Sheenagh Gordon-Hart, Independent Director at The Director’s Office
Pension fund regulation and the OECD figures
One thing that sends my antennae into overdrive is when hints are dropped that investors should be mandated to invest in a particular way, or in preferred projects.
Years ago, many countries had rules that curtailed geographic diversification for pension funds, and exchange controls limited the ability of investors to access global markets.
Gradually the varying constraints of exchange controls fell away. However, many less-developed countries with a poor record of public debt management and under-developed financial markets had expanded their control to the investment portfolios of institutional investors to aid in financing the public sector and favoured domestic industries.
The OECD publishes an annual report on the regulation of pension funds1 across 38 OECD member-countries and 50 non-OECD jurisdictions. The 2022 report, referencing data available at end-2021, notes that most countries have quantitative investment limits on investment by pension funds in specific asset classes and/or foreign exposures, with a minority of countries opting for the ‘prudent person principle’, eschewing specific rules on asset class investment.
Hard limits reducing over time
Amongst non-OECD member countries only Guernsey and Malawi apply the prudent person principle, but this approach is more prevalent within the OECD, with nine countries including the UK, Canada, Australia2, Norway and the Netherlands applying the principle. Hard limits that mandate portfolio allocations have been reducing over time across the world, allowing more discretion to pension providers; examples of this include Canada which removed the 30% limit on foreign investment in 2005 and Latvia which in 2021 increased the cap on equity investment for its state mandatory funded pension plans from 75% to 100%3. Interestingly, Latvia also raised the limit on investment in sustainable non-UCITS from 15% to 25%. So far, so good: a review of developments over the past 20 years largely shows a good deal of liberalisation for asset owners, such as pension funds, expanding the available investment universe and sources of return.
The Future for Britain?
However, will the pendulum swing back, as pendulums are wont to do? The mood music doesn’t augur well. In the UK, a report entitled ‘A New National Purpose: Innovation Can Power the Future of Britain’ was published in February 2023 by the Tony Blair Institute for Global Change and co-authored by Tony Blair and his unlikely bed-fellow, William Hague. The report suggests Britain needs a radical new policy agenda that harnesses science and technology to re-shape the state and enables Britain to find its place in a world dominated by the technological superpowers of the US and China. In and amongst the high-tech jargon littered with lofty ambition we find out that part of the programme would be ‘incentivising pension consolidation and encouraging growth equity’ by limiting the CGT exemption available to pension funds to those funds with over GBP 20 billion4 under management and that allocate a minimum 25% of their investment to UK assets.
Radical change for better outcomes
Given the fragmentation of UK pension funds, there is no doubt that beneficiaries of UK pension funds could be better served and that consolidation is long overdue, but I’m unsure as to the moral basis for effectively penalising smaller pension funds through the imposition of taxes, and uncomfortable with the idea of penalising smaller and larger funds for failing to invest a specific minimum percentage in UK domestic assets. I might even venture to suggest that a bonfire of regulations might result in a more vibrant pension fund sector that produces better returns for beneficiaries. The UK’s Chancellor is apparently keen on consolidation and, according to the FT, has left open the possibility of mandating the types of investment that can be made by pension funds if consolidation cannot be achieved. Unsurprisingly, the opposition Labour Party, the hot favourite to win the next UK election, is also prepared to mandate investment, with the Shadow Chancellor noting that she did not think it would be necessary, given goodwill in the sector.
The Green Agenda
The developments surrounding sustainable investing are of importance as the idea of regulating where money should be invested creeps back into the mainstream. The body of regulation that has been spawned by the EU’s green agenda is vast and growing as we speak, with asset managers of EU funds grappling with SFDR and at the beginning of this month, the European Parliament agreed its position on the Corporate Sustainability Due Diligence Directive (‘CSDDD’), complementing the Corporate Sustainability Reporting Directive (‘CSRD’) that was published in the Official Journal in December 2022. The CSDDD will require large companies to undertake due diligence not only on their own activities but also those of their suppliers to identify and prevent, end or mitigate, any actual or potential adverse impacts on human rights and the environment.
That is quite a tall order and could become quite a costly exercise, not only in the conduct of such regular due diligence exercises, but also in obtaining the necessary certifications and presumably audit of claims made. Importantly from an economic perspective, will prescriptive and likely actionable requirements persuade companies to avoid being ‘in scope’ by limiting their growth ambitions. Parliament’s position would also require in scope companies to formulate a transition plan in accordance with CSRD that aims to limit global warming in line with the Paris Accord, and companies with more than 1,000 employees would be required to link directors’ variable remuneration to the achievement of the objectives of their transition plan.
We shall see what emerges from trialogue discussions and whether asset managers escape these requirements. So, will a level of sustainable investment become mandatory, for pension funds, or even individuals with associated tax incentives? Perhaps making sustainable investment mandatory won’t be necessary as the larger part of the investible universe conforms to the standards set in EU legislation and regulation. I won’t venture to suggest that the EU could make sustainable investing mandatory anytime soon, but the conditions exist under which it may come to pass via other regulatory means.
