Pension Funds and Fiduciary Duty

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.