Fiduciary duty is an oft-cited cause for resistance to innovation in investment culture, but it must not be mistaken for the only, or even most important one. While trustees’ fears relating to fiduciary duty and environmental impact are understandable given conservative interpretation of the prudence standard in the past, the influence of fiduciary duty is overstated. This paper has argued that there is no inherent conflict between pension funds’ fiduciary duty and the consideration of the risks and opportunities associated with climate change, in circumstances where climate change is likely to have a demonstrable financial impact over the long-term.
The inherent flexibility of fiduciary duty, although incremental, is such that it should be able to adapt over time to the demands of an economy cognisant of the financial implications of climate change. Clarification by legislators could go a long way toward reducing the confusion-induced inaction on environmental issues attributed to fiduciary duty. In the meantime, the prominence of fiduciary duty as an explanation for stagnation in pension fund investment culture dissembles the more insidious reasons: the behavioural phenomena of institutional inertia and short-termism, which feed into a collective action problem.
This section argues that short-termism and inertia with respect to financial performance and environmental impact are central reasons for pension funds’ slow reaction to change, and specifically, to climate change. While much has been said about how behavioural biases can affect financial performance, much less studied is how these biases can prevent innovation in the wider sense. In reality, these behavioural biases mean that the pension fund industry is slow to conduct selfexamination, slow to diagnose its systematic shortcomings, and slow to treat them. It is asserted here that strong leadership from within the pension fund industry is needed to combat these problems.
Initiating change is an enduring problem for institutions. This problem becomes all the more pertinent as today’s increasingly complex financial, economic and environmental conditions require not only change, but urgent change, to the way that financial institutions operate. Studies in psychology and economics have shown that behavioural inertia exists at an individual level, and that this individual behaviour is carried into group decisions within institutions. As a result, fiduciary duty’s tendency to limit investment innovation is matched by resistance to change within the boards of pension funds.
Pension fund trustees, this section argues, have a strong preference for the status quo when faced with decision-making. Moreover, pension fund trustees generally find it difficult to integrate unfamiliar and complex variables, such as those associated with climate change, into their decisions about investment. These limitations to trustees’ ability to innovate investment processes in the context of climate change need to be recognised: even when legislation clarifies the reach of fiduciary duty, pension funds themselves will need to address their tendency toward inertia in investment strategy development.
Individuals generally are resistant to behavioural change. William Samuelson and Richard Zeckhauser demonstrate that when making a decision, people are biased toward maintaining the status quo. They suggest that status quo bias exists largely because individuals want to avoid the cost of changing their behaviour, and because people tend to prefer the certainty of the status quo to the uncertainty of change. This behavioural trait may be linked to a second trait: loss averseness. People generally prefer accepting a lower, but more certain gain than taking a risk for a higher, but more uncertain gain. Therefore the status quo is not only less costly, but also more certain.
This preference for the status quo has been demonstrated in the decisionmaking of pension fund trustees. It is perhaps somewhat counterintuitive that pension fund trustees are subject to behavioural biases in their trust fund management capacity, given that in their role as trustees they are investing other peoples’ money. However, Clark et al. have shown that trustees are often even more careful with trust funds, reflecting perhaps a desire to respect the parameters of fiduciary duty and a reverence toward the higher stakes involved, and their potential personal liability. Their study finds that ‘trustees believe that their beneficiaries would not, all things being equal, assume any risk if they could avoid it.’
It should be noted that status quo bias also appears to affect beneficiaries when faced with similar decisions in defined contribution funds. In these funds, beneficiaries have some ability to direct the investment management of their own fund benefit. However, the majority of such beneficiaries in the US and UK retain the default plan, rather than opting for a tailored plan. As a result, defined contribution funds are unlikely to differ much in practice from defined benefit funds when it comes to tackling the problem of climate change: since beneficiaries usually choose to leave decisions up to trustees, trustees voices still remain crucial to the investment strategy of most defined contribution funds.
The addition of novel contextual layers, such as the consideration of unfamiliar variables, to decision-making, may weaken the ability of pension fund trustees to make sound investment decisions. Clark et al.’s 2007 study indicates that pension fund trustees, who are generally men in the 50s, while more competent than Oxford undergraduates ‘when asked to solve a problem that drew upon specific knowledge derived from the context of their roles and responsibilities’, are less competent at integrating new contextual layers into their decision-making than Oxford undergraduates. It was found that the inclusion of new ‘normative issues’ expanded decision-making requirements ‘well beyond trustees’ roles and responsibilities’.
The addition of the new considerations surrounding climate change tests pension fund trustee decision-making in just this way: it adds a novel contextual layer to decision-making. Because pension fund trustees prefer to avoid changing their current investment processes, the addition of a novel contextual element to the process makes it harder for pension fund trustees to make rational decisions. The context of climate change is likely to be difficult for pension fund trustees to accommodate under their current decision-making frameworks. Status quo bias is therefore a major challenge for pension funds adjusting to innovative investment strategies in a climate change economy.
It is worth noting that a higher degree of professional qualification in trustees appears to increase, rather than decrease, their aversion to innovation in investment strategies. This may indicate that professional training in trustees reinforces existing bias toward inertia within the industry.
The second behavioural bias restricting pension fund innovation in the context of climate change is institutional myopia, or short-termism. That humans discount the value of the future is well established in psychology and economics. What matters here is the extent to which this phenomenon also affects pension fund trustees in their capacity as fiduciaries: most institutional investors focus on short-term performance to such an extent that investee corporations act to promote short-term gains at the expense of long-term performance.
While pension funds usually have long time-horizons (to provide retirement income to current workers in the future), the Myners Report investigating shorttermism in UK institutional investment found that the reward system of pension funds is structured to favour short-termism. In particular, bonuses for asset managers are awarded on an annual basis, and investee company performance is monitored quarterly. Moreover, while short-term performance is easily measured, long-term value can only be predicted. The practical shortcomings in the methods available for measuring long-term performance are difficult to overcome. A potential solution for measuring long-term value is to assess the soundness of the investment process itself, rather than to make continuous reference to share price, but this method does not provide the quick and easy answer found in share price.
In this context, the tendency for fiduciary duty to encourage the maintenance of the status quo reinforces pension funds’ ingrained preference for short-term performance over long-term value. It does more than merely reinforce these preferences, however. It also provides a smokescreen behind which these behaviours may escape scrutiny. To the extent that pension fund trustees and asset managers attribute their inaction to fiduciary duty, the concept of fiduciary duty obscures a capacity for change which is not only real, but also, increasingly, necessary.
When combined with the tendency of the trustees and courts to judge prudence by reference to conventional behaviour, these behavioural biases (especially inertia), create a problem of collective action within the pension fund industry. As this paper has argued, courts, legislation and trustees themselves all refer to conventional behaviour in order to determine what prudent investing is. As short-term focused, narrowly construed strategies are conventional for pension funds, these are widely seen as prudent missions. Independently of this, pension funds prefer to behave in accordance with conventional investment culture, which emphasises short-term financial performance, because they have behavioural biases toward cultivating, and then maintaining, short-termism on the one hand, and toward maintaining the status quo (that, is not challenging convention) on the other.
Under these conditions, a collective action problem arises to hinder investment innovation: the adoption by a small number of pension funds of a climate change conscious investment strategy will be seen as imprudent, because these innovative funds will be bucking convention in the minority. In order for change to occur, it will require the participation of a larger number of funds, or at least a number of respected, leading pension funds – in short, it will require a change of convention, so that courts and other funds will find climate change to be a prudent consideration.
This Chapter has argued that the uncertainty surrounding the requirements of fiduciary duty (and most relevantly here, the duty of prudence), could be alleviated through legislative clarification. However, legislative clarification would only go part of the way toward facilitating the adaptation of pension funds to a climate change economy. In order to overcome the behavioural biases that sustain short-termism and inertia, and fuel a collective action problem that nurtures an unhealthy dedication to convention, change needs to come from within the pension fund industry itself. The best way for funds to address these biases is to implement considered governance practices. Pension funds that believe in the need to innovate investment strategies with respect to environmental and social issues, and climate change in particular, need to promote change through strong leadership.
Pension funds, with their staggering financial holdings, have the capacity to bring climate change to the forefront of business agendas. By including risks and opportunities associated with climate change explicitly in their investment strategies, pension fund trustees stand not only to improve the long-term financial performance of their funds, but also to contribute to a more sustainable economy. Furthermore, given their prominence as service providers in the vacuum created by the retreat of the state, it is arguable that pension funds have a responsibility to look beyond the financial impact of their decisions. However, very few pension funds have chosen to do so thus far. For most pension funds, climate change, like other issues trustees see as tangential to financial performance, remains beyond the scope of investment strategy.
Pension funds’ reluctance to expand their investment strategies beyond their conventional barriers into the consideration of environmental issues is frequently attributed to trustees’ fiduciary duty. For many years, trustees have interpreted this duty as preventing the consideration of non-financial issues in investment decisionmaking. Climate change, whose potential economic effects have only recently become widely accepted, is perceived as one of these. This paper has argued that this interpretation of fiduciary duty, based on outdated case law, is too narrow. Moreover, to the extent that climate change presents a real financial concern which is likely to increase as further legislation affects the price of carbon, pension funds’ consideration of the risks and opportunities associated with climate change in devising their investment strategy should not, in theory, conflict with even a narrow interpretation of fiduciary duty.
In practice, however, the lack of recent case law and unclear commentary on fiduciary duty has created uncertainty for pension funds wishing to adapt to a climate change economy. Pension funds’ concerns about fiduciary duty are to an extent justified. Past legal analyses have supported the classification of environmental issues as ‘non-financial’ issues, which, together with ethical, political and social issues, should not influence a fiduciary’s investment strategy. As it stands, fiduciary duty in both the US and the UK provides a reason for pension funds to delay changing their investment policies to accommodate a broader (and arguably more sustainable) approach to strategy. Although fiduciary duty has a proven ability to adapt to changing social circumstances, this adaptation is incremental, and ill suited to the rapid changes required to meet the challenges of climate change. Clarification through legislation would help to alleviate the uncertainty surrounding fiduciary duty.
The advent of the financial crisis has given us a moment of pause to examine the state of finance and what it represents. For the work presented here, it represents both an end and a beginning. First, an end: the financial crisis heralds the demise of the efficient markets hypothesis. With its end, the colourful realities of human behaviour are suddenly more apparent against the hitherto black and white background of economic theory. These realities of human behaviour, in particular biases of inertia and myopia, are the greatest barrier to the pension fund industry’s shift toward more sustainable investment strategies.
The truth is, this paper has argued, fiduciary duty is only part of the problem. An unclear notion of fiduciary duty feeds into these biases, making them crippling. When these biases combine with prevailing pension fund trustee view that prudence equates to conventional behaviour, a collective action problem results: pension funds are unlikely to break with convention unless a significant number of them change their approach simultaneously. Any institutional acceptance of innovation toward a longer term, more sustainable investment strategy will take strong leadership from pension funds themselves. It is fortunate then that the financial crisis also represents a beginning: it provides an opportunity for re-evaluation, and a chance to improve the sustainability of the financial system.
The implications to be drawn from this Chapter are threefold. First, the uncertainty surrounding pension fund fiduciary duty and environmental considerations, in particular those associated with climate change, should be clarified through legislation. Without this clarification, pension fund trustees will have all the impetus they need to shy away from changes they were already reluctant to make. Second, pension funds must re-examine their approach to investment, as they once did at the advent of modern portfolio theory – any move toward a more sustainable investment approach will require funds to act on their own behalf. An adoption of best practice governance measures will help pension funds to surmount the behavioural barriers to innovation.
Finally, a broader point: this paper has allowed a brief, and rather dismal, glimpse at how UK and US courts interact with the institutional investment industry – in short, they appear to reinforce the industry’s existing behavioural problems and mutual uncertainties about the application of fiduciary duty in an investment context. In this light, the spectre of fiduciary duty becomes a means to ensure that existing financial norms, of the sort that fuelled the present financial crisis, remain unaddressed.
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