Does your organisation sponsor a defined benefit (DB) pension scheme? If it does, it will be responsible for making up the deficit in the scheme. It therefore has a direct interest in how the scheme’s investments perform.
One difficulty for a sponsoring employer is that it is one step removed from the decision-making process on investments: the assets of the scheme will be held on trust and invested by the trustees, not by the employer.
However, there is a statutory duty on trustees to consult the employer about the statement of investment principles they are required to put in place. This process of consultation does not have to result in agreement between the trustees and the employer, but it does give the employer an opportunity to express its views on how the trustees should invest the scheme’s assets and manage its liabilities.
Is your organisation equipped for this consultation? In particular, does it understand the range of investments in which the scheme can and does invest, and does it have a view on which of those investments are the most suitable for it to invest in?
This article explains some of the more ‘alternative’ investments that are available to DB scheme trustees so that the in-house lawyer can understand the general nature of those investments and the legal risks they pose.
TRUSTEES’ INVESTMENT POWERS
When deciding how to invest scheme assets, the trustees’ first question (from a legal perspective) will be whether the provisions of the scheme’s governing documents are worded broadly enough to permit the investments the trustees wish to make. Not all are. For example, not all schemes’ investment powers permit their trustees to enter into swaps. As explained in this article, the use of swaps by pension schemes is increasingly common.
TRUSTEES’ INVESTMENT DUTIES
The trustees’ next question will be whether their proposed investment is compatible with their common law duty 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.’
This duty was established by the 19th century Learoyd v Whiteley (1887).
In addition to this common law duty, trustees are now under statutory duties regarding their investment powers. These are set out in s33-36 of the Pensions Act 1995 and the Occupational Pensions Schemes (Investment) Regulations 2005 (the Investment Regulations). In particular the Investment Regulations oblige trustees to invest in members’ best interests.
TYPES OF INVESTMENT
Traditionally, trustees have created asset portfolios consisting of some balance between equities (UK and non-UK), bonds (corporate and government), real property and cash. However, there are many asset classes besides equities, bonds, property and cash in which trustees can invest (with the appropriate advice), and many more sophisticated methods of making those investments than by a simple direct holding.
For example, increasingly, trustees are investing in unregulated markets. This is permitted under the Investment Regulations provided the investments are kept to a prudent level. Trustees are also entering into derivative contracts. This is also permitted, provided their holding in derivatives does not involve excessive exposure to a single counterparty and either contributes to a reduction of risk in the scheme’s investment strategy, or facilitates ‘efficient portfolio management’ (a technical FSA term).
Modern pensions legislation recognises the existence of these ‘alternative’ asset classes and puts statutory restrictions on the extent to which trustees can expose their scheme to unregulated markets and derivatives. However, the rest is left to the trustees’ discretion – provided that they consult the scheme sponsor and avoid trading activities, borrowing (other than on a temporary basis to provide liquidity to the scheme), and investing in their sponsoring employer (or a company in its group) beyond a permitted maximum level.
If trustees invest in an asset that has associated legal risks that they do not understand, they are exposing themselves and their schemes to liability that a sponsoring employer could ultimately be required to meet.
TYPES OF ALTERNATIVE INVESTMENT
Alternative investments could be investments in funds, such as commodities, or investments in funds (sometimes called ‘collective investment schemes’), which themselves invest in non-traditional assets, or which enter into derivative contracts, short-selling arrangements or highly leveraged investments.
Regulated funds
The most common types of regulated collective investment scheme in the UK are Undertakings for Collective Investment in Transferable Securities (UCITS), Non-UCITS Retail Schemes (NURS) and Qualified Investor Schemes (QIS). All three types of fund are regulated by the Financial Services Authority (FSA) under the terms of the Collective Investment Schemes (COLL) sourcebook. This provides investors with a substantial level of protection.
UCITS funds are subject to the highest level of regulation. They are collective investment schemes that can be marketed freely throughout the EU (including to retail investors) while being authorised in just one member state. The required features of a UCITS fund are prescribed in EU legislation, as transposed into the national law of the particular member state in which the fund is authorised. The EU Directives give some latitude to member states as to precisely how the UCITS requirements are to be implemented, so member states can implement them in slightly different ways.
NURS funds are less regulated than UCITS funds, but they too can be marketed throughout the EU (even to retail investors) while only being authorised in one EU member state. The main difference between NURS funds and UCITS funds is that a fund manager’s investment powers are wider under the former than under the latter.
QIS funds are less restrictively regulated than UCITS and NURS funds, and have wider investment and borrowing powers than those funds. Accordingly, a QIS fund cannot be marketed to retail investors – it can only be marketed to qualified investors.
Hedge funds
A hedge fund is an unregulated fund that may invest in a diverse range of investments, typically with a view to generating an absolute return for its investors, although sometimes the desired return could be outperformance over a benchmark. Hedge funds are less regulated than UCITS, NURS and QIS funds, and have traditionally been domiciled offshore in jurisdictions of low taxation and low regulation, such as the British Virgin Islands, the Cayman Islands and Bermuda.
More recently, some hedge funds have begun to move onshore, such as into Ireland and Malta. This has been caused by fears that EU legislation may soon place onerous restrictions on non-EU domiciled funds marketing themselves to EU-based investors. There have been industry concerns that this change will lead to lower returns because of the increased tax and regulatory compliance.
Private equity funds
Private equity funds typically invest in a portfolio of unlisted companies, with a view to achieving returns for their partners by improving the performance, and thus the profitability, of those companies. Private equity funds are commonly established as limited partnerships. The investors in the partnership are ‘limited partners’ (and have limited liability); the manager of the fund is a ‘general partner’. An investment in a private equity fund is relatively illiquid: it is normally a medium to long-term commitment of capital. This means that it can be difficult for investors to withdraw from a private equity fund, particularly where the fund is performing badly and other investors wish to withdraw from it at the same time. However, where a private equity fund performs well, the returns can be high. Private equity funds are often domiciled in the Channel Islands.
A FUND’S INVESTMENT STRATEGY
It is not just the nature of a fund that the trustee investor – and the scheme’s employer – should be aware of. It is also the investment strategy that the fund employs to generate returns. For example, a hedge fund may have a strategy of entering into derivative contracts or engaging in short selling, and a private equity fund may use leveraging.
Derivatives
Pension funds increasingly enter into swaps to hedge out risks by exchanging a variable stream of cash flows for a fixed stream of cash flows. For example, a key risk for pension funds is movements in interest rates. As interest rates reduce, pension fund liabilities increase. Trustees might reduce interest rate exposure by entering into an interest rate swap, under which they exchange cash flows that vary according to movements in interest rates (the ‘floating leg’ of the swap) for fixed cash flows from a counterparty bank (the ‘fixed leg’). Other derivative instruments commonly used by pension schemes are inflation swaps and longevity swaps. These reduce exposure to movements in inflation rates and life expectancy.
It is equally possible for a fund in which a scheme invests to enter into swaps. This could be done to manage risk (in a similar way to pension schemes). However, it could be done to speculate and, if that is the case, volatility in the fund could be increased.
There are other types of derivative that a fund could use besides swaps, such as options and futures, but these will not be covered in this article.
Short selling
This is where an asset is borrowed and then sold in the hope that its value will fall before it has to be repurchased and returned to the lender.
Leveraging
This is a strategy of borrowing to invest. It is typically used by private equity funds.
KEY RISKS
Derivatives and shorting
Where a hedge fund uses derivatives or short selling as part of its investment strategy, the trustee investor in that fund will be exposed to the risk that the market moves against the hedge fund and the fund is then forced to realise its loss under the terms of the derivative contract or shorting arrangement it has entered into.
Collateral
An additional commercial risk for the trustee investor, where the hedge fund has entered into a swap, is the risk that the counterparty does not have sufficient collateral to cover the extent to which the market has moved against it and in favour of the hedge fund.
Leveraging
Leveraging can multiply gains but it can also multiply losses. In addition, there is also a technical point regarding trustees’ powers to borrow. Because a private equity fund normally takes the form of a limited partnership, it normally has no independent legal personality apart from its partners. This means that any borrowing by the fund could be viewed as direct borrowing by a trustee investor. As described above, borrowing by trustees is not permitted, other than for certain limited purposes. This issue can be avoided where the limited partnership invests in a special purpose vehicle that then makes the investments the fund would otherwise have made itself. Debt can be raised by the special purpose vehicle, rather than by the limited partnership, without the trustees breaching the restrictions against borrowing.
Liability for sub-custodians
It is common for a fund manager not to accept liability for the actions of any sub-custodians that hold fund assets. This could make it difficult for the trustees to recover losses that arise because of the default of a sub-custodian, especially if the sub-custodian is in a jurisdiction where enforcement is difficult.
Law and jurisdiction
If there is no withholding tax treaty between the UK and the jurisdiction in which a fund is located, the trustees could be taxed in that jurisdiction even where they would not be taxed in the UK.
Trustees’ preference (and the employer’s) will be for any litigation to be conducted in the most cost-effective jurisdiction (which, for UK pension schemes, will normally be England and Wales). However, depending on the investment structure being used, this may not always be possible.
IMPORTANCE OF DUE DILIGENCE
Unregulated funds are governed by documentation agreed between the investors and the fund manager. Unlike regulated funds, these arrangements are not subject to any overriding supervisory regime (of the kind policed in the UK by the FSA). The structure of an ongoing fund is often virtually impossible for a new investor to change, because the fund will have pre-existing investors who have already invested on the original basis. However, the existence of the risks listed above should make it clear that legal due diligence on pension scheme investments is vital. As the employer will ultimately pick up the cost if an investment goes wrong (for whatever reason), it clearly has an interest in making sure that due diligence is done properly. If the risks involved in an investment are too great, it should seek to persuade the trustees not to make it.
Some of the most important features of the fund to focus on during this due diligence process will be:
- the investment restrictions;
- the redemption terms;
- the reporting obligations;
- the supervisory mechanism; and
- the trustees’ liability (which should be limited).
CONCLUSION
Although a DB scheme’s assets are held on trust and invested by trustees, the scheme’s employer has a clear interest – and a formal role – in making considered representations to the trustees about how those assets should be invested. In-house lawyers should now be equipped with some of the background needed when an employer is consulted by trustees about their proposed investment strategy.