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The trm Report - June 2006

Trustee Risk Management

Pension Scheme Investment: The New Law
Mark Grant

The investment of a pension scheme’s assets, although important at all points of the economic cycle, is a central concern of trustees when employer funding alone cannot, at least in the short term, address a scheme’s deficit. Trustees need to achieve an appropriate funding outcome for the scheme and to consult with (but not take orders from) the employer. Presently, conventional investments are increasingly being supplemented by exposure to other asset classes, with view to obtaining more attractive returns than may be available from what may be perceived as lacklustre equities or overpriced Gilts.

Trustees should therefore be aware of important changes to the scope of their investment powers (and, indeed, the standards against which their investment-related decisions would be judged by a court) which have been brought about by the Occupational Pension Schemes (Investment) Regulations 2005 (the “Regulations”), which came in force on 30 December 2005 and give effect to the requirements of the European Pensions Directive (2003/41/EC) (the “Directive”).

The requirements of the Regulations, which are analysed in more depth below, include the requirement for a statement of investment principles, the diversification and suitability of investments, and trustees’ knowledge and understanding of investment issues.  As will be seen, some expressions used in the Directive are reproduced in the Regulations verbatim and without amplification, resulting in some regrettable uncertainties.

Statement of Investment Principles (“SIP”)
The requirement for a SIP is already familiar.  Surprisingly, this is now only a requirement for the trustees of pension schemes with at least 100 members.  There are important procedural differences regarding SIPs under the Regulations.  The SIP must now be reviewed at least every three years, as well as “without delay” where any “significant change” has occurred to the scheme’s investment policy (and not merely reviewed “from time-to-time”, as was required previously). 

It is important to note that the three-year period does not appear to run from the effective date of the Regulations, but rather requires that all existing SIPs have been reviewed within three years of the point when the SIP took effect; this means that in practice many schemes (those where the SIP was prepared in, say, 2001 and has not subsequently been reviewed) are already in breach of this provision.  Trustees should check this point in relation to their own SIP at the first opportunity, instigating a review without delay where necessary.

On the positive side, the requirements in terms of the content of the SIP are substantially unchanged, although trustees must now be more active in the way they deal with investment risk, and must set out in the SIP the “ways in which risks are to be measured and managed”, rather than simply stating their policy on risk.  It remains to be seen whether this will mean any change in practice. 

How will the Regulations affect trustees’ investment decision-making?

The new Regulations regulate the investment processes of trustees of pension schemes with at least 100 members, and are more prescriptive than was the case regarding the types of investments which can be made.  In addition to having regard to the content of the SIP when exercising their powers of investment, trustees must now comply with the detailed investment requirements of the Regulations.  The key provisions from the Regulations are set out below.

Security, quality, liquidity and profitability

In exercising their powers of investment, trustees (and fund managers to whom the discretion is delegated) must ensure the “security, quality, liquidity and profitability of the portfolio as a whole”, a phrase lifted from the Directive.  Concern was expressed that this seems to require trustees to generate profits (and not merely to meet the scheme’s liabilities).

The DWP has indicated that this is not intended to impose a new trustee duty to generate profits by investment, but to reflect the requirement for prudence already familiar in English trust law.  It must be said, however, that the policy intention and words used to express it do not sit happily together. 

Nature and duration of expected benefits

Assets must now be invested “in a manner appropriate to the nature and duration of the expected future retirement benefits payable under the scheme”. This Regulation (introduced late on and not included in the draft Regulations) effects a marked potential shift away from the previous law.  It potentially places increased pressure on trustees to match the scheme’s assets more closely to its liabilities. 

Although the previous law required trustees to have regard to the ‘suitability’ of assets held, which probably meant that they should consider how they compared to the scheme’s liability profile, this new Regulation spells out in a more direct way a need for trustees to study their liability profile and then invest in a way that is ‘appropriate’ to that. 

Whatever ‘appropriate’ means is of course a matter for debate!  One could easily see scheme members or even the PPF arguing that the assets and investment strategy chosen by trustees were not appropriate for these purposes.  Breach of investment duties by trustees cannot be exonerated under a scheme’s rules, and so trustees must read especially careful on issues such as this.

This requirement happens to coincide with the recent increase in the popularity of Liability-Driven Investment (often referred to as “LDI”), a process which increasingly is being advocated by professional investment advisers and actuaries.  LDI generally seeks to generate cashflow for a scheme which moves in line with the anticipated movements in the scheme’s liabilities (e.g. increasing the income derived from the investment annually in line with movements in a specified index, perhaps the amount by which scheme pensions in payment will need to be increased). This matching might be achieved by the use of derivatives to ensure that liabilities are matched. 

Derivatives as a class of transaction are still shrouded in mystery to many trustees, and expert advice would need to be taken on this very specialised area in the light of the provisions in the Regulations (see below).

The trustees or fund managers must ensure that the scheme assets are properly diversified in such a way as to avoid “excessive reliance on any particular asset, issuer or group of undertakings and so as to avoid accumulations of risk in the portfolio as a whole”.  The risks associated with putting all of a scheme’s eggs in one basket should already be part of trustees’ investment discussions, so it seems unlikely that this will in reality mean a change of approach.

Deciding what constitutes “excessive” reliance in any particular case will be a key issue, however, and trustees will look in vain for any detailed or concrete guidance on the point. 

Predominantly regulated markets

Lifting language from the Directive, the Regulations provide that scheme assets must now “consist predominantly of investments admitted to trading on regulated markets”.  What, then, does “predominantly” mean?  The DWP has decided not to define the term on the basis that to do so would set an arbitrary limit not required by the Directive.  Little guidance can be drawn from the DWP’s consultation response, which states only that “were all investments held outside ‘regulated markets’, trustees would risk being held to breach the regulation unless their circumstances are unusual”.

Trustees would be excused for finding it unsatisfactory that they are being invited to take a pragmatic approach to a legal requirement to which the Government itself cannot attach any precise meaning.


Trustees may only invest in derivatives to the extent that they reduce investment risk or help efficient portfolio management (which includes the reduction of cost or the generation of additional capital or income with an acceptable level of risk).  That gloss on “efficient portfolio management” should in effect mean that the use of derivatives will not be unduly restricted.

Prohibition on borrowing

Except on a “temporary basis” and for the purpose of providing liquidity for the scheme, trustees and relevant fund managers are now prohibited from borrowing money or guaranteeing debts where there would be any liability to repay from the scheme assets.

The DWP has stated that the prohibition will not have an impact on activities such as gilt repurchase agreements, swaps, derivative instruments and borrowings by scheme subsidiaries, nor the use of borrowing or derivatives in indirect investment vehicles such as pooled funds, hedge funds and property unit trusts. 

Internal controls

The Occupational Pension Schemes (Internal Controls) Regulations 2005 provide that trustees must establish and operate internal controls to ensure that their schemes are administered and managed in accordance with the scheme rules and the law. ‘Internal controls’ include arrange-ments and procedures for administration (and monitoring systems in respect of these), and arrangements and procedures to be followed for the safe custody and security of scheme assets. 


Much of the new law regulating pension scheme investment is intended to be underpinned by the notional ‘prudent person’ of the Directive, which is already recognised under current English trust law.  However, some of the changes made by the Regulations potentially impact on the way in which trustees and fund managers are able to invest scheme assets, and at the very least could lead to arguments being mounted that they have not correctly followed the Regulations. Where this has led to loss to the scheme assets/members/
employer, one can expect that claims will not be far around the corner…

Mark Grant
Pensions Ombudsman Unit
CMS Camerom McKennal
Tel: 020 7367 3000


the trm report
Mark Grant

Mark Grant
Pensions Ombudsman Unit

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