Fiduciary Duty: Making the right impact
Impact funds range from those that seek to generate attractive returns while pursuing social objectives to those that focus solely on the social aims
- Impact investing, ESG and socially responsible investing should be seen as distinct categories
- Financially material ESG factors encompass non-traditional factors associated with environmental and governance matters
- Ethical considerations refer to decisions, such as moral or religious ones, taken for non-financial reasons
- Impact investment includes socially beneficial aims within its remit
There has never been more interest in impact investing for defined contribution (DC) pension schemes but this is an area where any initial interest can quickly become mired in confusion over trustee duties and, at a more fundamental level, around terminology.
For DC pension schemes, there are some important themes: how should trustees understand their fiduciary duties to members; what is the role of member views or ethical considerations; and should trustees ultimately just be seeking to maximise return? (to the latter point, the answer is categorically ‘no’). It is undoubtedly possible to navigate these waters but not without first paying some attention to the basic terminology.
Impact investing is often used synonymously with or grouped together with, for example, ESG or socially responsible investing. It is also sometimes connected to ethical investing (perhaps with more justification). There are several distinct ideas here and the grouping is unhelpful both to investment decision-makers and to the proponents of impact investing. There is clearly a place for impact investing but trustees need to consider impact funds as a distinct proposition to properly engage with them.
It is helpful to refer to three broad ideas:
• Financially material ESG factors (which I would loosely group together with social responsible investing). This encompasses non-traditional factors associated with environmental and governance matters. Importantly, these are factors which can be analysed in terms of how they affect either the risks of an asset class or strategy, or the opportunities associated with it.
In a DC context, ESG is about ensuring that manager selection, monitoring and asset allocation reflects the trustee’s policy on financial material ESG factors.
At a manager level, it might, for example, result in a manager focusing on green tech or moving away from industries that have a high carbon footprint, and which might therefore be adversely affected by legislation. Again, in all these cases, the analysis is a financial one.
• Ethical considerations (non-financial factors). This refers to an investment decision-maker (whether a trustee or a manager) taking a religious or ethical belief into account, not for financial reasons, but from a conviction that it is the right thing to do. For trustees, from the legal perspective, ethical funds may form part of member-select options (for example, sharia funds) but there are limited circumstances where the trustee can use their investment power to express an ethical or religious view and can do so without significant financial detriment to the fund.
• Impact funds – the term ‘impact fund’ is used differently but may tentatively be defined as any fund whose objectives include a socially beneficial aim. Impact funds sit within a spectrum. At one end there are funds whose objective is both to achieve an attractive return and to pursue a social objective. For example, this could be a fund for social housing in a deprived area which improves conditions in that area but also generates an attractive risk-adjusted return through secured income tenants.
At the other end of the scale, there are funds where the onus is not on returns at all but, instead, on the social objective; the fund is essentially philanthropic or charitable. There is a wide range of everything in between, so understanding where a fund sits within the spectrum will be crucial for a trustee considering whether to invest in the fund or offer it as a member-select option.
The question of stewardship and the trustee’s responsibilities as asset owners probably deserve a category in their own right, although as they are not a focus for this article, they can be grouped under the broader financially-material ESG banner.
Impact funds for a pension scheme
The trustees of a DC pension scheme owe a fiduciary duty to scheme members to use their powers, including investment selection, for the purpose that power was given and to act prudently in doing so.
In practice, these obligations must be adapted depending on whether the trustee is selecting a default option or choosing member-select funds.
In the case of a default fund, the member may well end up invested without having made any choice, as the overwhelming majority of DC members do. The trustee must therefore construct the default option to balance returns over an appropriate timescale with the risks within the portfolio, to ensure an adequate pot for the member’s retirement.
It is not a great leap to see why ESG (which is ultimately about financial risk and opportunity) should form part of the trustee’s and manager’s decision making in relation to the default options. It is much harder to see where ethical considerations come into it because the purpose of the investment power is not to express the trustee or members’ ethical views (subject to one exception which we return to below).
Where then does the impact fund sit? The difficulty here is that impact funds may be designed as attractive investment propositions or as social vehicles, or a bit of both. If the trustees’ duty to the member for default funds is primarily focused on what is financially material, the impact fund must be able to justify its place purely on financial grounds. This inevitably makes it harder for those impact funds whose financial objectives are subordinated to their social objectives to form part of the default fund options.
With member-select funds, the expression of the trustee’s fiduciary duty is very different. In this context, the trustee is not selecting a fund on the members’ behalf but selecting an appropriate range of funds into which members may choose to invest. If members wish to invest in a fund that expresses their ethical or religious views, or to invest in an impact fund which combines a social objective with an investment objective (and may even sacrifice some return), that is a matter for them. Trustees must, of course, be satisfied that the funds they make available meet adequate quality standard, so it will also be of the utmost importance to ensure that such funds are labelled in a way that ensures (as far as possible) that members fully understand what they are investing in.
From a UK legal perspective, member views need to be treated with care, particularly in the context of default funds. This is because, ultimately, trustees are responsible for discharging their own investment responsibilities and cannot and should not abrogate those responsibilities by acting on the basis of member views. It is no more appropriate to consult members on their views on ESG risks in a default fund than it would be to ask them about foreign exchange risks or asset security.
That is not to say that members’ views are unimportant. Trustees are, in my experience, conscious of whose money they are investing. They want to engage with members not merely because they must meet disclosure requirements but also because they aim to help and encourage members to take an interest in their pensions in the hope that those members may ultimately choose to save.
Beyond that, there are specific circumstances where member views clearly do have a bearing.
First, with member-select funds. If the range of funds is well aligned to members’ interests and priorities, the hope is that they will be encouraged to save. This is one context where trustees may find member surveys valuable when selecting fund options.
There are also schemes where the membership is sufficiently homogenous that the trustees may be able to satisfy themselves that the membership share a particular set of beliefs – for example, a pension scheme associated with a religion, charity or interest group. This set of circumstances may create a narrow lacuna where, legally, the trustees may (as an exception) take this common shared set of beliefs into account in investment matters. However, they may only do this if they can do so without significant detriment to the fund’s investment strategy.
Ralph McClelland is a partner at Sackers, a UK law firm specialising in pension