Commentary: BlackRock’s ESG Strategy Plays Politics with Public Pensions

This article originally appeared in Barron’s on May 28, 2020.

In a relatively short time, BlackRock has become the largest asset manager in the world. The firm built its impressive franchise as a low-fee, efficient provider of index portfolios. Now, however, Larry Fink, the mortgage-bond trader who founded the firm in 1988 and has been CEO ever since, wants to take BlackRock in a different direction. Why? And what does the shift mean for clients, especially pension funds?

BlackRock held its annual shareholders’ meeting last week and emphasized the new role of sustainability standards in its letters to clients and CEOs. On March 31, 2020, even after a rough month in the markets caused by Covid-19, BlackRock was still managing nearly $6.5 trillion in stocks, bonds, and cash—an almost 15-fold increase over 15 years. The firm’s index portfolios, including its iShares exchange-traded funds, comprise 70% of its long-term holdings. The firm is the second- or third-largest owner of stock in Microsoft, Apple, Amazon, and Procter & Gamble, and among the top five in nearly every large U.S. company.

Despite this successful formula, Fink announced in January that the firm was suddenly changing its strategy. “Sustainability” would become “BlackRock’s new standard for investing.” The firm defines sustainability as “understanding and incorporating environmental, social and governance (ESG) factors into investment analysis and decision-making.”

Two years earlier, Fink had drawn wide attention with a letter telling businesses they have to do more than just make profits. “Society is demanding that companies, both public and private, serve a social purpose,” he wrote.

While that letter was dominated by bromides, the new one had surprising specifics. BlackRock is going to jettison companies involved in burning coal. It will make “sustainable funds,” currently a minuscule proportion of the firm’s assets, “the standard building blocks in these solutions wherever possible, consistent with client preferences and any applicable regulations” and its analysts will now consider “ESG risk with the same rigor” they use in analyzing “traditional measures such as credit and liquidity risk.”

BlackRock’s foundational investment philosophy, rooted in index portfolios, had previously been based on the efficient market hypothesis, which holds that today’s share price reflects all possible information. Stock prices move according to what Princeton’s Burton Malkiel famously called a “random walk.” As a result, investors can do better by investing in low-cost, passive portfolios than in stocks that they or others choose because they think shares will appreciate. A study conducted last year by the Institute for Pension Fund Integrity looked at the performance of state pension funds, and determined that only 17 of the 50 states would have outperformed a portfolio made up of 50% in stock index funds and 50% in bond index funds. In other words, over 66% of all state pension funds could not beat a simple benchmark.

BlackRock’s reputation derives not from its ability to pick undervalued stocks or see into the future but from its skill at offering low-cost index investments efficiently. But there’s one problem. Index investing has become a commodity business, with competitors offering undifferentiated funds at wafer-thin margins, and for pension funds, sometimes for free through their custodian.

Investors that follow the efficient market hypothesis and random walk philosophy of investing do not give a hoot about the policies and practices of individual companies as all information is priced into the market almost immediately. It appears that Fink is now rejecting this old credo by assuming that the prices of shares do not properly reflect the threat of climate change, and thus, BlackRock will now make investments that correct for this “mistake.”

No doubt Fink and his colleagues believe in the critical importance of a sustainability screen in their active management, but that explanation is insufficient to explain a change of this magnitude. Instead, the driving force may be simple economics. BlackRock can charge higher fees with both actively and passively managed ESG funds than it can with conventional index funds.

For example, BlackRock’s iShares Global Clean Energy ETF, one of the largest ESG funds in the world, carries an expense ratio of 0.46%. Compare that with iShares Core S&P 500 ETF at 0.04%. A shift to ESG investing would both allow BlackRock to charge higher fees and, from a marketing perspective, distinguish it from competitors like Vanguard, State Street, and Fidelity.

The shift may be BlackRock’s only palatable choice. Right now, the large indexers are in a race to the bottom. BlackRock’s quarterly earnings fell for four quarters in a row on a year-vs.-year basis between the fourth quarter of 2018 and the third quarter of 2019. 

BlackRock is making a big gamble. ESG investing has its adherents, but it’s doubtful that it can outperform the standard indexes on which BlackRock has relied for decades. For example, despite the recent decline in oil prices, for the five years ending May 15, BlackRock’s S&P 500 Growth ETF beat the Clean Energy ETF by an annual average of more than 10 percentage points.

Research has consistently indicated that conventional index portfolios perform better than ESG portfolios, partly because ESG portfolios charge higher fees. A Pacific Research Institute study last year, for example, found that for 18 public ESG funds with a 10-year track record, “a $10,000 ESG portfolio would be 43.9% smaller compared to an investment in a broader, S&P 500 index fund.” Only two of the ESG funds would have beat the S&P fund over a 10-year period.

In a 2016 paper, Alicia Munnell, a former Treasury Department official under President Clinton, and now director of the Center for Retirement Research at Boston College, and her colleague Anqi Chen, a researcher at the center,concluded: “While social investing raises complex issues, public pension funds are not suited for this activity. The effectiveness of social investing is limited, and it distracts plan sponsors from the primary purpose of pension funds—providing retirement security for their employees.”

By contrast, Fink is pursuing a course which, while possibly more profitable for BlackRock, puts public pension funds and other client portfolio performance in jeopardy by opening the door to politics as part of pension portfolio management. I have nothing against companies embracing ESG, and in fact, virtually all the leaders and boards of Fortune 500 companies now embrace ESG principles—many for decades. Rather, what I object to is Fink opening the door for politicians to play politics with public pensions rather than adhere to a strict fiduciary standard of the highest returns at a reasonable risk.

If individual investors want to choose social investments, they are certainly welcome, but pension plans shouldn’t be making social and political decisions for their millions of members. Instead, if they are wise, they will pursue the low-fee, index strategy that was the solid foundation on which BlackRock was built, and in doing so, will immediately be in the top third of all state pension plans by performance.

Christopher Burnham has served as the Treasurer of the State of Connecticut, the chief financial officer of the U.S. Department of State, Under Secretary General of the United Nations. He is the founder and president of the Institute for Pension Fund Integrity.

IPFI Issue Brief: Behind BlackRock’s ESG Shift

BlackRock, the world’s largest private asset manager, has over the past two years begun to shift its investment strategy, placing a much greater emphasis on environmental, social, and governance (ESG) factors and boosting the presence of ESG funds in its portfolios.

In a newly released issue brief, the Institute for Pension Fund Integrity delves into the steps that BlackRock and its founder Larry Fink have taken to arrive at this point, and examines the consequences that this shift will have on investments – particularly public pension funds. Some major takeaways include:

  • Transition to a High-Fee Forecaster – Over time, BlackRock will look less like a low-fee, efficient index provider and more like a higher-fee forecaster of economic and social trends, with a bias toward stocks and bonds that meet its new ESG bias. Index investing has become intensely competitive, putting the firm’s returns in jeopardy. ESG investing permits much higher fees. In addition, BlackRock may see an emphasis on ESG as beneficial in drawing new customers by differentiating the firm from other index-portfolio specialists.
  • Adverse Effects on Public Pension Funds – BlackRock takes the position that the pricing of many stocks does not properly reflect the risks of climate change. This view undermines the fiduciary duty of public pension fund managers, who will have to explain to retirees that their money is no longer being invested according to an established, time-proven methodology but is open to influence from outside political interests.
  • Lower Returns on Investment – Research has consistently indicated that conventional index portfolios outperform ESG portfolios. By increasing the importance of social and environmental investing in its clients’ portfolios, BlackRock has created a major distraction from the focus of achieving the highest risk-adjusted returns for its client.
  • Outsized Influence on Corporate Policy – The shift also indicates that BlackRock will try to take a more active role in influencing corporate policy through proxy voting and direct advocacy. That, too, is bad news for pension funds. Businesses run best when they are run by their own managers rather than being pressured in their governance by investment funds.
  • BlackRock’s ESG Strategy: A Marketing Ploy with Higher Fees – Because the shift puts BlackRock’s own franchise at risk, why the change? A major reason is that index investing has become intensely competitive, putting the firm’s returns in jeopardy. ESG investing permits much higher fees. (BlackRock’s iShares Global Clean Energy ETF, one of the largest ESG funds in the world, carries an expense ratio 11 ½ times as great as the expense ratio for BlackRock’s S&P 500 ETF.) In addition, BlackRock may see an emphasis on ESG as beneficial in drawing new customers by differentiating the firm from other index-portfolio specialists such as State Street and Vanguard.

While BlackRock may perceive the shift in its own interests, pension fund leaders must consider whether the shift is in the best interests of its own current and future retirees.

Click here to read IPFI new issue brief: Behind BlackRock’s ESG Shift

Open Letter: Congress should reconsider banks’ government guarantees if the banks abuse their fiduciary duty

Recently, a group of 19 U.S. Senators sent a letter to the Small Business Administration, Treasury Department, and Federal Reserve raising concerns that several major financial institutions may be inclined to withhold support for certain industries through the Paycheck Protection Program and other COVID-19 relief efforts. The industries in question – the energy sector, federal contractors for ICE, and gun manufacturers, among others – operate in good faith and compliance with the law but have been singled out because they are politically contentious to some. This discrimination against entire legitimate sectors of the economy falls well outside the authority of these banks and is an affront to workers and small businesses across the country struggling to recover from this downturn.

The Institute for Pension Fund Integrity has sent an open letter to Congressional Leadership and key members of the House Financial Services and Senate Banking, Housing and Urban Affairs Committees in support of these efforts to combat banking discrimination.

Several banks have cited their operation in the free market as justification for their decisions to provide or not provide credit. While most private companies do have the flexibility to operate as they see fit and do business based on broader political trends, this is not the case for federally chartered and insured financial institutions. Frankly, banks do not operate in the free market – without significant federal backing, and formal approval from the FDIC, they would be unable to do business. The relationship between the banks and the government is symbiotic. Just as the government came to the rescue of big banks in the aftermath of the 2008 financial crisis in order to stabilize the economy, these banks now have an obligation to step up and do their part in this time of economic turmoil. Denying loans to entire industries based on political pressure is an affront to the American taxpayers who have subsidized these institutions. It is especially egregious when it involves money loaned through the Paycheck Protection Program and other COVID-19 relief bills.

We strongly believe that in this time of economic crisis, every resource available in the public and private sectors must be utilized to bring about a robust and widespread recovery. We welcome and applaud the efforts of these Senators to ensure that the financial resources at the disposal of financial institutions are used in an unbiased manner, and that their loan decisions are made based on creditworthiness, not politics.

IPFI Open Letter to Congress

Alternative Investments: An Overview

In 2006, alternative assets made up just 11% of state pension investments. By 2016, that number had shot up to 26% of pension fund allocations. These investments almost entirely came out of what had previously been allocated to traditional equity investments, with fixed income sources’ share of pension fund investments remaining largely unaltered. But what does this mean? What are these investments vaguely labelled “alternative assets,” and why have they become so popular in recent years?

Alternative assets can most broadly be defined as anything that is not a publicly traded stock or fixed-income asset. This can include anything from real estate to commodities to collectible items (that is not to say, however, that CalPERS has a safe full of Honus Wagner cards locked away somewhere). Venture capital and private equity also fall under this category.

Most pension funds’ forays into the alternative asset world are dominated by investments in real assets. The Los Angeles County Employees Retirement Association, for example, is 16.7% real asset and inflation-hedging investments. Just over half of this is real estate, supplemented by investments in infrastructure, natural resources, commodities, and treasury inflation protected securities.

Large pension funds are uniquely suited for investments of these sorts. While real estate is one of the most common investments people make, infrastructure, on the other hand, requires huge amounts of cash and long-term commitments that are not as attractive to individual investors and smaller funds.

Alternative assets carry their own unique costs and benefits. Long-term investments such as infrastructure and stable commodities can shield a portfolio from a market downturn, as they are significantly less volatile than most publicly traded stocks, while still offering a greater ceiling than a fixed-income asset. The downside of this, however, is that they can cause diminished returns during times of economic prosperity by not increasing in value the way most equity investments will. Alternative investments have even been blamed for public pensions’ inability to fully benefit from the strong market of the past ten years. This is a problem when state and local pensions’ assets are barely half of the value of promised future benefits.

While the markets have been thrown into chaos in recent months as a result of the COVID-19 pandemic, this only underscores the importance of seizing opportunities such as a decade-long period of market growth. Investments in assets which exist largely independent of the market during such times prevent underfunded pensions from picking up some of the slack and catching up to their soaring liabilities.

As the markets went up throughout the 2010’s, pensions invested defensively, opting for assets that might shield them from a downturn that did not come for a decade. The past ten years, in fact, were the best on record for simple equity and bond portfolios, but you might not know it by looking at the performance of public pensions. Alternative assets amount to more than a quarter of public pension portfolios, but what do these funds have to show for it, other than a stake in some toll roads?

Commentary: The SEC’s New Rules For Proxy Advisory Firms Are A Key Step Toward Accountability

This article originally appeared in Forbes on April 30, 2020.

In a recent Op-Ed in Barron’s , four current state treasurers argue that the SEC’s proposed rules for proxy advisory firms are a harmful overstep by the agency tasked with protecting investors and promoting the creation of wealth in this country. As the former State Treasurer of Connecticut, I strongly disagree with their position. The proposed regulations by the SEC will correct the unintended consequences of a 2003 SEC rule that required investment advisors to adopt policies and procedures to vote on all proxy proposals as a way of improving the function of the capital markets.

Most pensions systems and money managers immediately outsourced this voting process to proxy advisory firms as a way of dealing with the tens of thousands of proxy votes each year, and to comply with a new SEC requirement that their vote be “based upon the recommendations of an independent third party.” The new proposed rules under SEC Chairman Clayton are meant to clarify and strengthen the 2003 rule, ensuring greater transparency and accountability by holding the two dominant and powerful proxy advisory firms to a much higher standard.

Currently, proxy advisory firms have zero fiduciary responsibility and zero transparency, and they represent a breakdown of the efficient market hypothesis. The proxy advisory world is dominated by two firms; together, they control approximately 95% of the proxy advice market. Their recommendations are all powerful—they alone know how a proxy vote will turn out because nearly all money managers and pension funds abdicate their responsibility for fiduciary oversight to these firms. As Professor David Larcker of the Stanford Graduate School of Business has estimated, these two firms control as much as 30% of any corporate proxy vote.

This duopolistic concentration of power is an absolute erosion of shareholder rights, not an enhancement. The role of a fiduciary, codified for over 1000 years in British and American common law, is to invest for the highest return at a reasonable risk. It is not to apply a personal activist agenda.

The worst manifestation of this unaccountable concentration of power over our public pension funds is so-called “robo-voting.” Robo-voting is the practice of money managers and pension funds to blindly rely on the recommendations of proxy advisors. Even when a company’s management contests the recommendation of the proxy advisory firm, automatic robo-voting continues as the proxy advisory firms provide the voting technology to money managers, which can be programmed to agree and vote in accordance with the proxy firm’s recommendations.

As a board member myself, I understand that boards and management must take into account environmental, social, and governance issues in the running of a company. For decades we called this “responsible leadership.” I do not, however, believe that blind robo-approval of any proposal is anything other than the injection of a political agenda into proxy voting by proxy advisory firms with zero oversight and no transparency.

Our terrific public employees, who are counting on duty, stewardship, and the highest standard of care for the management of their retirement funds, deserve to be protected from individual political agendas, and the return to accountability, transparency, and politics-free management of our public pension funds. Our four state treasurer colleagues are wrong in their injection of politics into pension fund management, and the SEC is correct in their new proposed rules to correct the mistaken interpretation of their 2003 rule.

As former SEC Commissioner, Daniel Gallagher, said in a speech in New York City in October of 2013,

I have grave concerns as to whether investment advisers are indeed truly fulfilling their fiduciary duties when they rely on and follow recommendations from proxy advisory firms. Rote reliance by investment advisers on advice by proxy advisory firms in lieu of performing their own due diligence with respect to proxy votes hardly seems like an effective way of fulfilling their fiduciary duties and furthering their clients’ interests. The fiduciary duty…must demand more than that. The last thing we should want is for investment advisers to adopt a mindset that leads to them blindly cast their clients’ votes in line with a proxy advisor’s recommendations, especially given that such recommendations are often not tailored to a fund’s unique strategy or investment goals.”

I could not agree more.

Christopher Burnham is the President of the Institute for Pension Fund Integrity and the former State Treasurer of Connecticut.

Robo-Voting: An Overview

Robo-voting: An Overview

With the focus of government, business, and the media all centered on the singular issue of coronavirus, attention toward the upcoming proxy shareholder voting season has been moved to the back burner. Over the next few months, shareholders of publicly traded companies will be voting on various resolutions, including who sits on boards of directors and what critical investment decisions will be made. In the run-up to this voting season, IPFI is committed to making sure that investors, shareholders, and especially pension beneficiaries are informed of the nuances and realities behind this process. More importantly, we hope to shed light on the more detrimental aspects of the industry that we believe have compromised the fiduciary integrity of public pension funds. 

The current economic crisis is causing many companies, investors, and pension fund managers to make tough decisions. While it is likely that major changes to pension management will not be made until after this pandemic has subsided, we hope that the new financial realities facing many fund managers will impress upon them the need for reform.

In the past, we have been critical of the outsized role played by proxy advisory firms in investment decisions, and specifically the “robo-voting” process through which their influence is actualized. In this post, we will expand upon the concept of robo-voting in order to provide the average shareholder or pension fund beneficiary some insight into how their money is being managed – or, in many cases, mismanaged. 

How did we get here?

As the intricacies of the financial industry and investment decisions have grown more and more complicated over the past several decades, a growing number of institutional investors have come to rely on the advice and analysis of proxy advisory firms in their decision-making process. While the rise in prominence of these outside consultants may have originally come about as a market reaction to the nature of the financial industry, their current standing does not reflect the realities of an open and free market. Only two firms – ISS and Glass Lewis – control 97% of the proxy advisory industry, creating an effective duopoly and preventing investors from doing any actual comparison shopping for a firm that might best meet their needs. The limited number of proxy firms (and employees who work for them) compared to the vast array of investors seeking their assistance has hindered responsiveness and limited the ability of investors to critically evaluate the advice they receive. Furthermore, questions have arisen over potential conflicts of interest among proxy advisory firms, calling into doubt their fiduciary obligations to their clients.

What is Robo-voting?

Robo-voting, also known as “automatic voting” or “proxy voting,” is the process by which asset managers, pension fund managers, and other investors automatically vote in line with the recommendations provided to them by proxy advisory firms. In a previous article, IPFI President Christopher Burnham compared the use of robo-voting to robocalls, and in a sense the reasoning behind the two is similar – by automating the process, robo-voting allows fund managers to save time and money. While many major institutional investors do spend considerable resources evaluating proposals from management and shareholders, this is certainly not the case overall. An overwhelming number of fund managers have outsourced the oversight and decision-making process to proxy advisors.

While proxy advisory firms have repeatedly stated that their role is simply to provide advice and guidance to investors, who can then use it as they see fit, the ultimate decisions made by investors demonstrate just how much ISS and Glass Lewis are calling the shots. How widespread is the trend of automatically following the advice and voting guidance of these firms? According to data released by the American Council for Capital Formation, 175 entities and investors, representing over $5 trillion in assets, vote in line with proxy firm recommendations at least 95% of the time. Of these, about half vote in line 99% of the time. 

Analysis from a Harvard Law School report notes that the level of influence of ISS alone may be as high as 25% of all voting outcomes.

Among the investment funds which have followed in lock-step with proxy advice are several public pensions. The same ACCF report notes that several pensions have followed proxy voting recommendations at least 99% of the time: the Virginia Retirement System, Los Angeles County Employees Retirement Association, Kentucky Teachers’ Retirement System, Pensionskasse SBB, and Alameda County Employees Retirement Association. For retired public employees who have entrusted their retirement to these funds managers, this would seem to be a major abdication of responsibility.

Why is this a problem?

When undertaken in a responsible manner, proxy voting is considered to be a key aspect in the effectiveness of capital markets – the SEC itself has said as much in the past. However, this is not the case when the reach and influence of proxy advisory firms has extended far beyond their stated role as straightforward providers of data and analysis. The duopoly of ISS and Glass Lewis wields enormous influence over the direction of publicly traded companies in the United States. Despite their influence, they are, unlike fund managers, under no obligation to uphold a fiduciary duty to the clients they represent, or to provide insight into whether their decisions are made based on the desire to maximize value for shareholders. Flawed recommendations are prevalent, and transparency into the decision-making process is lacking.  

At the end of the day, these firms are for-profit entities, and are therefore incentivized to make decisions that will improve their own standing and develop a wide-reaching market for their services. This may even entail the pursuit of certain political priorities in investment decisions, over which the ultimate beneficiaries have little say. Given their broad reach and impact, the potential for conflicts of interest could have grave ramifications for pensions and investment funds. 

Where do we go from here?

The prevalence of robo-voting is in itself not something that has come about through the pressure of proxy advisors, but rather as a function of the needs of investors looking to find efficiencies in the face of numerous shareholder proposals and the complexities of the financial industry. This is especially true among smaller investment firms and pension funds who may not have the resources at their disposal to conduct a comprehensive critique of proxy recommendations. 

Fortunately, growing awareness of the practice of robo-voting and the undue influence of proxy advisory firms has spurred calls for regulation. The SEC is in the process of considering new rules that would boost transparency requirements for these firms – unfortunately, deliberation and implementation has been delayed by the outbreak of the coronavirus. In the meantime, it is the responsibility of pension fund beneficiaries to demand that their fund managers take a critical approach to the use of proxy advice in their investment decisions.


In Case You Missed It: IPFI Has Been Busy Fighting For Public Pensions

See below for a round-up of the latest material from IPFI:
SEC Rulemaking and What It Means for Proxy Advisory Firms
  • “The SEC recently announced proposed rules aimed at addressing the outsized influence of proxy advisory firms, restoring much-needed protections to the proxy voting process and those who bear the financial consequences of the decisions made throughout. The proposed rules stand to correct a number of issues related to proxy advisory firms that compromise the shareholder voting process, company performance, and financial returns on public pension investments.” Read the full report here.
CalSTRS Need to Focus More on Investment Performance, Less on Proxy Advisory Firms
  • “CalSTRS’ management – by voting automatically with proxy advisory firms’ recommendations – is silencing the voice of everyday pensioners who are the main beneficiaries of the pension fund. Reforming this automatic voting status will create greater transparency for all CalSTRS pensioners.” Read more here.
LACERS Must Stand Up Against Divestment Pressure
  • “As the new year begins, fiduciaries must remain vigilant against misguided abuse of our nation’s pensions. Those in charge of California’s retirees have a duty to manage the Los Angeles City Employees’ Retirement System (LACERS) with the sole objective of increasing returns. Forced divestment and politically-motivated financial decisions have been shown to compromise that outcome.” Read more here.
The Misguided Movement to Divest
  • “The head of the world’s largest money manager should know that selling stock is an ineffective vehicle for change. Instead, it provides an opportunity for major oil and gas companies to buy back their stock. In the end, it’s the pension plan members who have committed a portion of every paycheck to funds that invest in these industries that wind up suffering.” Read more here.
Bucking the Trend to Rescue New Jersey’s Pension
  • “As three of New York City’s five pension funds move to divest from fossil fuels, one state government in the neighborhood is bucking the trend to move away from corporations operating in the carbon-based fuel industry. Governor Phil Murphy of New Jersey has warned against the impulse to sever ties completely with industries or companies when one does not agree with their practices.” Read more here.
Fallout from COVID-19 Demonstrated Rose-Colored Perspective on Pension Returns
  • “While an economic disruption of this magnitude may not have been on the radar of investors and public officials, it demonstrates the unrealistic optimism that states have held for pension fund returns on investment.” Read more here.
Latest Commentary 
The SEC Is Right To Force More Transparency Into Proxy Voting
  • IPFI President Christopher Burnham lends his support to the SEC’s efforts to codify overdue regulations limiting the influence of proxy advisory firms on the shareholder voting process. “The Securities and Exchange Commission is about to take an important first step in bringing accountability and transparency to the proxy voting world. For far too long pension funds have off-loaded their fiduciary duty to their beneficiaries to proxy advisory firms by outsourcing to them, the review of proxy proposals. These firms, in turn, then make recommendations to plan sponsors but without any oversight and very little transparency.” Read the article here.
ESG Versus Impact Investing
  • “ESG is used around the world as a way to help both large and small companies increase shareholder value by good governance, being good stewards of the environment and taking care of their employees. ESG is not about forcing pension funds, or banks, to stop funding soda companies, coal companies, private prison companies, defense industry companies or anything else that offends politicians, activists, elitists or scared bank CEOs seeking to impose their supercilious arrogance over fiduciary responsibility.” Read the full article here.
What the SEC’s Proposed Rule Means for Investors
  • IPFI Advisory Board member Chris Cummiskey details how investors can navigate the new SEC rules relating to proxy advisory firms. “As the SEC’s recently proposed rule S7-22-19 […] makes its way through the public comment period, investors must understand how this rule will bring long-overdue accountability to the proxy voting process, and what that means for bottom-line dollars.” Read the full article here.
In the coming months, IPFI will continue to assert its four core principles:
  •  Adherence to fiduciary responsibility
  •  Balanced economic, social and governance (ESG) factor investment
  •  Long term pension fund returns
  •  Data driven investment

Fallout from COVID-19 Demonstrated Rose-Colored Perspective on Pension Returns

As of the writing of this article, global markets have experienced the largest drop since the Great Depression as a result of fallout from the COVID-19 virus, erasing all gains from the economic upswing of the last two years. It is likely that with a global quarantine in effect, markets will continue to reel in the weeks and months to come. The global economy will face a daunting recovery, and although we can rest assured that this crisis will pass, it will take years for certain sectors to regain their footing. Fallout and a change in mindsets and habits after the virus may cause some industries to disappear entirely.


In the face of all this, public pensions and the returns that they are supposed to guarantee to retired public servants will undoubtedly face a funding crisis. While an economic disruption of this magnitude may not have been on the radar of investors and public officials, it demonstrates the unrealistic optimism that states have held for pension fund returns on investment. In an effort to compensate for mounting unfunded liabilities, many state officials have pegged future investment growth to a rosy rate-of-return that assumes annual market growth upwards of 8%, which does not account a recession, now likely approaching. For pensions to meet their mark, this would entail a booming economy for years to come. Even a minor economic downturn that slowed growth by a percentage point would cause pensions to drastically miss their targets, possibly increasing liabilities nationwide by as much as $500 billion. What will they look like now in the face of global economic collapse?


This is not the first time that we have seen such fallout. In the wake of strong economic growth throughout the 1990’s (coupled with the Dot Com boom), many state pension funds were in a stable and financially sound position as investments poured in. Unfortunately, many public officials were reluctant to use this increased revenue to take action to shore up pension funds in the long run or establish “rainy-day” measures, instead opting to boost their political standing by increasing pension fund payouts. One major example of this was in California, where in 1999 the state legislature passed SB 400 which increased pension benefits on the basis of an estimated $17.6 billion in state pension surplus. Soon after the benefits were granted, the economic fallout from the 9/11 attacks dragged the pension fund deep into the red – a fund that was now obliged to make larger payouts to beneficiaries. Given that recessions impact government revenue streams across the board, the infusion of additional public money into the pension fund in an effort to shore up losses becomes much more difficult in lean times. One would think that this failure to account for economic fluctuation in the long term would have been a lesson for public pension fund managers, but given our current situation, this does not appear to be the case.


Unfunded liabilities in public pension plans are a problem that has a tendency to compound upon itself. In order to make up losses and ensure that the fund will be stable in the future, fund managers and public officials are faced with several options: increase contributions from workers, reduce expected benefits, or adjust their investment strategy in an effort to boost returns. Because the first two options are politically detrimental to elected officials who will then face the scorn of public employees, the third choice is usually first on the table. Unfortunately, seeking out investments with a higher rate of return by their very nature increase the risk of the fund and makes it much more susceptible to economic volatility. This is a tradeoff that many states have been willing to make, especially coming off of the last decade of strong economic growth. We are now seeing how these decisions can backfire.


What policy changes could be implemented to prevent such pension funding crisis in the future? First, public officials should begin to move toward realistic actuarial assumptions when calculating future pension fund growth and the contribution levels that will be necessary to correct unfunded liabilities. Fortunately, many states and localities have begun to move in this direction in the wake of the record-low interest rates we have seen since the financial crisis of 2008. This trend needs to expand on a more profound scale. Second, when the COVID-19 crisis passes (and it will) and the economy returns to a positive level of growth, public officials must avoid the immediate political gains of using surpluses to fund larger pension payments and must instead think long-term. If history teaches us anything, the next economic downturn is right around the corner.


Ultimately, the failure to realistically project pension rates of return and to adequately re-invest surplus comes down to a failure in political leadership. No governor wants to tell their constituents that a realistic re-assessment of pension investment returns means that their unfunded liability problem is much worse than before. However, the hard-working public employees who have dedicated their careers to public service in anticipation of stable retirement benefits deserve the truth. Our leaders need to get real. Economic disruptions happen. Recessions happen. And yes, major crisis like pandemics, war, and terrorist attacks happen. To simply ignore this reality when evaluating rates of return in an attempt to cover up underlying problems is a dereliction of the duty that public servants swear to uphold. Hopefully, this pandemic will finally bring about some frank conversations and hard decisions to ensure the stability of public pensions for generations to come.

Bucking the Trend to Rescue New Jersey’s Pension

As three of New York City’s five pension funds move to divest from fossil fuels, one state government in the neighborhood is bucking the trend to move away from corporations operating in the carbon-based fuel industry. Governor Phil Murphy of New Jersey has warned against the impulse to sever ties completely with industries or companies when one does not agree with their practices. A spokesman for New Jersey’s investment division laid out the state’s reasoning for staying in the game. Divestment means forfeiting shareholder voice, the New Jersey official said, meaning that they would no longer be able to move the company in a direction more in line with their views. Murphy, a former senior director at Goldman Sachs, understands how the market and corporations actually work, and therefore the negligible impact of divestment.

Further showing the ignorance of the divestment movement, it is major energy companies that have made important breakthroughs in clean energy science since the beginning. Given the kind of change climate activists are seeking, they should be doing everything they can to have a say when Exxon and BP are deciding where to put their money. Nature Conservancy, the nation’s largest environmental nonprofit, has been partnered with Royal Dutch Shell for over a decade.

In the face of criticism, Governor Murphy is taking the right steps to improve one of the country’s worst funded pension systems. His budget proposal includes more than $500 million in increased pension funding in addition to his support of returns-focused investing. Struggling funds cannot afford to play futile political games with average Americans’ financial security. Meanwhile, the three New York City funds are moving a combined $3 billion to appease activists. Mayor Bill de Blasio claims that this move shows that “New York City is taking action,” but really it is the opposite. Taking action means doing something to effect change. Mayor de Blasio is giving up his seat at the table and leaving retirees out to dry in the process.

What the SEC’s Proposed Rule Means for Investors

This article originally appeared on Morning Consult on March 5, 2020.

In the new year, we often make many promises. This time, we must resolve to protect the interests of retail and institutional investors from the meddling of proxy advisory firms. I have always argued for clear and navigable investment voting processes, and this moment is particularly critical. As the SEC’s recently proposed rule S7-22-19, Amendments to Exemptions from the Proxy Rules for Proxy Voting Advice makes its way through the public comment period, investors must understand how this rule will bring long-overdue accountability to the proxy voting process, and what that means for bottom-line dollars.

Proxy advisory firms amassed their influence through a series of unintended consequences and a prevailing lack of oversight. Until the SEC issued Staff Legal Bulletin No. 20 in 2014 clarifying that investors were not required to vote every proxy, the misconception that they were prompted institutional investors to disproportionately rely on proxy advisory firms to carry out their voting duties.

During that time, a duopoly flourished. Glass Lewis and International Shareholder Services (ISS) dominate 97 percent of the market, which affords them the ability to dictate the rules of the game with little competition. Proxy advisory firms position themselves as third-party “allies” to investors while wielding enormous power to sway voting outcomes and determine where and how fiduciaries invest others’ money. And that’s cause for concern. 

For one, proxy advisory firms are rife with conflicts of interest. Consider that ISS bases its voting recommendations, in part, on an analysis of a company’s governance performance demonstrated by an ISS Governance Score. ISS also offers a service to companies on how to improve their ISS Governance Score. Hence, ISS collects payment on opposite sides of the same mechanism. 

ISS also sells voting services to investors as well as consulting services to companies considering management-proposed resolutions. This introduces the risk of the proxy firm recommending that investors vote in favor of management when it’s a consulting client. The Ohio Public Employees Retirement System (OPERS) understood the danger this posed to its pension plan members’ long-term financial security and swiftly ended its contract with ISS in the mid-2000s.

Conflicts of interest become even more troubling given the preponderance of automatic voting. On average, investors vote following proxy recommendations 80 percent of the time. A single negative ISS recommendation on say-on-pay leads to a 25 percentage point reduction in support.

As a fiduciary, an investment adviser owes each of its clients a duty of care with respect to services undertaken on the client’s behalf. However, proxy advisory firms provide several different voting guidelines that obfuscate fiduciary duty and skew investments toward subjective goals, including faith-based and sustainability guidelines. By relying on shadow reports, proxy firms offer investors the best of both worlds: the ability to vote how they please while simultaneously recusing themselves of any responsibility by supposedly following the unbiased advice of a third party.

As it turns out, everyday investors are becoming increasingly aware of the many flaws in the existing proxy advisory process. A recent survey found over 80 percent of investors in support of the SEC’s proposed rule at the end of the survey. Additionally, the survey found that the more asset managers and investors learn about proxy firms, their business and what drives their recommendations, the more they support responsible regulation.

Currently, proxy advisory firms provide recommendations based on inaccessible, private data unavailable for public review. S7-22-19 would require proxy firms to ensure their recommendations include dissenting opinions and also allow companies the opportunity to correct inaccuracies in proxy advisory reports.

Proxy voting functions, fundamentally, as an “information production process”. These firms are modern-day factories; their product is information. A proxy firm survives only by maintaining a constant rate of production. By creating reports, data and analyses that tailor to specific political and financial agendas in secret, proxy firms are capable of re-defining public opinion among investors and manipulating large swaths of capital, almost single-handedly.

Though charged with helping investors generate revenue, it seems that proxy advisory firms are only concerned with one bottom-line: their own. The proposed rule rightfully addresses the many transgressions inherent in the proxy advisory process. With the help of the SEC, I believe that we can shift the balance back in favor of investors.