Pension Funds Shouldn’t Toe the Line on ESG
— January 4, 2021
But this can run up against pension funds’ core mandate - to serve their members under strict fiduciary standards of loyalty and care. Fund members are looking for maximum risk-adjusted portfolio returns over a long investment horizon. This is a “hard” target that can be defined and measured. In contrast, ESG metrics and impact-results are often “fuzzy,” subject to interpretation and consensus. ESG targets may reflect the wishes of some pension beneficiaries, but not others. But they’re all in the same pot. If ESG-driven investment decisions adversely affect pension fund performance and/or encounter serious conflicts among members, things can easily come to a boil.
Bottom line: ESG-sensitive pension investing is problematic in the best of circumstances - even in the unlikely event that pension beneficiaries are of one mind. Things are far more problematic if they have different preferences, while transparency and replicability in ESG assessment leave a lot to be desired.
Pension fund managers and trustees don’t have the resources to identify and measure ESG outcomes except in general terms - for example, climate change or wilderness preservation in E, inequality or human rights violations in S, and board inclusiveness or management compensation in G.
They can cook-up some ESG performance benchmarks, or maybe compare notes with peers, to help triage “bad” from “good” ESG performance against which to calibrate fund investments. They have even less ability to figure out what factors actually drive ESG performance, how to weight each of them, and how to aggregate them in an operational way that has some predictive power in explaining attainment of the objectives. Consequently, they usually end up outsourcing both.
On ESG targets, pension fund trustees can key-off a long list of conduct “principles” emanating from the United Nations and various non-governmental organizations. Some are hard to disagree with, while others may be arguable and controversial. Trustees will have to decide whether and how to adopt these principles and forge them into their fund’s own approach to consensus-building, performance benchmarks and portfolio decisions.
On ESG metrics, pension fund professionals can wade into a fast-growing, highly competitive, chaotic and opaque ESG ratings industry. There they will find big issues about the quality of the ESG data-collection process, self-reporting, quantification of qualitative information and associated nuances, missing information, indicator mismatches in the use of published data, factor aggregation and weighting, setting scoring-breaks, as well as reporting formats and comparability across rating firms.
This is a formidable list, which can frustrate transparency, replicability, and therefore credibility. In a competitive “investor-pays” ESG ratings marketplace that looks a bit like Swiss cheese served at a Voodoo ceremony, it’s caveat emptor. But if people believe in Voodoo, it’s important to know something about Voodoo rituals.
In the case of public employee pension funds, this involves mostly defined benefit plans that offer members no choice and are heavily protected against default on benefit payments. This brings taxpayers into the equation, since they are generally forced to cover any shortfalls in contractual public employee pension benefits. The assumption that the broad community of stakeholders (public employee pension participants backed by a diverse community of taxpayers) share the same values and opinions about ESG objectives is a mighty stretch.
In the private sector – the home of defined contribution pension plans – things are a bit easier, especially if employees are given a range of choice among funds. There are plenty of pitches and sales materials about fund objectives, and good research and disclosure of fund returns and risk attributes from third-party vendors like Morningstar. And there is oversight by the U.S. Department of Labor under the 1974 Employee Retirement and Income Security Act and its traditional fiduciary standard applied to fund managers – currently suspended under investment industry and Trump administration pressure, but likely to be reinstated before long under the Biden administration.
Anyway, 401k and 403b pension plan investors may have plenty of actively-managed ESG investment funds to choose from and align them to their own preferences. If they outperform, great. If they underperform, the plan participant may consider the negative gap (even after high fees) a small price to pay to reflect his or her ESG preferences.
There are even products for devotees of index funds who don’t believe actively-managed funds generally outperform or who want to save on fees. So-called “direct-indexing” provides an answer, and has been available to wealthy individuals for some time. Under this scheme people can invest in an index fund offered by one of the major providers like Vanguard or BlackRock and have it modified by specialists to exclude stocks on a personal “blacklist” or one preselected as being ESG-compliant. Direct-indexing has now been rolled-out to a much broader audience of 401k investors, and many of the bespoke portfolio-design specialist firms have now been bought-up by major investment firms seeking ways to charge higher fees.
At the end of the day, though, retirement security in advanced years probably trumps all else when it comes to pension savings. So, they look to cumulative financial performance and the associated risks. Anyway, people have other ways to address ESG issues. Pension trustees browbeaten into ESG impact-investing in today’s “stakeholder driven” environment should take careful note. And the more comprehensive and uniform the pension plan, the greater is the tension between the core retirement objective and moving the needle on ESG. It’s a problem that won’t go away anytime soon.
Ingo Walter is a professor emeritus of finance at NYU Stern School of Business.