Trustees of defined benefit pension schemes must keep a firm grip on the tiller of first principles, however calm or turbulent the water is. Before trustees choose from the array of complex investment options they need to know the legal background to their decision.

A range of legal requirements shape the way trustees invest, but two have a practical impact at the strategic level, assuming the scheme runs its own portfolio rather than investing with an insurance company.

Considering the employer
When trustees set an investment strategy the law requires them to consider the position of all those with an interest in the scheme. Clearly, the interested group includes all the scheme members. But in the light of the two Pensions Acts in particular, it also includes the employer, as it has an obligation to meet the cost of the benefits. So when trustees review their strategy, they must consider the views of the employer’s finance director, as they contemplate future sets of company accounts.

But when it comes to their final decisions, trustees must make them with robust independence from the employer and members’ partisan interest. After all, the legislation hands the scheme investment power to the trustees to exercise unilaterally, even where the scheme rules say that the employer is to have a say.

Interestingly, the key to the high-profile Telent case was an unrecognised conflict of interest that the Pension Corporation had over investment strategy and the proposed use of the scheme investment power.

Taking advice
Trust law requires trustees to take advice on matters that, understandably, they know little about. For the majority this includes big picture questions about investment strategy (for example, active versus passive, asset allocation, choice of benchmark) and day-to-day tactical decisions about which specific holdings will best serve the strategy.

At the tactical level that duty is strongly reinforced by pensions and financial services legislation, which forces trustees to delegate the daily business of managing their assets to an authorised fund manager.

Scheme governance
The trustees’ statement of investment principles (SIP) ­ a document they are required by law to draw up and keep under review ­ brings together the themes of considering
the employer’s views and taking advice.

The SIP is a high-level statement of the trustees’ policy on such things as investment risk, expected returns, the types of investments they will hold, and in what balance.

Trustees must now also prepare and update a companion document ­ the statement of funding principles (SFP) ­ about how they plan to meet the statutory scheme-specific funding standard and any other funding objectives they have adopted.

There is a statutory requirement for both documents that, in most cases, the trustees consult the employer about the contents. Following a court case, ‘consult’ means being genuinely ready to receive and consider the employer’s views in an unhurried way. But it does not mean the trustees have to acquiesce to what the employer wants.

It is also mandatory for trustees to take professional advice on both documents; for the SIP from an appropriately experienced investment adviser and for the SFP from the scheme actuary. This will generally be high-level strategic advice about what the trustees want to achieve and their means to get there.

Scheme governance is a headline topic for all schemes at the moment, not least because the Pensions Regulator is keenly interested in it. The SIP and the SFP are two of a wide range of documents with policies and procedures on all aspects of running a scheme that are coming into being.

What is encouraging about governance is that, viewed in the right way, it is not a sterile compliance exercise but a way of taking an open look at a scheme with a view to improving its performance all round, including investment.

The right course
They must also have robust and scheme-specific discussions with them about all aspects of investment to make sure they explore all reasonable options and come to patently well informed decisions.

Whether that means having a risk budget of a certain amount, going active or passive, or opting for liability-driven investment, depends on the conditions at sea and the course the investment consultants help to set.

Clive Pugh is a director at Temple Trustees