firm or to use its services in a certain way, provided it does not relate to specific investments.
Specific concerns about this apparent lack of regulation were that:
• The concentration of the investment consultancy market leads to a narrow range of advice and “herding behaviour”. This has been thought to contribute to a short-termist approach to investment.
• Consultants may experience conflicts of interest. For example, the presence of an in-house investment solution, which would affect the independence of their advice.
• Many trustee boards do not have the expertise to challenge their investment consultants and believe that their actions will not be called into question if they do what their consultants tell them to.
But, the Commission decided not to recommend a review of the regulation of investment consultants, even though the majority of organisations and individuals who responded to its consultation said it should.
The Commission’s justification is that increasing the scope of regulation could make it harder for investors to obtain advice easily and cheaply. It adds that investment consultants are regulated in respect of other services that they provide, and “will in any event owe duties of care in respect of all advice they give”.
Views on how investment consultants should be regulated differ. During the consultation, two of the target consultancies, Mercer and Towers Watson, took opposing sides. Arguing against further regulation, Mercer says that it offers its services in a competitive market and knows its clients have a choice among providers.
Towers Watson advocated regulation on the grounds that it would help all trust-based pension funds achieve a minimum standard of advice. It said: “The regulation of investment consultants now seems somewhat dated, with advice on the provision of pooled vehicles regulated, unlike similar advice on segregated portfolios. Furthermore, advice on portfolio strategy can have a more profound impact on a scheme’s finances than advice on manager selection, yet it does not need to be provided by a regulated advisor.”
Others also have differing views. John Lawson, head of policy at Aviva, believes the Law Commission has side-stepped this issue and sees conflicts of interest.
“Some of these consultants recommend their in-house blended funds,” he says. “These are constructed from funds available on the market but no-one knows how they are made up, their performance is not publicly reported. No-one knows what the consultants are doing and if they add value.”
James Double, scheme manager at PS Independent Trustees, thinks the advisers he works with are well qualified and regulated. “They need to give trustees the reasons for their recommendations so trustees have an audit trail to demonstrate why they have chosen a particular provider, default fund and range of investment options. I don’t see any need to increase the level of regulation,” he says.
This may not be the end of the story. Despite stopping short of recommending change, the Law Commission concludes that the lack of regulation seems anomalous and asks the government to actively monitor this area. One possibility, is for the government to commission independent research into the issues raised by the current regulation, saying that regulation would be justified if this reveals specific risks.
John Lawson, head of policy at Aviva, believes contract-based schemes will be better governed and more transparent than trust-based schemes. “A lot of trustees are not particularly skilled. Despite [trustee knowledge and understanding] requirements, knowledge levels lag behind where they should be.”
The Law Commission recommends that pension providers be required to indemnify IGC members against any liability they may incur. It feels that, as pension providers will appoint the members and resource the committees, they are best placed to control the quality of IGCs’ work. Without such an indemnity, the Commission says, if IGCs fail to act in the best interests of scheme members, this may expose them to breach of statutory duty. It also believes that an indemnity would give pension providers “a clear interest in ensuring that the committees carry out their tasks correctly”.
This proposal has been supported. In its consultation response, the NAPF said an indemnity would appear to be a pre-requisite in order to attract individuals to join and actively participate as members of IGCs. But not everyone agrees that this is necessary.
Aviva’s Lawson says: “I don’t really see the need for indemnity. IGCs have no powers or control; they don’t have any contractual or fiduciary responsibilities.… IGC members will need to be competent and will want to perform well to make sure they are reappointed at the end of their term of office.”
What is agreed is that the recommendations made by this report, together with, changes arising from the OFT and DWP’s reviews, will improve the governance of all DC schemes.
* Fiduciary Duties of Investment Intermediaries, The Law Commission, June 2014