Changes to the Investment Regulations mean greater ESG disclosure requirements in statements of investment principles.

By Paul A. Davies, Michael D. Green, and Shaun Thompson

In response to trustees’ uncertainty about how environmental, social, and governance (ESG) factors — as non-financial factors — apply to pension schemes, the Law Commission and the Department for Work and Pensions (DWP) have been exploring fiduciary duties and regulatory changes to better accommodate ESG factors in pension schemes since 2014.

This joint exploration culminated in the publication of the DWP’s Government Response: Clarifying and strengthening trustees’ investment duties, which outlined the UK government’s intended changes to the pension sector’s incorporation of ESG factors.

This blog will explore the pre-2019 pensions and ESG landscape and outlines future changes to pension disclosure requirements.

ESG Disclosure Pre-2019

The Occupational Pension Schemes (Investment) Regulations 2005[i] (Investment Regulations) require trustees to disclose, in a pension scheme’s statement of investment principles (SIP), “the extent (if at all) to which social, environment or ethical considerations are taken into account in the selection, retention and realization of investments” (the Extent Requirement).[ii]

The Investment Regulations were recently amended to incorporate new ESG disclosure requirements introduced by two regulations:

  • Pension Protection Fund (Pensionable Service) and Occupational Pension Schemes (Investment and Disclosure) (Amendment and Modification) Regulations 2018[iii] (2018 Regulations)
  • Occupational Pension Schemes (Investment and Disclosure) (Amendment) Regulations 2019[iv] (2019 Regulations)

ESG Disclosure From 2019 Onwards

The 2018 Regulations removed the Extent Requirement, replacing it with a requirement for trustees to disclose the following matters in a SIP by October 1, 2019:

  • Financially material considerations during the appropriate time horizon of investments, including how those considerations are taken into account in the selection, retention, and realization of investments
  • The extent (if at all) to which non-financial matters are taken in account in the selection, retention, and realization of investments
  • The trustees’ policy in relation to undertaking engagement activities in respect of the investments

The 2019 Regulations added a suite of new SIP disclosure requirements to the Investment Regulations, which must be disclosed on a “comply or explain” basis by October 1, 2019. These new disclosure requirements must outline a trustee’s policy in relation to a trustee’s arrangements with any manager, including the following matters:

  • How an arrangement with an asset manager incentivizes the asset manager to align its investment strategy and decisions with the trustees’ policies
  • How that arrangement incentivizes the asset manager to make decisions based on assessments about medium-to long-term financial and non-financial performance of an issuer of debt or equity and to engage with issuers of debt or equity in order to improve their performance in the medium to long-term
  • How the method (and time horizon) of the evaluation of the asset manager’s performance and the remuneration for asset management services are in line with the trustees’ policies
  • How the trustees monitor portfolio turnover costs incurred by the asset manager, and how trustees define and monitor targeted portfolio turnover or turnover range
  • The duration of the arrangement with the asset manager

The 2018 and 2019 Regulations provided updated definitions to clarify the meaning of new terminology:

  • Appropriate time horizon: The length of time that the trustees of a trust scheme consider is needed for the funding of future benefits by the investments of the scheme
  • Financially material considerations: Include (but are not limited to) environmental, social, and governance considerations (including but not limited to climate change), which the trustees of the scheme consider financially material
  • Non-financial matters: The views of the members and beneficiaries including (but not limited to) their ethical views and their views in relation to social and environmental impact and present and future quality of life of the members and beneficiaries of the trust scheme
  • Portfolio turnover costs: The costs incurred as a result of the buying, selling, lending, or borrowing of investments
  • Targeted portfolio turnover: The frequency within which the assets of the scheme are expected to be bought and sold

These amendments apply to both defined benefit and defined contribution pension schemes that are required to produce a SIP.

Stewardship Obligations From 2019 Onwards

The Investment Regulations have always contained a requirement for a SIP to disclose the trustees’ policy on the exercise of rights (including voting rights) attaching to the investments (the Rights Disclosure).

The 2018 Regulations extend disclosure requirements for stewardship obligations, which must be included in the SIP by October 1, 2019, concerning the trustees’ policy in relation to:

  • Undertaking engagement activities in respect of the investments (including the methods by which, and the circumstances under which, trustees would monitor and engage with relevant persons about relevant matters) (the Engagement Disclosure)

Again, updated definitions further clarify this new terminology:

  • “Relevant persons” includes (but are not limited to) an issuer of debt or equity, an investment manager, or another holder of debt or equity
  • “Relevant matters” includes (but are not limited to) matters concerning an issuer of debt or equity, including their performance, strategy, risks, social and environmental impact, and corporate governance

Defined Benefit Communication Requirements

From October 1, 2020, occupational defined benefit schemes required to publish a SIP must publish the SIP on a public, free-to-access website.
Additionally, a SIP must include an “implementation statement” (IS) containing the following information (relating to the period October 1, 2020 and October 1, 2021):

  • Confirmation of how policies relating to the Rights Disclosure and Engagement Disclosure have been followed during the year
  • Details of trustees’ voting behavior during the year, and the use of proxy voters

Additionally, the following information must be published on a website (relating to the period October 1, 2020 and October 1, 2021):

  • Information for inclusion in the annual report relating to how the trustees monitor the capital structure of investee companies
  • Details as to how the trustees monitor the management of actual or potential conflicts of interest on the part of those investee companie

Defined Contribution Communication Requirements

The Occupational and Personal Pension Schemes (Disclosure of Information) Regulations 2013[v] have been revised to include enhanced ESG and stewardship disclosure requirements for defined contribution schemes. From October 1, 2019:

  • Trustees of a scheme with 100 or more members must include both the Rights Disclosure and the Engagement Disclosure
  • The SIP must be published on a public, free-to-access website

Further disclosure requirements will come in to force in October 2020 and October 2021. These requirements establish the need for an IS which, from October 1, 2020, must be produced by defined contribution schemes with more than 100 members.

The IS must be published on a public, free-to-access website, and must include (relating to the period October 1, 2020 and October 1, 2021):

  • Details of how the SIP has been followed during the year
  • Details of any SIP review conducted during the year (in accordance with requirements to review the SIP at least every three years)
  • Details of any changes to the SIP, following review
  • If no review has been conducted, publication of the last review date

From October 1, 2021, the IS must include a statement covering the following (relating to the period October 1, 2020 and October 1, 2021):

  • Confirmation of how policies relating to the Rights Disclosure and Engagement Disclosure have been followed during the year
  • Details of trustees’ voting behavior during the year, and the use of proxy voters

Conclusion

The 2018 and 2019 Regulations introduce a suite of new disclosure requirements to defined benefit and defined contribution schemes, aiming to further integrate ESG factors and disclosure into standard pension reporting requirements.

The new disclosure requirements build upon the Investment Regulations’ requirements to cement ESG considerations as key non-financial considerations for investors and support the continuing march of ESG into mainstream finance.

Latham & Watkins will continue to monitor developments in this area.

This post was prepared with the assistance of Martin Cassidy and Victoria Wan in the London office of Latham & Watkins.

[i]SI 2005/3378.
[ii]Occupational Pension Schemes (Investment) Regulations 2005 (SI 2005/3378), Regulation 2(3)(b)(vi).
[iii]SI 2018/988.
[iv]SI 2019/982.
[v]SI 2013/2734.