IPFI Statement on the proposed Department of Labor rule on ESG investing

The Department of Labor last week released a proposed rule on tax-qualified retirement plans governed by the Employee Retirement Income Security Act (ERISA) in order to determine the extent to which Environmental, Social, and Governance (ESG) considerations factor into investment decisions. The question at hand is whether the plan managers, bound by fiduciary duty to their beneficiaries, are sacrificing investment returns or increasing risks in order to meet ESG goals unrelated to the participant’s bottom-line financial interests.
Adherence to fiduciary duty is a cornerstone of pension fund management. Any effort to inject politics or political opinion into the management of other people’s money is plainly dead wrong. This is particularly true for the retirement monies of our first responders, our teachers, and the men and women who every day make our state and local governments function. Any effort to inject ESG or any political interest into the management of other people’s money should be treated as a violation of fiduciary duty. There are many laudable social initiatives that individuals, religious endowments, school endowments, and other private concerns may wish to consider. It is, however, never correct to impose those personal political opinions on pension funds.
Today, massive unfunded liabilities plague public pension plans across the country. However, even if they were all fully funded, injecting politics into their management would still be a gross violation of fiduciary standards. That America’s public pension plans may be over $10 trillion in the hole would seem to turn politician’s, and now apparently, banker’s efforts to politicize public pension fund investments from a fiduciary crime into a fiduciary blunder.
The Institute for Pension Fund Integrity (IPFI) takes no issue with ESG as a tool for corporate managers and boards of directors to utilize to make their enterprises faster, better, cheaper, safer, and more responsible to their shareholders and employees. The board room and the C-Suite is exactly where that consideration should reside. It should not be hijacked by activist politicians, bankers and proxy advisory firms, seeking a political agenda in the name of good governance.
We at IPFI applaud the Department of Labor’s efforts to clarify and correct guidance on the fiduciary obligations of pension fund managers as far as ESG investing is concerned, and we believe that ERISA must be modernized to ensure that fund’s investment strategies remain focused on fiduciary duty and the best risk adjusted return. We can only hope that public pension plans, who are not subject to ERISA, instead sign-on to IPFI’s Principles of Fiduciary Investing (PFI), which requires plan sponsors and managers to pledge unwavering commitment to fiduciary duty.

Commentary: Proxy Firms’ Social-Ills Advice Wrongheaded

This article originally appeared in the Chief-Leader on June 22, 2020.

In this time of economic turmoil, firefighters deserve stable pensions, not political gamesmanship.

The COVID-19 crisis has put an incredible strain on public pension funds. State and city governments will be under enormous budget pressure as leaders scramble and struggle to recover from the pandemic and bring our economy back to “normal.” Meanwhile, our dedicated public servants—firefighters, law enforcement, health-care workers, and others—continue to uphold their duty in the face of these overwhelming challenges.

Having served on the FDNY for 28 years, I’ve witnessed first-hand the hard work that my fellow firefighters have poured into our community. We each took an oath to serve, accepting the risks of the profession. As a part of our compensation, we were fortunate enough to have a pension guaranteeing a secure retirement. In many cases, this meant sacrificing pay during our working years.

Across the country, nearly 3,000 public-pension plans provide retirement and disability benefits to over 350,000 career fire service and EMS employees. But chronic under-performance and unfunded liabilities in our public pension systems continue to intensify. Meanwhile, institutional investors have become increasingly reliant on proxy advisory firms to guide them on votes affecting company performance and returns on our pension investments.

Advisory-Firm Duopoly 

Given the sheer volume of proposals which investors must consider when voting, proxy advisory firms offer direction by informing and making recommendations on the resolutions. However, two firms, Institutional Shareholder Services (ISS) and Glass Lewis, control 97 percent of the proxy advisory market. With a duopoly, there is very little market choice for plans to choose from.

Pension funds are some of these firms’ customers, which means our retirement security is directly impacted by their advice. Too often, this advice seems aimed at solving society’s perceived political and social ills rather than increasing returns.

Private investors may choose to structure their portfolios around such considerations, as they are solely affected by the financial strategy they implement, but public pensioners are not granted the choice to enter or exit a fund’s investing strategy. Because of this, pension boards must make prudent investment decisions that meet one goal—maximizing returns.

While investment managers are supposed to adhere to their fiduciary responsibility, proxy advisory firms do not have the same obligation. Given their outsize impact, this disparity is very concerning. To combat some of the problems associated with proxy advisors, the SEC is currently reviewing reforms to the industry in order to boost transparency—clearly a move in the right direction.

When young firefighters assume the risks that are associated with the position, their first thought isn’t always their public pension. It’s the fiduciary’s responsibility to ensure that our public servants’ retirement is safe, so that they can focus on the immediate situations in front of them, not the ones at the end of their careers.

Richard Brower is the former Vice Chairman of the New York City Fire Department’s Pension Fund and an Advisory Board member of the Institute for Pension Fund Integrity. He is also the former president of the Uniformed Fire Officers Association.

Commentary: As Shareholders Come Together to Vote, Investors Must Work to Keep Politics Out of Public Pensions

This article originally appeared in Morning Consult on June 9, 2020.

With the proxy voting season in motion, corporations and shareholders are preparing to debate numerous potential changes to how thousands of businesses operate. This year, a single issue will be at the forefront of everyone’s minds: the COVID-19 pandemic. The virus has upended the status quo of just about every facet of our lives, not the least of which how we do business. The massive disruption caused by the coronavirus will have a lasting impact on our economy. As such, the manner in which organizations change how they operate during this year’s proxy season is uniquely consequential.

Public pension funds, already reeling from years of underfunding, mismanagement and the unwillingness of public officials to make tough political decisions, now face one of their greatest challenges yet. The COVID-19 market crash has greatly exacerbated pension liabilities in many states and localities – even ones which had previously been well-funded. It is likely that the record job losses and a prolonged economic downturn will limit tax revenues and force many fund managers to make tough decisions in the months ahead.

Given the severity of the current situation, it is imperative that public officials re-commit to their fiduciary obligations and ensure that public pension investments are freed from any outside political considerations. The public servants who have spent their lives paying into these funds deserve stable returns, not ideological posturing. Investment decisions must be made on financial criteria, not political correctness.

In spite of the challenges brought about by the economic downturn, it is likely that the issues put forward for shareholders to vote on this season will include numerous proposals intended to allow companies and financial firms to take political stances. Perhaps the most prominent example of this is BlackRock, the largest investment firm in the world, which has for the last several years tried to set itself apart as a firm at the forefront of Environmental, Social, and Governance investing standards.

While the movement toward ESG investing has gained traction among investors in recent years, the sheer size and influence that BlackRock has across the market means that its heavy emphasis on these standards presents a problem for those of its clients who value the maximization of returns over the advancement of a political agenda. Because pension beneficiaries do not control how their funds are allocated, it is important that the asset managers who do channel their clients’ money in a way that first and foremost protects their financial security. With ESG funds consistently underperforming passive index funds by as much 43.9 percent (and charging higher fees while doing so), placing them at the center of an investment strategy is an irresponsible violation of fiduciary duty.

BlackRock is a major shareholder in many corporations, and therefore has enormous influence in the voting decisions being made across the market. Due to the enormous amount of power BlackRock wields, investors are pressured to vote along the ideological lines drawn by the firm rather than what will maximize shareholder value in a time when the markets have plummeted in a way not seen since the Great Depression.

The problem with the kind of activist investment BlackRock is pushing is that its effects are felt not just on Wall Street, but across the country by those who serve their communities every day. Teachers, firefighters and countless other public servants put their trust in asset managers with the expectation that their financial security will be the No. 1 priority, a sentiment echoed on BlackRock’s own website. Its actions, however, say otherwise.

Kevin O’Connor is a retired Baltimore County firefighter who led the Governmental Affairs and Public Policy Division of the International Association of Fire Fighters, and also serves as an advisory board member of the Institute for Pension Fund Integrity.

California Supreme Court Examines Pension Spiking

In May, the California Supreme Court heard a case with the potential to set a new precedent for pension reform across the country. The court’s decision will impact the pensions of over one million public employees and will either confirm or limit the government’s ability to adjust pension benefits after they are promised to public employees.

The case addresses the 2013 Public Employees’ Pension Reform Act enacted under the administration of Governor Jerry Brown. The most controversial component of the law banned a practice known as “pension-spiking.” Given that a worker’s year of highest earnings was used to calculate pension payments, public employees were able to work overtime and cash in accumulated vacation and sick pay to increase their earnings for one year in order to enjoy more lucrative benefits during retirement.

The financial savings incurred by the law for the California Public Employees’ Retirement System (CalPERS) fall between $28 billion and $38 billion over the next 30 years. Although huge sums, the savings are relatively meager considering the overall $300 billion in the retirement system. The California State Teacher Retirement System fund would see similar savings: almost $23 billion for the $200 billion system. Despite the relatively modest savings, Governor Gavin Newsom called for the California Supreme Court to uphold the law.

The state’s lawyers argued that public employees should be prohibited from using payments other than their salaries for pension calculations. They asserted that pension-spiking was an unauthorized practice and the state carries a responsibility to eliminate loopholes which allow employees to unlawfully tamper with their benefits, especially when the alternative includes layoffs and furloughs. Although judges are not supposed to consider current events in their decision, the current economic context certainly plays an important role in the need to enact cost-saving measures.

The unions challenging the pension reform argued that the reform violates the “California Rule,” a 60-year old law which stipulates that public employees are entitled to the pension benefits they were promised at the beginning of their employment. According to them, upholding the law would set a precedent allowing “retroactive reductions in pensions already earned”. They also argued that “pension-spiking” has long been accepted as a legal practice and therefore, the new law unconstitutionally violates both the California Rule and an implied contract.

Given California’s prominence, other states will be attentively watching the outcome of the case, which tests the government’s ability to institute pension reform. The Court could choose to make a decision without addressing the California Rule by very specifically limiting “pension-spiking” without addressing the underlying, larger questions. This certainly impedes the government of California’s progress to balance their retirement system but lacks the long-term implications that would accompany a broader decision.

On one hand, striking down the California Rule would help California make headway towards a better-balanced budget. Allowing adjustments for pension budgets would relieve city managers of some pressure to enact budget cuts, furloughs, and layoffs. The decision opens the door to future pension reform, and the ability to legislate changes to the pensions of current public employees. Although this ability could certainly be manipulated, any reforms will undoubtedly be challenged in court.

Upholding the California Rule, on the other hand, would be a blow to retirement systems in desperate need of cuts, especially given the current economic context. CalPERS, the state’s largest pension system, only secured 70% of its funding before the pandemic delivered economic chaos. In order to offset the deficit caused by strict limits on pension cuts, furloughs and layoffs would be forthcoming. A future with the California Rule in-place would significantly impede the progress of pension reform.

California was already in billions of dollars of pension debt before the economic consequences of COVID-19 hit. Unfortunately, unions and state governments disagree on the methods to successfully balance the budget. Given that significant budget cuts loom in the state’s future, the court’s decision will play a role in whether retirement systems can be reduced and the extent to which state governments can do so.

Supreme Court weighs in on fiduciary duty in pension fund management

On June 1st, the Supreme Court Ruled in the case Thole vs US Bank N.A., with important implications for pensions that could help shape future retirement investment.

The plaintiffs were James Thole and Sherry Smith, both retirees that were invested in US Banks’ defined benefit retirement plan. They alleged that US Bank violated the Employee Retirement Income Security Act’s (ERISA) fiduciary duties of loyalty and prudence by unwisely investing the plan’s assets and causing the plan approximately $750 million in losses from 2007-2010.

The defendants, US Bank, claimed that neither plaintiff ever experienced a concrete injury because US Bank continued to deliver the Plan’s benefits regularly, even though they had sustained the $750 million loss. Additionally, the defendants maintained that the ERISA duties are “generalized” and “wholly abstract” concerns that shouldn’t be grounds to sue, and that any risk that was created during 2007-2010 went away when the plan became overfunded in the following years.

The Court held in a 5-4 decision in favor of the defendants, saying that “Participants in a defined-benefit retirement plan who are guaranteed a fixed payment each month regardless of the plan’s value or its fiduciaries’ investment decisions lack Article III standing to bring a lawsuit against the fiduciaries under the Employee Retirement Income Security Act of 1974.”

This ruling is very timely because the COVID-19 pandemic caused a large-scale economic downturn that could create the basis for similar suits. The ruling in this case is decisive and defined, in particular about what kind of plan can sue under ERISA’s fiduciary duties. Because of the defined nature of the ruling, future cases about ERISA and the Third Article will be fewer and farther between and much more limited in scope. This is partly because more cases will now be decided at lower levels due the precedent this case provides.

More broadly, the ruling in Thole vs US Bank N.A. has serious implications for pensions. New uncertainty surrounding the financial situation of current retirees could influence their decisions about how to retire. Regarding defined benefit pension plans, like the ones Thole and Smith were receiving benefits from, this ruling seemingly allows for heavy losses that could potentially permanently damage the plan, or even push it into closure. Future reform could help curb or eliminate the worry this ruling causes, but for the time being uncertainty and a lack of accountability prevails.

BlackRock under increased scrutiny as it continues to push its ESG goals

Larry Fink knows better than you.

At least, that is the message the world’s largest asset manager is sending following the January letter announcing BlackRock’s shift towards ESG activism. Fink threatened to use the firm’s massive influence to undermine boards that do not adhere to BlackRock’s agenda, saying, “we will be increasingly disposed to vote against management and board directors when companies are not making sufficient progress on sustainability-related disclosures and the business practices and plans underlying them.” The evidence indicates that this was no empty threat. The financial giant voted against board recommendations at more than 30% of first-quarter shareholder meetings this year, casting doubts that BlackRock trusts companies to run themselves.

Meanwhile, BlackRock’s clout in Washington is catching up to its Wall Street prestige. Bloomberg hailed the firm as the “fourth branch of government” after it took on a role as an advisor to the Federal Reserve as the central bank struggles to alleviate the effects the COVID-19 pandemic has had on the U.S. economy. Money has always bought power in Washington—and BlackRock certainly has money—but turning to a company that has so publicly stated that their top priority is no longer delivering value to its clients during a time of crisis is cause for concern. 17 members of Congress think so, at least. The cohort of Senators recently wrote to Treasury Secretary Steven Mnuchin imploring the Treasury to ensure that the government remains “neutral and free of bias” as it seeks to stabilize the U.S. economy.

Despite BlackRock’s very public revelatory moment, the company is facing criticism for failing to live up to its own agenda.  The asset manager has come under fire for its growing interest in Chinese investments despite the country’s abysmal environmental record.  Climate change activists are beginning to question BlackRock’s commitment to promoting sustainability, and not just due to the firm’s Chinese designs. BlackRock did not back environmental resolutions at two major Australian oil companies in an apparent break from their stated ESG goals, leaving many to wonder how much of BlackRock’s new agenda is genuine and how much is simply than posturing for good press.

This conflicting behavior spells trouble for corporate boards and shareholders. BlackRock’s commitment is unclear, save for its commitment to throwing its weight around when it suits its management team, leaving decision makers to speculate how one of the world’s largest investors will come down their operations in a time when their biggest goal is simply to right the ship. With proxy voting season upon us, boards should expect to dance around an agenda known only to BlackRock.

Maybe Fink does know better, because no one else knows quite what to think about BlackRock’s record lately.

Commentary: BlackRock’s new ESG priority is probably about collecting more fees

This article originally appeared in ValueWalk on May 28, 2020.

BlackRock has been moving to redefine its identity from a firm focused on index investing to a firm that emphasizes ESG (environmental, social and corporate governance) investing. However, one organization argues that this move is less about doing something good for investors and more about enabling BlackRock to charge more in management fees.

The Institute for Pension Fund Integrity said in a recent white paper that BlackRock’s ESG shift is moving it from being a low-fee, efficient index provider and toward becoming a “higher-fee forecaster of economic and social trends, with a bias toward stocks and bonds that meet its new ESG bias.”

The organization also noted that about $4 trillion of the $6.5 trillion in assets it manages for clients are held by institutional investors like pension funds, governments, foundations, sovereign wealth funds and family offices.

The IPFI noted that this year BlackRock’s Larry Fink wrote a letter to clients talking about the firm’s focus on sustainability and climate change, which he said are creating a “fundamental reshaping of finance.” The BlackRock Global Executive Committee also said in a second letter that sustainability is the foundation of the firm’s investment strategy.

BlackRock’s definition of sustainability is “understanding and incorporating environmental, social and governance (ESG) factors into investment analysis and decision-making.”

The client letter stated that the company would make “ESG funds the standard building blocks in multi-asset solutions such as model portfolios.” The firm also promised to reduce the supposed ESG risk in actively managed portfolio and remove from its discretionary active investment portfolios the stocks and bonds of “companies that generate more than 25% of their revenues from thermal coal production.”

Further, BlackRock plans to launch new ESG-oriented investment products and strengthen its commitment to sustainability and transparency in its “investment stewardship activities,” a reference to its proxy voting and other types of pressure it exerts as a shareholder.

The IPFI noted that BlackRock has historically been a packager and marketer of index portfolios, meaning that it doesn’t actually choose their contents. In addition to the index business, the firm also has a smaller business in active investment management.

As of the end of March, the firm held managed assets of $609 billion. It also manages non-public portfolios for institutions, which is most of its business. Most of those portfolios are index portfolios, but some are managed.

At this time, just a minimal amount of BlackRock’s assets are invested in ESG portfolios. The IPFI said just 1% of its public funds are held in ESG assets. The firm wants to double the number of ESG products it offers and make those products “building blocks” of client asset holdings. The IPFI expects the company to make its sustainability-focused models into its flagships.

The organization notes that owning a cap-weighted index of stocks is much more transparent than owning an index weighted by ESG factors. It also pointed to research which indicates that conventional index portfolios outperform ESG portfolios.

One of the reasons for this outperformance is because ESG portfolios charge higher fees. The IPFI pointed to a study conducted by Pacific Research Institute that looked at 18 public ESG funds over 10 years. The study found that a $10,000 ESG portfolio would be 43.9% smaller than an investment in an S&P 500 index fund. Only two ESG funds beat the index fund over 10 years.

The IPFI argues that pension funds should be wary of BlackRock’s new ESG focus. The organization quoted a 2016 paper by former Treasury Department official Alicia Munnell, who said public pension funds aren’t suited for social investing. She said the effectiveness of social investing is limited, and it “distracts plan sponsors from the primary purpose of pension funds — providing retirement security for their employment.”

The IPFI argues that BlackRock is distracting from the primary purpose of pension funds as retirement security will no longer be the sole or even primary purpose of pension funds that invest with BlackRock.

“Judging from Fink’s letters, we can only conclude that the world’s largest asset manager wants the public to view it as a firm deeply concerned with climate change and ESG investing,” the white paper states. “Those may be admirable pursuits, but for public pension funds, the BlackRock shift is a red flag. It is an indication that BlackRock is adopting a goal for its investing decisions outside of the goal of the best returns for shareholders.”

The IPFI believes having two goals like ESG and strong returns is impossible, although BlackRock argues that ESG investing recognizes risks the rest of the market doesn’t. The IPFI describes this as “a hubristic notion that runs directly counter to the philosophy and strategy of index investing, which has been BlackRock’s franchise.”

In considering the reason for BlackRock’s shift toward ESG, the organization said it could be “a sincere recognition that the market does not know how to price the prospects of climate change and the policy changes that may jeopardize earnings or the very existence of some businesses in the future.” The organization also said Fink might see a march niche that’s not being filled by asset managers, or he might have to respond to the “race to the bottom among similar firms.”

The IPFI also said that cutting fees lower and lower might not be a good way for BlackRock to boost the returns of its shareholders, but looking for a way to increase its fees could be.

A BlackRock spokesperson did not respond to a request for comment.

Equal accountability needed for all companies listed on U.S. exchanges

With the American economy taking its first steps toward re-opening after months of lockdown, businesses and public officials alike must now confront staggering losses across the market and evaluate how to best focus their recovery efforts. Public pensions, already struggling with staggering unfunded liabilities in many states, have been hit especially hard by this crisis. As we move forward, it is imperative that fund managers take the necessary steps to re-focus their investment decisions, ensuring that pensions aim to maximize returns for the public servants who have paid into them. However, now more than ever, it is also important that public officials take a closer look at how American financial markets operate, how publicly listed companies are held to account, and whether or not investors really know what their money is buying.

Recently, lawmakers from both parties have increased their scrutiny of many Chinese companies listed on U.S. financial exchanges, noting that they have not been subject to the same level of oversight and regulation as companies from the U.S., or, for that matter, anywhere else in the world. Given the sheer size of and potential of many of these companies, Chinese and American investors alike have been understandably enthusiastic about the prospect of major Chinese corporations making inroads into American financial markets – U.S.-listed Chinese companies currently have a market capitalization of over $1 trillion. However, in some cases a lack of transparency has prevented an honest accounting of company prospects, leaving investors in the lurch. The most prominent example of this is Luckin Coffee, once touted as the Chinese Starbucks. When it first launched on NASDAQ last year, it was valued at around $12 billion. However, increased scrutiny after the launch quickly told a different story – namely, that hundreds of millions of dollars in transactions had been fabricated in an effort to boost valuation. Prospects quickly diminished, and NASDAQ eventually suspended trading in Luckin stock. The Chinese government has subsequently launched a fraud investigation into Luckin in cooperation with the SEC.

Luckin serves as a case study illustrating challenges U.S. regulators face in conducting oversight for the audits and financial reporting of Chinese companies listed on American stock exchanges. According to the SEC, Chinese law requires that the records of transactions and events be kept in China and not transferred out of the country. Chinese state security law is often used to narrow American regulators’ ability to supervise the financial reporting of Chinese companies listed in the United States. Beijing also invokes national security to restrict foreign access to Chinese entities’ books and curb American efforts to audit these corporations, allowing these companies to circumvent regulations their American peers on the exchanges cannot.

Investors should be careful investing in these companies as long as this issue goes unaddressed, or they may fall victim to the next Luckin: a huge corporation that attracts investors with creative accounting rather than actual value.

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