In the United Kingdom, pension fund investment is governed by: Requirements of legislation, which build on the general legal principles.

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1 The prudence standard in pension fund investment in the United Kingdom Edward Jewitt, Partner, Mayer Brown International LLP 1. Introduction In the United Kingdom, pension fund investment is governed by: (a) General legal principles, established by case law. These began with the "prudent man" principle and additional requirements were added as case law developed; and (b) Requirements of legislation, which build on the general legal principles. This paper explains the key points. Overall the combination of general principles and legislation gives a sensible level of protection for beneficiaries but without imposing an excessive regulatory burden on pension scheme trustees. 2. General legal principles from case law (a) Acting prudently - the "prudent man" standard The requirement for prudence was set by the Court of Appeal in 1886 as follows: "The duty of a trustee is to take such care as an ordinary prudent man would take if he were minded to make an investment for the benefit of other people for whom he felt morally bound to provide" 1. This was confirmed by the House of Lords in 1887: "As a general Rule the law requires of a trustee no higher degree of diligence in the execution of his office than a man of ordinary prudence would exercise in the management of his own private affairs. Yet he is not allowed the same discretion in investing the moneys of the trusts as if he were a person sui juris dealing with his own estate. Businessmen of ordinary prudence may, and frequently do, select investments which are more or less of a speculative character: but it is the duty of a trustee to confine himself to the class of investments which are permitted by the trust, and likewise to avoid all investments of that class which are attended with hazard 2. So, so long as he acts in the honest observance of these limitations, the general rule already stated will apply" 3. At first sight this does not seem a particularly high standard. The requirement is only to exercise the degree of care of an "ordinary prudent man" investing for the benefit of "other people for whom he 1 Whitely, Re (1886) L.R. 33 Ch. D Note that the decision in Nestle v National Westminster Bank (below) meant that modern trustees are entitled to be judged by current standards of portfolio theory which emphasise the risk level of the entire portfolio not each investment in isolation. 3 Learoyd v Whitely (1887) 12 L.R. App. Cas Jun-10 13:01

2 felt morally bound to provide". This is materially less demanding then the standard of care which is implied into a contract for a professional managing pension fund assets by way of business, which is to exercise the standard of care which would reasonably be expected of a professional providing services of that kind. (iv) However, the prudent standard must be viewed alongside the other general principles from case law and the legislative requirements discussed below. These add up to a sensible level of protection for pension scheme beneficiaries, without being unrealistically demanding. (b) Acting in the best financial interests of the beneficiaries (iv) (v) The case of Cowan v Scargill set out the principle that Trustees should exercise their investment powers in the "best interests of the present and future beneficiaries" of the scheme. The case concerned the Mineworkers Pension Scheme. Some of the trustees were appointed by the National Union of Mineworkers. The leader of the National Union of Mineworkers, Arthur Scargill, who is famous in the UK for masterminding industrial relations battles with Margaret Thatcher's government in the 1980s represented the union appointed trustees in court. A dispute had arisen among the trustees because the union appointed trustees objected to investment in oil and gas companies which competed with the coal industry and also to overseas investments. The court's decision - that the trustees should act in the best financial interests of the scheme's beneficiaries - meant that the trustees were required to put aside their own personal or political views when investing. They should choose investments which would lead to the best financial outcome even if the investments would conflict with those views. The actions of the union appointees were intended to support union policy. The actions were designed to support the UK economy generally and the coal industry in the UK which would aid the prosperity of the scheme and its beneficiaries. The court considered that this was of no relevance to the deferred pensioners and pensioners who were no longer employed because the pension scheme was fully funded. It was therefore not a proper approach. The judge distinguished the US case of Withers v Teachers Retirement System of the City of New York (1978) 447 F. Supp In that case the trustees had purchased speculative bonds issued by New York City to try to avoid the bankruptcy of the City. That was held to be proper because the scheme was unfunded and only had reserves for 8 or 10 years payments. Unless contributions from the city continued the reserves would be exhausted. The action of the trustees was therefore in the interests of all the beneficiaries and not motivated just by concern for public welfare or the interests of the employed teachers Jun-10 13:01 2

3 (vi) (vii) The principles in Cowan v Scargill were developed in Martin v City of Edinburgh District Council 4. In this case, councillors who objected to apartheid asked their investment advisors to disinvest from companies on a United Nations list of companies with substantial investments in South Africa and to make alternative investments. This was in respect of trusts for which the council was trustee The court held there had been a breach of trust because the trustees had failed to consider whether this course of action was in the best interest of the trust's beneficiaries. (viii) The judge said that it was not reasonable and practicable for trustees to divest themselves of personal, political, religious or moral views but a trustee "must recognise that he has those preferences, commitments or principles but nonetheless do his best to exercise, fair and impartial judgment on the merits of the issue before him". (ix) This means that normally it is difficult for trustees to impose their political or moral or religious views when making investments. (x) The United Nations Environment Programme Finance Initiative's 2005 report argued that Cowan v Scargill did not prevent pension trustees from having regard to environmental, social and governance issues in investment decision making: "At most, Cowan v Scargill may be treated as endorsing the accepted rule that trustees exercising fiduciary investment powers must exercise those powers for the purpose for which they were granted. Where that purpose is to achieve a financial return, as in the case of a typical pension or mutual fund, securing a financial return must be the primary motivation behind investment decision in respect of the fund. There may be one other respect in which Cowan v Scargill offers useful guidance: it confirms that fiduciary powers must be exercised in the interests of the beneficiaries; as such, the interests of beneficiaries beyond financial return should be considered in arriving at investment decisions in certain circumstances". 5 (xi) Our view is that in practice the extent to which environmental and social issues influence investment decisions remains limited in the UK. This is despite the fact that trustees are required to prepare a statement of the principles they follow in decision making which includes an item on the extent (if at all) to which social, environmental or ethical considerations are taken into account 6. 4 [1989] PLR 9 5 Extract from executive summary of "A legal framework for the integration of environmental, social and governance issues into institutional investment" produced for the Asset Management Working Group of the UNEP Finance Initiative in October See 3(g) of this paper Jun-10 13:01 3

4 (c) Acting for a proper purpose In Bishop of Oxford v The Church Commissioners 7, a case about funds of the Church of England, the court confirmed that investment powers must be exercised to further the purposes of the trust: "It is axiomatic that charity trustees, in common with all other trustees, are concerned to further the purposes of the trust That is their duty. To enable them better to discharge that duty, trustees have powers vested in them. Those powers must be exercised for the purpose for which they have been given: to further the purposes of the trust." (iv) The court said that the starting point is that the purposes of the trust would be most appropriately served by the trustees seeking to obtain the maximum return which is consistent with commercial prudence. There might be rare cases where the objects of the charity would mean that the holding of certain investments by the trustees would conflict with the aims of the charity (e.g. a cancer research charity investing in tobacco shares). There might be other cases where the holding of certain investments would hamper the work of the charity by making potential recipients unwilling to receive help or alienating supporters. There might be cases where the trust deed provides that in investing the assets non-financial criteria should be used. This case underlines that in pension fund investment it is considered to be difficult for moral views to override the requirement to invest prudently and in the best financial interests of the beneficiaries. It will be easier to do this where the trust deed provides for such considerations to be taken into account. (d) Acting impartially between the different categories of beneficiary Another duty outlined in Cowan v Scargill was for trustees to hold "the scales impartially" between the different classes of beneficiary. This meant that it was not proper for the union appointed trustees to veto investments in competing industries to coal to help preserve the jobs of the employed pension scheme members. This did not benefit the deferred and pensioner members. In Nestle v National Westminster Bank plc 8, Miss Nestle 9 sued the bank as trustees and executor of her grandfather's will. She claimed 7 (1991) 135 S.J.L.B. 180, [1993] 2 All ER [1994] 1 All E.R. 118, CA 9 "If ever anyone was born with a mission in life, it was Miss Georgina Nestle. That mission was to wreak vengeance on the National and Provincial Bank Trustee Department for the supposed wrongs inflicted on her family. She was brought up from infancy in her mother's unshakeable belief that the Bank had tried to destroy their lives She and her mother paraded through the City carrying sandwich boards inscribed with suitably uncomplimentary text Through the good offices of BBC investigative journalism, Miss Nestle was enabled to broadcast her grievances to the nation " Hoffman J Jun-10 13:01 4

5 that there had been a breach of trust in the way they had managed the investments of her grandfather's estate. (v) (vi) (vii) Hoffman J decided that the bank had not been in breach of trust. He set out the duty to hold the scales equally between the different classes of beneficiaries as "the trustee must act fairly in making investment decisions which may have different consequences for different classes of beneficiaries". The judge noted, in particular, that investment was not a mechanistic process. The Trustees had a wide discretion and could take into account a range of factors peculiar to the trust such as income needs of beneficiaries with life interests, foreign residents, capital gains tax and advances to beneficiaries with life interests. There was a wide range of courses of action, where there is room for a genuine difference of opinion, but where the different courses are not improper. In the pensions context, different investment approaches may be appropriate for pension schemes of different maturities. For example a scheme with many active members and few pensioners may have a different approach compared to a scheme with many pensioners and few actives. Trustees are expected to act impartially when considering the implications for the different classes of beneficiary but it should not be improper to tailor an investment approach to reflect the balance of the membership profile. (e) Considering all relevant factors Trustees have a general duty when exercising discretionary powers to consider all relevant factors, to disregard irrelevant factors and not to reach a perverse conclusion 10. There seems no reason why these requirements would not apply to investment decisions. Where a trustee does not comply with these requirements a decision is voidable 11. (f) Those are the key principles from case law. The rest of this paper examines how legislation builds on these principles. 3. Legislative requirements (a) (b) This section sets out the key legislative requirements. Requirement to be authorised to manage pension fund assets 10 Re Hastings-Bass [1975] Ch 25, Edge v Pensions Ombudsman [2000] Ch Abacus Trust Company (Isle of Man) v Barr [2003] Ch Jun-10 13:01 5

6 The broad effect of The Financial Services and Markets Act 2000 and regulations 12 is that it is a criminal offence for "day to day" decisions about the management of the assets of an occupational pension scheme to be taken by a person who is not authorised under that Act or exempt from authorisation. Pension fund trustees are not normally authorised. There are some exceptions, particularly to allow pension trustees to make decisions about investing in pooled funds. But, subject to these exceptions, pension trustees are in practice required to delegate day to day management of their investments to an authorised fund manager in the UK or a professional fund manager outside the UK. (b) Delegation to fund managers permitted The Pensions Act 1995 contains an express authorisation for pension trustees to delegate to an authorised fund manager in the UK 13 or an overseas fund manager 14. The act provides that trustees are not responsible for the actions of a UK authorised fund manager to whom they have delegated investment discretion provided that they have "taken all such steps as are reasonable" to satisfy themselves that the fund manager has the appropriate knowledge and experience for managing the investments of the scheme, and that he is carrying out his work competently and complying with the requirements referred to at (d) below. Similarly, it is possible for trustees to rely on an exclusion clause in their trust deed protecting them from person liability where they have delegated to an overseas fund manager, subject to the same conditions as in above. (c) No exclusion of liability for breach of the prudent man test It is not possible for trustees or fund managers to restrict their liability for "breach of an obligation under any rule of law to take care or exercise skill in the performance of any investment functions" 15. In the case of trustees this means failure to comply with the prudent man standard referred to in 2(a) above. In the case of professional fund managers it means a duty to exercise reasonable care which is implied into contractual arrangements with agents acting for reward. 12 S19 Financial Services and Markets Act 2000, Article 37 Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 SI2001/544, Article 4 Financial Services and Markets Act 2000 (Carrying on Regulated Activities by way of Business) Order 2001 SI2001/ S34(2) and (3) Pensions Act S34(5) Pensions Act S33 Pensions Act Jun-10 13:01 6

7 (iv) A recent example of the application of this clause is set out in a decision of the Pensions Ombudsman relating to the ES Group Pension Scheme. 16 Trustees bought shares in two of the employers participating in the pension scheme. The employers were in financial difficulty and the shares became worthless. The Ombudsman determined that the trustees had failed to exercise "reasonable" care. They were not permitted to rely on the exclusion clauses in the scheme's trust deed and were personally liable for losses to the scheme. (d) Formalities for choosing investments Trustees and fund managers who are choosing investments must comply with a list of requirements set out in regulations 17. These are derived from a European directive 18 and are listed in the schedule to this paper. They include: That investment powers must be exercised in the best interest of the scheme's beneficiaries. That powers of investment must be exercised in a manner calculated to ensure the security, quality, liquidity and profitability of the portfolio as a whole. That assets of the scheme must consist predominantly of investments admitted to trading on regulated markets. That the assets of the scheme must be properly diversified. That investment in derivatives must be for risk reduction or efficient portfolio management. Trustees must also obtain advice (normally from a person authorised under the Financial Services and Markets Act 2000) on whether a proposed investment is satisfactory having regard to the requirements in the regulations (so far as they relate to the suitability of investments) and to the principles in the statement of investment principles (see below) 19. Trustees retaining any investment must decide how often they need further advice about retaining the investment and then go on to take that advice Determination of the Pensions Ombudsman dated 11 March 2009 relating to the ES Group Pension Scheme Reference M and others 17 S36(1) Pensions Act 1995, Regulation 4 Occupational Pension Schemes (Investment) Regulations Directive 2003/41 19 S36(3) Pensions Act S36(4) Pensions Act Jun-10 13:01 7

8 (e) Prohibition on borrowing Trustees are not permitted to borrow except to provide temporary liquidity for the scheme 21. (f) Restrictions on employer related investment Trustees are prevented from investing more than 5% of the scheme's assets in "employer-related investments" 22. This includes: shares or other securities issued by the employer or a connected or associated person; land which is occupied or used by, or subject to a lease in favour of, the employer or any such person; and other property used for the purposes of any business carried on by the employer or any such person. In addition, none of the assets of the scheme may be lent to the employer or a connected or associated person. (g) Statement of Investment Principles Trustees are required to prepare and keep up to date a written statement of the principles governing decisions about investments for the purposes of the scheme 23. The matters which have to be included in this statement are set out in schedule 2 but they include: the kinds of investments to be held, the balance between different kinds of investments, risks and the extent (if at all) to which social, environmental or ethical considerations are taken into account. (h) Trustee knowledge and understanding 24 Trustees are required to be "conversant with" the trust deed and rules of the scheme (including the investment powers) and with their statement of investment principles. Trustees are required to have knowledge and understanding of the principles relating to the funding of occupational pension schemes and to the investment of the assets of such schemes. The degree of knowledge and understanding required is that appropriate for the purposes of enabling the individual properly to exercise his functions as a trustee. These obligations arguably extend the prudent man standard by describing expressly some of the background knowledge which is expected where trustees make investment decisions. Myners principles Finally, although not a legislative requirement, trustees should also have regard to the principles for institutional investment published by HM Treasury 21 S36A Pensions Act 1995, Regulation 5 Occupational Pension Schemes (Investment) Regulations S40 Pensions Act 1995, Regulations Occupational Pension Schemes (Investment) Regulations S35 Pensions Act 1995, Regulation 2 Occupational Pension Schemes (Investment) Regulations S Pensions Act Jun-10 13:01 8

9 4. Conclusion (known as the Myners Principles) 25. These principles codify best practice within the pensions industry in investment decision making. While they are voluntary, trustees are expected to consider their applicability to their own fund and report on a "comply or explain" basis how they have used them. The principles are set out in Schedule 3 of this paper. That is a summary of the key legal requirements which apply to investment by pension trustees in the UK. General legal principles from case law, starting with the prudent man principle, have been expanded by legislation. The result is a legal framework which strikes a fair balance between protection for beneficiaries and avoiding excessive regulation. Edward Jewitt Mayer Brown International LLP 15/06/ Updating the Myners Principles: a response to consultation, published by HM Treasury in October Jun-10 13:01 9

10 Schedule 1 Regulation 4 of the Occupational Pension Schemes (Investment) Regulations 2005 Investment by trustees (1) The trustees of a trust scheme must exercise their powers of investment, and any fund manager to whom any discretion has been delegated under section 34 of the 1995 Act (power of investment and delegation) must exercise the discretion, in accordance with the following provisions of this regulation. (2) The assets must be invested: (a) in the best interests of members and beneficiaries; and (b) in the case of a potential conflict of interest, in the sole interest of members and beneficiaries. (3) The powers of investment, or the discretion, must be exercised in a manner calculated to ensure the security, quality, liquidity and profitability of the portfolio as a whole. (4) Assets held to cover the scheme's technical provisions [the amount needed to meet the scheme's liabilities] must also be invested in a manner appropriate to the nature and duration of the expected future retirement benefits payable under the scheme. (5) The assets of the scheme must consist predominantly of investments admitted to trading on regulated markets. (6) Investment in assets which are not admitted to trading on such markets must in any event be kept to a prudent level. (7) The assets of the scheme must be properly diversified in such a way as to avoid excessive reliance on any particular asset, issuer or group of undertakings and so as to avoid accumulations of risk in the portfolio as a whole. Investments in assets issued by the same issuer or by issuers belonging to the same group must not expose the scheme to excessive risk concentration. (8) Investment in derivative instruments may be made only in so far as they: (a) contribute to a reduction of risks; or (b) facilitate efficient portfolio management (including the reduction of cost or the generation of additional capital or income with an acceptable level of risk), and any such investment must be made and managed so as to avoid excessive risk exposure to a single counterparty and to other derivative operations. (9) For the purposes of paragraph (5): Jun-10 13:01 10

11 (a) an investment in a collective investment scheme shall be treated as an investment on a regulated market to the extent that the investments held by that scheme are themselves so invested; and (b) a qualifying insurance policy shall be treated as an investment on a regulated market. (10) To the extent that the assets of a scheme consist of qualifying insurance policies, those policies shall be treated as satisfying the requirement for proper diversification when considering the diversification of assets as a whole in accordance with paragraph (7). (11) In this regulation: "beneficiary", in relation to a scheme, means a person, other than a member of the scheme, who is entitled to the payment of benefits under the scheme; "derivative instrument" includes any of the instruments listed in paragraphs (4) to (10) of Section C of Annex 1 to Directive 2004/39/EC of the European Parliament and of the Council on markets in financial instruments; "regulated market" means: (a) a regulated market within the terms of Council Directive 93/22/EEC on investment services in the securities field; (b) a regulated market within the terms of Directive 2004/39/EC; or (c) any other market for financial instruments: which operates regularly; which is recognised by the relevant regulatory authorities; in respect of which there are adequate arrangements for unimpeded transmission of income and capital to or to the order of investors; and (iv) in respect of which adequate custody arrangements can be provided for investments when they are dealt in on that market; "technical provisions" has the meaning given by section 222(2) of the 2004 Act (the statutory funding objective) Jun-10 13:01 11

12 Schedule 2 Matters to be covered in the statement of investment principles under s35 Pensions Act 1995 (taken from Regulation 2(3) Occupational Pension Schemes (Investment) Regulations 2005) A statement of investment principles must be in writing and must cover at least the following matters (a) the trustees' policy for securing compliance with the requirements of section 36 of the 1995 Act (choosing investments); (b) their policies in relation to the kinds of investments to be held; the balance between different kinds of investments; risks, including the ways in which risks are to be measured and managed; (iv) the expected return on investments; (v) the realisation of investments; and (vi) the extent (if at all) to which social, environmental or ethical considerations are taken into account in the selection, retention and realisation of investments; and (c) their policy (if any) in relation to the exercise of the rights (including voting rights) attaching to the investments Jun-10 13:01 12

13 Principle 1: Effective decision-making Schedule 3 Myners Principles Trustees should ensure that decisions are taken by persons or organisations with the skills, knowledge, advice and resources necessary to take them effectively and monitor their implementation. Trustees should have sufficient expertise to be able to evaluate and challenge the advice they receive, and manage conflicts of interest. Principle 2: Clear objectives Trustees should set out overall investment objective(s) for the fund that takes account of the scheme's liabilities, the strength of the sponsor covenant and the attitude to risk of both the trustees and the sponsor, and clearly communicate these to advisers and investment managers. Principle 3: Risk and liabilities In setting and reviewing their investment strategy, trustees should take account of the form and structure of liabilities. These include the strength of the sponsor covenant, the risk of sponsor default and longevity risk. Principle 4: Performance assessment Trustees should arrange for the formal measurement of the performance of the investments, investment managers and advisers. Trustees should also periodically make a formal policy assessment of their own effectiveness as a decision-making body and report on this to scheme members. Principle 5: Responsible ownership Trustees should adopt, or ensure their investment managers adopt, the Institutional Shareholders' Committee Statement of Principles on the responsibilities of shareholders and agents. A statement of the scheme's policy on responsible ownership should be included in the Statement of Investment Principles. Trustees should report periodically to members on the discharge of such responsibilities. Principle 6: Transparency and reporting Trustees should act in a transparent manner, communicating with stakeholders on issues relating to their management of investment, its governance and risks, including performance against stated objectives Jun-10 13:01 13

14 Trustees should provide regular communication to members in the form they consider most appropriate Jun-10 13:01 14