Investment and derisking - current issues for trustees
In recent years there has been a trend in DB schemes towards more and more complex
investment products as trustees seek to find investments that match or offset some of the risks that
the scheme is exposed to.
This issue of Horizon looks at some topical issues that trustees should be aware of in relation to
complex investment products and recent developments in relation to what can happen where
investments do not perform as expected.
Derivatives and EMIR
Derivative products can provide a useful tool for trustees by allowing them to protect against
various funding risks, including rises in inflation and interest rates. However, they are
sophisticated products and trustees need to ensure that they understand the nature of the
investments that they are entering into and the risks that they might pose to the scheme. The 2005
Investment Regulations provide that “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…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”.
Trustees also need to be aware that there are regulatory requirements governing some derivative
products which may directly affect them.
The European Market Infrastructure Regulation (EMIR) applies to over-the-counter (OTC)
derivative transactions – that is those not traded on an exchange but negotiated directly between
the parties. This is likely to be most derivative transactions that pension schemes enter into.
EMIR requires OTC derivatives to go through a central clearing process with conditions applied to
that clearing, including specified arrangements for posting collateral.
There is a temporary exemption from the clearing requirements for pension schemes which
currently lasts until 2017. However, the exemption only applies to derivatives which are
“objectively measurable as reducing investment risks directly relating to the financial solvency of
pension scheme arrangements…” There is some uncertainty as to the exact scope of that
exemption, particularly as it appears to be drafted more narrowly than the provision of the
Investment Regulations quoted above.
As the provisions of EMIR gradually come into force, it is becoming more important for trustees to
identify whether or not any derivatives they hold come within the scope of the pensions exemption.
In particular, counterparty banks need to know the answer because it has an impact on their credit
valuation adjustment risk and whether they need to apply a capital charge (known as the “CVA
It is also important to remember that the pensions exemption does not cover most of the risk
mitigation requirements under EMIR, including the requirements relating to margin which come into
force from 1 September 2016 albeit on a phased in basis. Trustees should speak to their fund
manager to confirm that they are ready to comply with these requirements and confirm that all
derivatives which the manager is permitted to invest in come within the pensions exemption.
You can find more information on how EMIR relates to pension schemes and relevant
considerations for trustees here.
The last few years have seen a significant growth in longevity hedging transactions. These are
transactions where the pension scheme agrees to pay a fixed amount over a period of time, based
on the cost of benefits if members live to a particular age, plus an amount representing fees. In
return, the provider pays the cost of the benefits that actually fall due. This means that trustees
have certainty over the cost of longevity and the risk of a significant increase in costs as a result of
members living longer than anticipated is passed to the provider.
Initially longevity hedging was only available to the largest schemes. However, 2015 has seen the
emergence of products aimed at smaller schemes. As a result, increasing numbers of trustees
may find that employers are encouraging them to consider this kind of arrangement.
Whilst longevity swaps are often driven by the employer, it is important for trustees to remember
that the ultimate power to invest the scheme assets is theirs and this is an investment like any
other. They therefore need to ensure that they comply with their investment duties when entering
into such an arrangement, fully understand it and are not driven to a product selected by the
employer without adequately considering where the needs of the scheme might differ from those of
Trustees need to understand the protections available to them if the other party to the swap
defaults or becomes insolvent. Different types of contracts (for example with a bank or an insurer)
are governed by different regulatory regimes and have different protections against insolvency.
The Pensions Regulator is increasingly keen that trustees understand such issues and the exact
level of risk to which the fund is exposed.
Another issue we have recently encountered is the problems posed for individual trustees entering
into such arrangements. These contracts will typically last for many years and individual trustees
will come and go during the period. The problem is the extent to which the contract will bind
trustees who were not party to it. Remaining trustees may need to ensure that new trustees
assume the responsibility to carry out the contract. This is something that trustees will need to
consider when entering into a longevity hedge and when new trustees are appointed.
What happens if things go wrong?
The general trust law rule in the UK is that trustees cannot be held responsible for investment
underperformance unless there is negligence, fraud or breach of trust. There have been few cases
looking at this question. Perhaps the most notable was Nestle v National Westminster Bank plc in
1992 where the Court of Appeal held that “trustees’ performance must not be judged with
hindsight: after the event even a fool is wise”.
US courts have looked more closely at liability for underperformance. In 1996, the US Court of
Appeals held in Mienhardt v Unisys that investment decisions should be judged by “a fiduciary’s
conduct in arriving at an investment decision, not on its results, and [by] asking whether a fiduciary
employed the appropriate methods to investigate and determine the merits of a particular
investment”. The US Supreme Court revisited the investment duties of a pension scheme fiduciary
earlier this year in the case of Tibble v Edison International. The court did not come to any startling
conclusions and held in that case that: “Under trust law, a trustee has a continuing duty to monitor
trust investments and remove imprudent ones. This continuing duty exists separate and apart from
the trustee's duty to exercise prudence in selecting investments at the outset”.
Although these cases are not based on UK law, similar principles are likely to apply here.
Investment is not a one off process and trustees have continuing obligations to review their
investments. The Regulator’s Scope document setting out the detail of the knowledge and
understanding that trustees should have says they should have knowledge and understanding of
“the mechanisms for monitoring investment”. This applies to the operation of complex products
just as much as it applies to more straightforward investment funds.
Trustee rights of action
Generally, if investments do not perform as expected, trustees do not have a right to claim against
a fund manager or the investment provider. Risk is an inherent part of investment and investments
do go down as well as up. However, sometimes, an investment will fall in value, not because or
market forces but because of possible wrongdoing. The most recent example would be the fall in
Volkswagen’s share price as a result of the alleged fixing of emissions data.
Taking legal action in such circumstances is expensive, but recent years have seen a growth in
class action type claims with many UK pension funds participating in US class actions.
Claims in the US are easier than those in the UK because claimants can be included automatically
in a class and the litigation can be conducted on a no-win-no-fee basis, without having to bear the
other side’s costs if unsuccessful. In the UK, someone has to co-ordinate the group litigation and
fees can be high. Trustees are often unwilling to expose their schemes to the risk of high litigation
costs and an unsuccessful outcome. They are also often concerned about pursuing a claim with
other parties that may not have the same objectives as the trustees.
However, a change in the law due to come into force on 1 October may make some class action
claims easier to pursue. The Consumer Rights Act 2015 will allow opt-out type class actions to be
brought before the Competition Appeals Tribunal in relation to infringements of competition law.
This may not at first glance appear to be particularly relevant to pension scheme trustees.
However, it is possible that claims in relation to the fixing of LIBOR and foreign exchange rates by
UK banks could be structured as competition claims and fall within this new provision and many
schemes may have suffered losses which could fall within such claims.
If claims are set up on this basis, trustees will need to give careful thought about whether they want
to remain part of such litigation and any risks that might be associated with it.