State and local public pension funds are trillions of dollars in debt. Without fully accounting for the risks, state public pension funds have $1.4 trillion in unfunded liabilities (e.g. debt) according to the Pew Center’s latest estimates. Even more troubling, this debt is still growing.
The sole priority of a public pension funds should always be to earn the highest rates of return possible for their members, but due to their precarious fiscal position, such a focus is more important than ever. Unfortunately, there is a growing trend among public pension funds to screen potential investments, not on their financial viability, but based on certain environmental, social and governance criteria (ESG investing).
Of course, ESG investing is the right choice for some people. Individuals undoubtedly have the right to engage in ESG investing with their own money, and perhaps they will earn a higher return and thus “do well by doing good”. Perhaps not. Either way, when individual investors engage in ESG investing they can ensure that the investments reflect their personal values and, if these values create financial losses, the individual investors bear the financial consequences of their decisions.
This nexus does not exist for public pension funds. Public pension funds manage the retirement assets for millions of public sector workers and, if their investment returns are inadequate, then it is the hundreds of millions of taxpayers who are currently responsible for the shortfalls. It is impossible to make ESG decisions that accurately reflect the values of such a diverse group of people.
Expressing these concerns, SEC Commissioner Hester Peirce noted that “problems arise when those making the investment decisions are doing so on behalf of others who do not share their ESG objectives. This problem is most acute when the individual cannot easily exit the relationship. For example, pension beneficiaries often must remain invested with the pension to receive their benefits. When a pension fund manager is making the decision to pursue her moral goals at the risk of financial return, the manager is putting other people’s retirements at risk.”
Beyond the problem of conflicting values, ESG investing often violates the fiduciary responsibility of public pension funds. The primary responsibility of a public pension fund is to secure the retirement of the current and retired public sector workers on behalf of taxpayers. However, it is commonly understood in finance that arbitrary investment restrictions lower investors’ risk-adjusted returns.
The problem runs deeper than investment selection as well. As I argued previously, the conflicted advice from the major proxy advisory firms (ISS and Glass Lewis, who control 97% of the proxy advisory market) encourages institutional investors, like public pension funds, to vote positively on ESG measures at shareholder meetings even if the measures are extraneous or harmful to the enhancement of shareholder value.
Many academic evaluations of ESG investing confirm these results.
A study in the Journal of Portfolio Management found that “the cost of socially responsible investing is substantial.” In another study, this one by the Center for Retirement Research at Boston College, the authors found that socially responsible funds significantly under-performed their benchmarks and concluded that public pension funds are not suited for social investing.
The consequences from ESG investing is evident by comparing the returns of ESG funds to the overall market. The 8 ESG funds that have existed for 10-years have all under-performed relative to the S&P 500 over the long-term, most of them by a wide margin.
In recognition of these concerns, the Department of Labor, which oversees private pension funds, issued a Field Assistance Bulletin in April of 2018 that reiterated the department’s policy “that, because every investment necessarily causes a plan to forego other investment opportunities, plan fiduciaries are not permitted to sacrifice investment return or take on additional investment risk as a means of using plan investments to promote collateral social policy goals.”
Due to the lower investment returns associated with ESG investing and the divergent values across the large number of people that public pension funds represent, it is clear that public pension funds harm public sector employees and retirees when they engage in ESG investing.
Given the SEC’s clear responsibility to protect investors, the agency should provide clarity, as the Labor Department has, on the role of ESG investing for public pension funds.
Specifically, the SEC should clarify that the ESG recommendations provided by proxy advisory firms must be consistent with the fiduciary responsibility of the public pension fund managers they are advising. Further, like the Department of Labor, the SEC should clearly state that the public-pension managers and boards are not permitted to sacrifice returns for non-financial “social policy goals.”
Without such clarifications, the retirement security of public sector workers will be jeopardized.