Save your money, save the world? Pension funds, we are told, can be a force for social good, from promoting sustainable environmental practices, to punishing companies that co-operate with oppressive regimes, to improving the quality of corporate governance itself.
Few would question the nobility of such goals, but should they be the concern of the prudent pension plan administrator with a legal duty to act in members’, not the wider world’s, best interests? Historically, many (but not all) have argued no. After all, pension funds are merely pots of money for the purpose of funding employees’ retirement. In this context, isn’t the administrator’s job quite simple: invest plan funds prudently (or ensure a menu of prudent investment options) to maximize the funds available to fund members’ retirements?
In 1984, the High Court of England thought so. In a seminal decision (Cowan v. Scargill), the vice-chancellor held that when the purpose of a trust, such as a pension trust, “is to provide financial benefits for the beneficiaries, as is usually the case, the best interests of the beneficiaries are normally their best financial interests.”
Cowan involved the pension fund of the U.K.’s National Coal Board. Half the trustees of the fund were board appointees while the other half were member appointees.
The member-appointed trustees proposed to change the pension fund’s investment policy to achieve what they viewed as a broader social purpose, namely, the cessation of overseas investments (to bolster the U.K.’s domestic economy) and divestment from industries directly competing with coal (like oil) to help to preserve current and future jobs for members.
The board-appointed trustees believed that restrictions along these lines were contrary to their fiduciary duty—their duty to administer the pension plan and invest pension fund assets in the best financial interests of plan members. Both sides applied to the High Court for guidance.
The court sided with the board appointees. It found that the member appointees could not show that their proposed restrictions were in the best financial interests of members. While the court did not close the door on accounting for broader social factors in pension fund investment, it firmly held that choosing a less beneficial investment on this basis could not withstand legal scrutiny.
The aftermath
Cowan may well be an example of the right result at the wrong time. Prior to Cowan, a court had not had an opportunity to assess a pension plan trustee’s or administrator’s fiduciary duty relating to investments in light of broader social objectives. Cowan therefore set the tone for the following decades. The decision has been influential in Canada, especially in the absence of any Canadian cases dealing with the same issues.
Given the result, some have read Cowan to suggest that a plan administrator’s fiduciary duty does not allow it to engage in socially responsible investment (SRI). The court was careful not to go this far. Nevertheless, following Cowan and even today, administrators struggle with how, if at all, to incorporate SRI into their investment decisions, and whether doing so exposes them to legal risk.
Cowan’s aftershocks are unfortunate, because SRI goes far beyond the narrow industry protectionism central to the 1984 dispute.
The investment community has long distinguished between “core” SRI and “broad” SRI. (Thanks to my friends at the Responsible Investment Association for helping to explain the difference.)
Read: Making green investments
“Core” SRI tries to influence the external world and behaviours, for example, as in Cowan, investing locally in the U.K. and helping to sustain and support the coal industry. To this end, core SRI may involve ethical investment screens (including prohibitions on investing in alcohol, tobacco, gambling or arms companies) and targeted investment in local or minority-owned businesses.
“Broad” SRI, on the other hand, involves the incorporation of environmental, social and governance (ESG) factors into the administrator’s (or external investment manager’s) investment evaluation toolbox. Broad SRI recognizes that ESG factors can affect the short-, medium- and long-term financial results of a particular investment. For example, in a choice between two comparable energy companies, broad SRI suggests that the company with the cleaner environmental record and reduced potential for environmental impact in the future is preferable, because its investment return is less likely to be saddled by clean-up costs and regulatory fines. Broad SRI recognizes that no investment is made in a vacuum, and often deploys SRI with a view to its ultimate potential financial impact.
Read: SRI growing among Canadian pension funds
The court’s decision in Cowan did not preclude the trustees from engaging in broad SRI (and did not even preclude core SRI in all cases). In fact, the court’s decision can be read to support broad SRI. If the best interests of pension plan beneficiaries are, as the High Court stated, “their best financial interests,” and if ESG factors ultimately affect an investment’s financial return, then a prudent trustee or administrator arguably ignores ESG factors at its peril. Many administrators may already be considering ESG factors without explicitly acknowledging it.
What’s next?
On Oct. 3, 2014, the Ontario government proposed legislative amendments that will require each Statement of Investment Policies and Procedures (SIP&P) and each annual member statement to set out whether and, if so, how the administrator incorporates ESG into its investment decisions.
The amendments force administrators’ hand. Administrators now must take a semi-public position on an issue on which even the experts continue to disagree.
Read: Principled investing
What is an administrator to do? Isn’t it enough that the administrator is held to the highest duty—the fiduciary duty—known to law? Do administrators now have to save the world, too? Will administrators of member-choice defined contribution plans or plans invested exclusively in pooled funds (e.g., index funds) need to overhaul their entire investment structure to incorporate ESG? Hardly. The new requirements are permissive. It is up to each individual administrator to consider whether and in what way a SIP&P should define ESG and how it, or its third-party managers, should incorporate ESG factors. Administrators ought to think carefully about how to amend their SIP&Ps in this regard—even if it only results in a few additional sentences addressing ESG issues.
In the 30 years since Cowan, it remains clear that the law surrounding SRI and pension funds is not (and has never been) black and white. What has changed since Cowan is a clearer distinction between core and broad SRI, and a recognition that incorporation of ESG factors under a broad SRI approach can influence investment outcomes. In a way, the evolution of SRI has confirmed Cowan. If the best interests of pension plan members are their best financial interests, then the administrator needs to consider and evaluate all factors that could affect those interests, which may include ESG factors. With Ontario’s new regulatory amendments, the administrator also must communicate how it will go about doing so.