Pension funds must look beyond returns criteria Source: Business Line (07-OCT-10)

The primary mandate of pension funds is to create financial returns for its beneficiaries. Typically, trustees appointed by the employer or other plan sponsors bear the legal responsibility for controlling the assets of a pension fund. However, trustees of pension funds often delegate the investment related decision-making to professional fund managers and an agreement between the trustees and the fund manager governs their relationship. This agreement usually makes fund managers effectively subject to the same prudential investment obligations as trustees. Moreover, fund managers often have a contractual obligation to provide service or advice that enable trustees to meet their fiduciary duties. Extra-financial criteria Thus any breach in fiduciary duties by pension fund trustees/managers is liable to make them compensate beneficiaries for the losses attributable to this breach of duty. This understanding of fiduciary duty has often restricted pension funds from taking extra-financial criteria into account in the investment process. However, if extra-financial criteria have a material bearing on the financial performance of the companies, then, on the contrary, not including them into the investment making process may actually be a breach of fiduciary duty. While it is true that the environment, social and corporate governance (ESG) factors are more likely to become material in the medium to long term, but so are the investment horizons of the pension funds. Not a static concept Fiduciary duty is not a static concept. Fiduciary duties of pension funds have evolved over a long time to reflect the modern investment practices. They are again undergoing a change to capture the impact of ESG factors on corporate financial risk and return. Today, the financial world is learning, though in hard way, that good ESG performance can in fact lead to better financial performance. Since failure to consider and incorporate ESG-related information is not prudent in the financial sense of the word, it should not be treated as prudent in the legal sense either. Therefore, if correctly formulated and applied, then while discharging their fiduciary duties trustees/managers should include rather than exclude ESG factors into investment process. A regulation to enable pension funds to lawfully take ESG factors into account if it has a material impact on corporate financial risks and returns can go a long way to dispel the notion that inclusion of extra-financial criteria into investment process is a breach of fiduciary duty. In fact, such a suggestion was put forward by the lawmakers as early as in 1993 in Canada where the Manitoba Law Reform Commission recommended that the province amend its legislation to permit trustees to consider non-financial criteria in their investment policies. More recently, in 2005, Canada Pension Plan (a contributory, earnings-related social insurance programme managed by the federal government) revised its investment policy to include ESG factors to the extent that they affect long-term risk and return. Interestingly, the CPP Investment Board`s ?overriding? responsibility continues to be - maximising investment returns without undue risk?. But the fact that the CPP Investment Board has begun to recognise the materiality of ESG issues without any amendment to its legislative charter is noteworthy. Even a report by United Nations Environment Programme (UNEP) in 2005 suggested that investment manager`s fiduciary duties should not necessarily preclude or overly hamper inclusion of ESG factors into the investment process. Legislative requirement Another way by which pension funds could be encouraged to include ESG factors into their investment process is through legislative requirements for fund trustees/managers to publicly report on their policies in this respect. The first such initiative took place in the UK where in July 1999 the government issued a regulation requiring pension fund trustees to disclose their ESG policies. Since then many other European countries have enacted similar ESG disclosure requirements for pension funds in their respective countries. Thus, fiduciary duties of pension fund trustees/managers do not restrict them from including ESG factors into investment consideration. However, due to prevalent conservative understanding/practices, it is unlikely that pension fund trustees/managers will include ESG factors into the ambit of fiduciary duties voluntarily. Even European countries needed regulatory intervention. Therefore, inclusion of ESG criteria by PFRDA (Pension Fund Regulatory and Development Authority) into the investments guidelines of fund managers will in no way undermine the fiduciary duties of pension fund trustees/managers. On the contrary, this will only help the pension fund investment managers improve investment practices and ignoring them may prove costly as was discovered by the Norwegian Government Pension Fund Global, which disclosed in its second quarter report that it has lost more than 1 billion on its 1.75% stake in oil giant BP in the wake of the Deepwater Horizon oil spill in the Gulf of Mexico. (The author is Head and Senior Economist at Crisil. The views are personal)