MSG Team's other articles

10796 Proof of Importance in Cryptocurrency

In the previous articles, we studied proof of work as well as proof of stake. We learned that the proof of stake mechanism was created in order to overcome the shortcomings of the proof of work mechanism. However, proof of stake itself has several shortcomings which have become increasingly visible over the years. In order […]

9045 Calculating Free Cash Flow to Firm: Method 3: EBIT

In the previous articles, we learned about how to calculate the cash flow from operations if the cash flow statement or the income statement were given in the question paper. In many cases, these financial statements may not be given in full in the question paper. Instead, some excerpts from these statements may be provided […]

11463 Swingline Loans – Meaning, Need and Its Alternatives

In the previous articles, we have seen the various non-lending-related commercial banking products which are offered by banks. However, at the end of the day, a commercial bank is a bank. This means that its main business is still to lend money. When it comes to commercial banking, the loan products are quite different from […]

12026 Why Uber Should Be Regulated?

In 2017, a top European Union court has ruled that since Uber’s drivers provide transport services to customers, it should be treated as a transport company. This is against Uber’s stance that it is a technology company. There was good reason that Uber wanted to be seen as a technology company. The biggest reason is […]

12229 The World without Bankruptcy Laws

Bankruptcy is one of the natural states which a company may find itself in. Entrepreneurship is primarily about taking risks. When companies take risks, some of them succeed, whereas others fail. Hence failure is a natural part of the business. However, many critics of bankruptcy laws believe that there isn’t a need for an elaborate […]

Search with tags

  • No tags available.

Whenever investors pool their resources together in order to create a fund that then invests in other assets, the concept of fiduciary duty comes into play.

The average investor considers fiduciary duty to be a complex legal subject and hence tries to avoid delving into the details. However, the subject is not very complex. Also, fiduciary duties of pension funds are at the center of another debate.

It is commonly believed that pension funds cannot direct large amounts of money towards socially responsible investments because their fiduciary duties restrict them from doing so.

In this article, we will understand the concept of fiduciary duty. We will also understand how it applies to pension funds and why some experts claim that it restricts the type of investments that a pension fund can possibly make.

Meaning of Fiduciary Duty?

The word fiduciary relates to the ethics which govern the actions of people who are in a relationship based on trust. The basic premise is that people spend their own money very carefully. However, when you put them in charge of someone else’s money, they become extremely callous and imprudent. Therefore, the concept of fiduciary duty binds the pension fund to act in the best financial interests of its client. The pension fund is known as the fiduciary in such a relationship whereas the investors are known as the beneficiary.

What are Some Fiduciary Duties of Pension Funds?

Now, since we know the meaning of the word fiduciary, it is also important to understand the set of duties which are referred to as fiduciary duties. The list of duties can be quite long and can differ based on the situation as well as the type of investors. However, the guiding principles remain constant. The details of these guiding principles have been listed below:

  • The fiduciaries must have an exclusive relationship with the beneficiaries. This is required to ensure that they act in the best interest of the investors.

    Fiduciaries are prohibited from creating other relationships without disclosing them to the beneficiaries and obtaining their permission. This is done to prevent any possible conflict of interest

  • Fiduciaries are bound by law to follow the prudent man rule. This means that their actions at any time must reflect that of a prudent person. The decisions can change based on the circumstances and the information available to them. However, none of these actions must be reckless since the money being used belongs to the beneficiaries.

  • Fiduciaries must create an investment plan which they must disclose to the beneficiaries. Once the beneficiaries approve the plan, the actions of the fiduciaries must be bound by this plan within reasonable limits.

  • Lastly, fiduciaries are required to diversify investments in order to reduce the risk of a large loss to the beneficiaries. However, if the diversification adds risk, then such diversification must be avoided.

How Does Fiduciary Duty Interfere with Pension Fund Investments?

For pension funds, fiduciary duty is defined as financial prudence. Hence, pension funds are not allowed to take non-financial factors into play while making investment decisions.

For instance, if pension funds have to make an investment in either a weapons manufacturing company or a renewable power company, their decision has to be driven purely by financial considerations.

Pension funds do want to make socially responsible investments. However, till now, there is no wide consensus on what constitutes a socially responsible investment.

There are some crude mechanisms that the pension funds have devised in order to help them define what socially responsible investments are. The details of these methods have been mentioned below:

  • Screening: Pension funds create a list of negative and positive screens and get them approved by the beneficiaries.

    Negative screens include companies that are directly or indirectly involved in questionable activities such as the arms trade, tobacco, alcohol, loan sharking, etc.

    On the other hand, positive screens include companies that are directly or indirectly involved in positive activities such as renewable energy, microfinance, etc. Pension funds can use these screens in addition to financial criteria in order to decide where finances need to be deployed.

  • Indexation Method: There are certain popular indices in the world where companies engaged in sustainable businesses are listed. The Dow Jones Sustainability Group Index is one such index. Some pension funds decide to replicate such indices whereas others invest only in companies that are included in such indices.

  • Corporate Engagement: Lastly, pension funds can make investment decisions based on corporate engagement and investor activism. They can create focus groups that are chosen randomly from among pension fund investors.

    Pension funds can present their analysis and findings related to probable investment targets to these focus groups. Such groups can work on behalf of the beneficiaries in order to help the pension funds choose better investments.

The entire fiduciary duty conundrum is based on a simple problem. The essence of the issue is that since we cannot clearly communicate to pension funds what socially responsible investments are, we should not be evaluating their performance on the same basis.

Some method has to be created by which investors can periodically specify their preferences to the pension funds. Once pension funds have the required information, we can expect them to include the same in their decision-making.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

The Chinese Pension System

MSG Team

Challenges of Risk-Based Supervisory System

MSG Team

Challenges Facing Pension Fund Governance

MSG Team