With efforts underway by the Department of Labor and other government agencies to address Environmental, Social, and Governance (ESG) investing in pension plans and other investment products, the topic has garnered significant attention over the past several months. Given its prominence, it comes as a surprise that this investment strategy remains ambiguous and lacks a standardized definition.
In a newly released issue brief, IPFI examines the history behind ESG investment strategies, the variations in how ESG is defined between different firms, and how the financial industry can come together to establish a uniform set of standards.
As noted in the issue brief, “Since the acronym’s first use in 2005, ESG has become a widespread term in the finance world. Although there are over $20 trillion in ESG assets under management, it lacks a standardized definition under which all firms can unite and under which regulators can address legitimate concerns. Most definitions, however, use certain strategies to define ESG on an individual level. Some firms make more of an effort than others to define ESG and demonstrate their commitment to ESG investing.”
This analysis comes at a prescient time, in which the benefits of investment strategies that prioritize alternative goals to financial return are being debated across government, the financial sector, and, most importantly from our perspective, pensions. IPFI has long pushed for the principle that while individual investors should be free to choose whatever strategy best meets their needs, the fiduciary duty which is the cornerstone of pension fund management must always prioritize maximized returns with reasonable risk above any other political or social considerations.
According to IPFI President Christopher Burnham, “ESG investments should be made when they add value to a fund. When such investments will not improve the financial performance of the fund, or the decision to invest in them is based on political motives, they should be forgone.” The first step toward ensuring this principle is to set a common understanding of how ESG standards are defined and put into practice.
This op-ed originally appeared in the Washington Examiner on August 14, 2020.
Over the past decade, a strategy known as Environmental, Social, and Governance, or “ESG investing,” has been pushed to the forefront as a tool by public officials and investment managers to promote environmental or social causes through pension fund investments. This requires special attention to making sure pension fund managers are bound by their fiduciary obligation to their beneficiaries and not acting from political motives.
Prioritizing issues other than pure financial returns may be an acceptable strategy for individuals managing their own money or for corporate officers contemplating the future of their company. But for fiduciaries, prioritizing any interest other than maximizing returns is a dereliction of duty.
The Department of Labor has released a proposed rule on tax-qualified retirement plans governed by ERISA in order to determine the extent to which ESG factor into investment decisions. The question at hand is whether plan managers, bound by fiduciary duty to their beneficiaries, are sacrificing investment returns or increasing risks to meet ESG goals unrelated to participants’ bottom-line financial interests.
As a former state treasurer of Connecticut, I have personally overseen the management of a public pension system. It is not possible to fully protect the financial security of a plan’s beneficiaries if those charged with managing a pension fund are trying to build an investment strategy around non-financial considerations. Decisions on new investment strategies, whether they are driven by political reasons or simply as an attempt to chart a new path forward, must be made in the boardroom.
There are many laudable initiatives that individuals, religious endowments, schools, and other private entities may wish to consider. However, it is never correct to impose personal political motives on pension funds. This principle is even more prevalent given the massive financial ramifications that the economic fallout of the COVID-19 pandemic has had on pensions.
The Department of Labor should be applauded for taking this necessary step toward clarifying and correcting guidance on the fiduciary obligations of pension fund managers as far as ESG investing is concerned. As Labor Secretary Eugene Scalia noted, this rule aims to “remind plan providers that it is unlawful to sacrifice returns, or accept additional risk, through investments intended to promote a social or political end.”
The proposal falls short, however, of fully protecting America’s pension beneficiaries from unsound investment practices. Public pensions are still vulnerable to ESG strategies. The trend towards “impact investing” has permeated the proxy voting industry, where two firms effectively control significant numbers of shareholder votes in thousands of publicly traded companies. These votes could become an important weapon against ESG policy that does not serve the shareholders, but under the current rules they mostly serve an ideological agenda separate from the interests of retirees and public employees.
SEC commissioner Daniel M. Gallagher acknowledged the problems with the proxy voting industry as far back as 2013, noting that the current system is not built to increase company value or generally operate on behalf of shareholders, but rather to serve the interests of the proxy voting companies themselves. The proxy voting issue is not one that the rule change at hand would address. While the proposal is a step in the right direction, it is important to think not only about how pension money is invested, but also how the voice that comes with a stake in any given company is used. Until we reform the proxy voting industry, that voice will be vulnerable to the whims of third parties.
The Department of Labor is currently considering the proposed rule. It is my hope that leaders in business, finance, and public policy will continue to voice their support for this initiative. Beyond the scope of this proposed rule, ERISA must be modernized to ensure that fund’s investment strategies remain focused on fiduciary duty and the best risk-adjusted return. The retirees of this nation deserve as much.
Christopher Burnham is founder and president of the Institute for Pension Fund Integrity. He previously served as Connecticut state treasurer, chief financial officer of the U.S. Department of State, and under-secretary-general of the United Nations.
With the comment period recently closed on the newly proposed Department of Labor rule on ESG investments in ERISA-backed pension funds, attention now turns to the evaluation process. Over the next several months, regulators will assess the thousands of comments submitted by organizations and individuals across the country. Attention has also been growing on this issue on Capitol Hill, where both Republicans and Democrats are looking to place their stamp on the eventual final rule.
One prominent individual who has weighed in on this proposal is Alicia Munnell, who served as the Assistant Secretary of the Treasury under President Clinton and currently serves as the director of the Center for Retirement Research at Boston College. In a recent op-ed in MarketWatch, Dr. Munnell voices her support for the rule, noting the downsides of ESG prioritization and need to maintain fiduciary responsibility in pension fund investment.
Munnell notes that:
“Pension fund investing is not the place to solve the ills of the world. ESG investing — which involves environmental, social, and governance factors — is a diversion that enriches financial managers, reduces participants’ retirement investment returns, and makes people think they are addressing a problem without doing anything substantial. No one can seriously think that stock selection is going to fix climate change.”
Noting the history of the Department of Labor’s actions to clarify ESG investment guidelines, she applauds the current proposal as a needed next step. Perhaps most importantly, she also mentions the need to expand the guidelines set forth by the Department for public pension plans outside the jurisdiction of ERISA:
“While the proposed rule is aimed at private pension plans, state and local plans, to date, have accounted for the bulk of the social investing activity. Screening pension fund investments has not been an effective means of achieving social goals, and it distracts plan sponsors from their primary purpose — providing retirement security for their employees.”
As these debates go forward, the Institute for Pension Fund Integrity will continue to press regulators and lawmakers on the need to keep politics out of pension investment. This proposed rule is a key step toward ensuring transparency and accountability in ERISA-backed pension funds, and it is our hope that Dr. Munnell’s comments are given the consideration that they deserve.
Just like many other parts of the economy, the stock market took a heavy hit due to the pandemic. At their lowest points of the crisis, both the Dow Jones and the FTSE 100 were down over 30%. Five months later, they each sit down 13.3% and 19.3% respectively.
With the stock market crashing in mid-to-late March, pension fund returns have shrunk. Moody’s Investors Service estimates that returns for many pension funds this year will reach only 1%, instead of the widely targeted 7% return rate. Roughly $1 trillion of value has been lost by public pension funds stemming from the poor market performance.
Investment returns are vital to pensions because employee and government contributions aren’t enough to support the scheduled payouts to retirees. This likely means that unfunded liabilities are going to increase. To cover for this increasing gap, funds will call on employees to contribute more. This will prove to be more tricky considering that unemployment is in poor shape as well, creating a smaller pool of contributors to pension funds across the nation. In 2007, federal and local government pension debt totaled about $1.6 trillion according to the Federal Reserve, or roughly 11% of US GDP. In 2019, unfunded liabilities reached $4.1 trillion, about 19% of the GDP.
Unfunded liabilities have more than doubled since the crash of 2008, with the COVID-19 pandemic greatly exacerbating the issue. Because of the handling of the pandemic to this point, many health experts predict that COVID-19 will be prevalent for many months to come. This, in turn, means a prolonged economic downturn, longer than originally anticipated. As reported before on the IPFI blog, remedies to these pension shortfalls will likely be brought up by elected officials in DC and elsewhere in the coming months. With the second stimulus bill stalling in Congress, it seems like the American economy, and people, will be faced with a tough road ahead.
This article originally appeared in Bloomberg Law on August 4, 2020.
A proposed record-keeping rule for socially conscious retirement investments must go unless plan sponsors want to spend more time in court, benefits advisers told the Labor Department.
The regulation would require plan fiduciaries to fully document their reasoning for investing in environmental, social, and corporate governance (ESG)-focused funds. That change would create a separate standard for evaluating ESG-related funds than other investments, something plan participants could latch onto in cases challenging the financial management of work-sponsored retirement accounts.
“The documentation of ESG considerations creates a possible litigation roadmap,” Aliya Robinson, an ERISA Industry Committee retirement policy adviser, said in a comment letter. Challenges “could be brought for any alternative that is not considered by the fiduciary,” she said.
The Employee Benefits Security Administration maintains the scrutiny on retirement investing is warranted to preserve the financial security of plan participants, as mandated by the Employee Retirement Income Security Act of 1974. But critics questioned the need to single out ESG funds.
“We oppose a heightened regulatory standard for any specific investment category, as the Department’s principles-based standards for ERISA fiduciaries and plan sponsors effectively protects plan participants from financial risk,” Insured Retirement Institute regulatory affairs chief Jason Berkowitz wrote.
Fiduciaries are already obligated under ERISA to protect plan participants’ retirement savings above all, precluding them from jeopardizing lifelong earnings by paying higher fees or accepting lower returns if better options are available. To that end, according to IRI, the proposal is redundant.
The comment period for the White House-ordered guidance project, which President Donald Trump set in motion in April 2019, closed on July 30. EBSA on Tuesday slowly began publishing some of the 1,500-plus letters that poured in.
No Agreement on ESG Value
None of the dozen comment letters collected by Bloomberg Law cited the exact same investment study or ESG-related research, showing lack of consensus on the funds’ values.
Some cited data showing ESG funds outperformed traditional stocks in recent years, while others railed against the higher fees, lower returns, and political considerations that can accompany “activist investing.”
Nearly two dozen Democrats on the House Committee on Education and Labor bashed EBSA for failing to provide a detailed analysis of how excluding ESG from retirement funds would substantially harm or benefit plan participants. House lawmakers criticized regulators for floating “unsubstantiated” arguments that the rule’s “the resulting benefits will be appreciable.”
Their colleagues on the Senate Health, Education, Labor and Pensions Committee detailed similar concerns.
Supporters Applaud Clarity
Robinson thanked regulators for attempting to address conflicting information that’s built up over time, but said EBSA should stop all ESG audits until a final rule is issued.
“The litany of sub-regulatory guidance on fiduciary requirement for plan investments has allowed for differing interpretations of these requirements, leading to confusion and inconsistency,” she wrote.
Meanwhile, Richard Brower, a board member at the nonprofit Institute for Pension Fund Integrity, lauded EBSA officials for “reaffirming the importance of financial considerations, not political considerations” as part of the crackdown.
“As long as asset managers are using ESG to demand higher fees for lesser returns, pension funds will not be safe from irresponsible investing,” Brower wrote.
Members of the National Center for Public Policy Research prodded administration officials to go further, pushing for exhaustive documentation “any time policy based analysis plays any role” in retirement investing.
And if policy-based investments can’t be eradicated, the group urged regulators to balance out progressive priorities like clean energy and corporate responsibility with policies conservatives might favor, such as divesting from Chinese government-backed firms.
The state of Kentucky revived and expanded a lawsuit that claims former officials of the state pension system and hedge fund firms violated their fiduciary duty by choosing risky investments. The state is demanding compensation from hedge funds for their excessive fees and underperformance.
Kentucky’s pension system remains one of the worst-funded in the nation, hovering around a 32.8% funding level. Lawmakers have discussed cost-saving measures such as cutting agencies’ spending and reevaluating employee contribution caps, but little progress has been made towards revitalizing the fund. Recent accusations may explain, in part, Kentucky’s lack of funding.
A case, which was originally filed in 2017 by eight state pension recipients, accused Kentucky Retirement System employees and a number of prominent hedge funds of mismanaging pension investments. Earlier this month, the Kentucky Supreme Court dismissed the case, asserting that the plaintiffs lacked legal standing to bring the lawsuit. Kentucky Attorney General Daniel Cameron, however, recently joined as a new plaintiff along with additional allegations concerning the Kentucky Teachers Retirement System (KTRS).
Between 2000 and 2009, the Kentucky Retirement System (KRS) lost half of its assets. Cameron’s complaint alleges that, given the massive losses KRS sustained in 2009, the fund managers sought a quick fix by gambling with “alternative investments.” According to Cameron, KRS employees bought risky investments from hedge funds in a last-ditch effort to rapidly fund the system, which had already been failing for years. When the funds’ performance didn’t meet their expectations, they allegedly attempted to cover up any indication of wrongdoing.
Along with accusing KRS employees of misconduct, the plaintiffs claimed that the CEOs of Blackstone and KKR benefited from significant financial gain from a relationship with KTRS, while selling the system faulty funds. These “alternative investments” were marketed by KKR & Co. and Blackstone Group, among others, to underfunded pension systems across the country. They referred to the strategy as an “absolute return strategy,” promising annual returns of 7.75 percent in addition to reduced risk. The funds were generally hedge funds that invest in other hedge funds and, although they promised higher returns, studies have shown these “alternative investments” fail to perform and include large management fees which reduce any existing profits.
Last week, an attorney representing the Blackstone Group responded to accusations, indicating that the fund’s shortfalls existed long before their collaboration with the Blackstone Group and stating, “As we’ve demonstrated repeatedly, these claims have absolutely no merit… We delivered more than $150 million in net profits to Kentucky pensioners and exceeded by nearly three times the benchmark set by KRS itself.” Kelly also expressed his surprise in learning that the attorney general’s office would actively pursue a case already addressed by the state’s supreme court.
Meanwhile, Krista Locke, deputy communications director for the attorney general’s office promised that their “goals in pursuing this litigation are straightforward: to protect the pensions of hardworking government employees and to safeguard taxpayer dollars”.
Although the case remains in its early stages, the question remains whether KRS employees violated their fiduciary duties by choosing risky investments. The case’s outcome will also determine whether Blackstone Group and KKR are forced to spend millions in payouts, a decision that will undoubtedly be hotly contested.
Washington, DC – Over the past month, the U.S. Department of Labor has solicited input on a proposed regulation concerning environmental, social, and governance (ESG) investments and their role in pension funds overseen by the Employee Retirement Income Security Act (ERISA). Under consideration is whether plan managers, bound by fiduciary duty to their beneficiaries, are sacrificing investment returns or increasing risks to meet ESG goals unrelated to participant’s bottom-line financial interests.
This week, IPFI advisory board members Kevin O’Connor and Richard Brower submitted comment letters in support of this new rule. It is our hope that over the next several days, leaders in business and public policy throughout the country will voice support of this proposal as well through comments.
Kevin O’Connor, a former trustee of the Baltimore County Employees Retirement System, notes in his letter that “in recent years, ESG principles and ESG-focused investment products have gained traction among investors, due in large part to outside pressure from individuals seeking to boost specific political or environmental goals. While individual investors, endowments, and corporations should be free to pursue whatever investment strategy they see fit based on their needs, the unique nature of pension funds requires that fund managers steer clear of any political agenda.”
Sharing a similar sentiment, Richard Brower, the former Vice Chairman of the New York City Fire Department’s pension fund, says in his letter that “pension beneficiaries have little to no control over the investment of their retirement money. As such, we owe it to them to manage their funds with the greatest care and with returns as the highest priority, rather than push a political agenda which may not represent the beliefs of the people whose money is being invested.”
The Institute for Pension Fund Integrity believes that ERISA must be modernized in order to set in stone the underlying fiduciary principles that have been the cornerstone of responsible pension management. While individual investors, endowments, and corporations should be free to pursue whatever investment strategy they see fit based on their needs, the unique nature of pension funds requires that fund managers steer clear of any political agenda. As stated in the proposed rule, “it is unlawful for a fiduciary to sacrifice return or accept additional risk to promote a public policy, political, or any other nonpecuniary goal.”
It is with great anticipation that we await the Department of Labor’s final determination for this rule. Ultimately, it is our hope that this change will come as part of a greater effort to maintain pension funds’ independence from politics and ensure a secure retirement for all Americans.
The term “ESG” – Environmental, Social, and Governance-based investing – was first used in an International Finance Corporation 2005 report Who Cares Who Wins and developed a widespread use in the following years. Currently, there is over $20 trillion in ESG assets under management and is a growing sector.
One of the key issues with ESG investing is that while it is seen as the right thing to do ethically, it is not clear whether it is the right thing financially. The performance of ESG-related investments has been widely questioned, and in a 2019 IMF report, it was found that there were comparable returns to traditional means of investment. Additionally, many institutions have created and formed standards around ESG, like the Sustainable Accounting Standards Board (SASB) and the Global Reporting Initiative (GRI). These actions have led to no prevailing standard. There is variation in many aspects of ESG and it has led to the sector being complex and not uniform.
All investment firms certainly overlap in their ESG definitions, but some go further than others in their commitment to describing exactly what that means and how they’re incorporating ESG into their decisions. On the base level, all firms describe ESG integration as the practice of incorporating ESG information into investment decisions – only some elaborate further.
Some firms, such as Schroders, acknowledge the haziness surrounding the precise definition of ESG. They explained that often “the most commonly used terms include “sustainable,” “responsible,” “impact,” and “ESG investing.” These are often used interchangeably to cover a wide spectrum of goals and strategies. Although ESG is distinct from SRI, there is some obvious overlap that many firms hesitate to distinguish between. Instead of pinpointing a solid definition, some firms, such as Shoroders, chose to view ESG as a spectrum where “At one end of the scale, ethical screens eliminate companies engaged in controversial activities, reflecting asset owners’ values and should have little expectation of improved investment returns. At the other end, sustainability analysis can, when approached thoughtfully and integrated with more traditional analysis, improve insights and enhance performance. Each approach has different objectives, requires different skills and demands different tools.”
Some firms, in lieu of defining ESG, dive deep into detail on how they will integrate ESG into their work. Most often, these firms include some form of “pillars” to convey their related corporate priorities. BlackRock, for instance, described three main themes around which they integrate ESG into their investment teams and strategies. The first is investment processes and they expect all active funds and advisory strategies to integrate ESG. They tasked portfolio managers with this task. Secondly, they use material insights in their ESG investments, and lastly they aim for transparency in their investments. Although BlackRock included a long description for how they integrate ESG into their work, they didn’t define ESG itself.
J.P. Morgan followed a similar approach of incorporating multiple elements into their ESG definition. Rather than choose their own pillars, they deconstructed the ESG acronym and individually defined “environmental,” “social,” and “governance.”
ESG has become a popular topic recently due to the possibility of restrictions being put into place by the Labor Department. The Labor Department Secretary, Eugene Scalia, said in June that the new proposed limitations would “remind plan providers that it is unlawful to sacrifice returns, or accept additional risk, through investments intended to promote a social or political end.”
This op-ed originally appeared in Townhall on July 27, 2020.
In 2001, Enron, then one of the most admired companies in the United States, collapsed in scandal and bankruptcy. Questions began emerging a year earlier regarding the energy giant’s accounting practices after investors, analysts, and reporters became concerned by Enron’s massive amount of debt. In the years following, details came to light about the lengths to which Enron’s leadership went to cover up losses and maintain an artificially high stock price. When the dust had finally settled, 20 people were convicted of crimes for their actions, Enron’s stock was worthless, and thousands lost their pensions. Arthur Andersen, previously a “Big Five” accounting firm, surrendered its CPA license and 85,000 of its employees no longer had jobs.
The Enron scandal, a fixture of business school case studies to this day, led to the Sarbanes-Oxley Act, which established the Public Company Accounting Oversight Board and resulted in the development of today’s standards for audit reports in the hopes of protecting the public from fraudulent accounting to inflate corporate value.
Sarbanes-Oxley has been powerless, however, to regulate Chinese companies listed on American stock exchanges. These companies, which together are valued at more than $1.2 trillion, are protected by Beijing’s policy barring foreign entities from auditing Chinese corporations. The Chinese law mandates that company records must stay in China, prohibiting any major international accounting firm from properly examining Chinese businesses. The Chinese government invokes state security law and claims that external audits would compromise state secrets.
In late June, Luckin Coffee, a Chinese company which debuted on the NASDAQ last year, was officially delisted after reports that it had falsified financial figures. Inflated sales numbers were a major factor in Luckin’s perceived value, which peaked at $12 billion.
The Luckin saga highlights the importance of standardized oversight of publicly traded corporations. The Holding Foreign Companies Accountable Act (HFCAA), which passed the Senate in May, would de-list companies that do not comply with standard auditing procedure. This is a step in the right direction towards leveling the playing field.
As of June 1, 175 U.S.-listed companies based in mainland China deny the PCAOB the ability to conduct audit inspections. These corporations are essentially playing a game of poker in which they do not have to show their cards to win the pot (investors’ money). Shareholders have no way of knowing if Chinese companies are as solvent as they claim as long as PCAOB-affiliated auditors cannot verify the numbers these companies release. As a result, Chinese companies can, through some creative accounting, present themselves as much more attractive investments than they actually are. Luckin, for example, raised $500 million from Wall Street before it was exposed as fraud.
As long as we do not hold these companies to the same standards to which we hold our own, anyone who looks to the American exchanges for investments is exposed to the risk that they have been misled by unverified financials.
Congress has the power to hold Chinese companies accountable so long as one thing remains true: China needs Wall Street more than Wall Street needs China. It is true that the People’s Republic represents trillions of dollars in untapped potential, but Wall Street did not need China to make it to the top of the financial food chain. China, however, cannot afford to lose out on the two largest exchanges in the world, which see more trading volume than the next seven put together. The aggressive economic expansion which has dominated Chinese policy for decades requires capital, and New York is still the best place to find it.
The United States learned a harsh lesson from Enron, but Luckin has exposed a glaring shortfall of our response. It is time for Congress to send a message to China: You’re playing by our rules now.