Environmental and social investing can put taxpayers and public pension funds at risk

These days just about everything is political—especially money. It’s no secret that tax revenue, investment returns, and free, i.e. taxpayers’, federal funds are pouring into state governments. In fact, some states have called special sessions just to manage it all. State legislators, who can be held accountable to their constituents, will publicly allocate this funding. In contrast, the historic investment returns recently reported by multi-billion dollar public pension plans are slated for a much different, less transparent, and more subjective process that can be ripe for corruption and political activism.

The most obvious temptation facing pension fund managers and policymakers is the yearning to engage in environmental, social, and governance (ESG) policies aimed at investing in their preferred political issues, sometimes at the expense of financial performance.

As private investors increasingly value environmental and social impact, corporations are targeting such policies to boost their brands and, ultimately, their bottom lines. Social-minded legislators and public pension fund managers have taken notice. Some state legislators are pressuring public fund managers to consider environmental, social, and governance factors in their investment policies, regardless of pensioners’ wishes or fund performance.   

Pension funds viewing investment evaluations and strategy through an environmental, social, and governance lens is in vogue for a myriad of reasons, which ultimately distill down to a subjective want or need on the part of shareholders and management. To date, it has been easy for most large public pension systems to engage in ESG investing at some level because, not only is there little to no public oversight of investments, but there is no clear directive from policymakers as to how to address the pressure.

For public pension funds, environmental, social, and governance policies are not three chapters of the same book but rather three independent books entirely. The environmental aspect of ESG investing is the most popular and public pensions are particularly well-positioned to take on this type of approach. The large amount of capital required and potential for sustainable, long-term returns makes large, forward-looking energy and environmental investments ideal for public pension funds. However, the ideal environmental investment is like any other, few and far between, requiring patience and due diligence. 

The social element of ESG investing is by far the most recorded and most contentious of the three. Countless bills have been filled in every state over the last decade aiming to steer those large pools of public pension funds toward or away from investments in order to promote social issues. Those states that apply limits to public pension fund investing are usually written in response to a plan taking a subjective, social position with public funds and usually go no further than reminding public pension board trustees of their fiduciary responsibilities. That simple language addresses a profound risk associated with this highly subjective area; it is hard to argue from a fiduciary perspective for subjective social impact investments when their intended modus operandi is to maximize returns at prudent levels of risk.

The fiduciary aspect of public pension plan investment management is also relevant to the final element of ESG investing, governance, for without line of sight there cannot be oversite. Governance in the ESG conversation is not so much an investment strategy as it is a tool with which the public and plan members can monitor and protect what is usually the largest pool of investible public money in every state. Holding those who hold others’ financial security in their hands responsible for their decisions protects, and can even expand, the capacity and effectiveness of the stakeholder to management feedback loop.   

Environmental, social, and governance factors influencing investments by public pension funds are really a symptom of a much larger, and more damaging disease. Ever since the 2000 dot.com bubble and stock market crash, followed by the 2008 financial crisis, bond yields have gone from double-digits to almost zero. As a result, many public pension funds have shifted their investments from predictable bonds and dividend-yielding blue-chip public stocks to more opaque and volatile assets like emerging foreign markets, private equity, and real estate. The constant search for higher returns has resulted in politically elected or appointed pension board members, often with little to no investment management experience, making key decisions on where to funnel billions of dollars. These conditions create an obvious opportunity for those with political objectives to secure funding for their own desired investments. 

Putting aside the internal operations aspect of the governance element of ESG policies and focusing on the investment and risk components of using public pension funds to engage in political investing, there are a few steps policymakers and stakeholders can take to ensure the financial security of both retirees and taxpayers.

First, it is important to remember why these huge investment funds are even able to engage in ESG investing. Most public pension plans factor in some level of investment return each year to ensure they will have the funds required to pay out constitutionally protected retirement benefits when the time comes. In 2000, most public pension plans assumed an annual investment return rate of over 8%. Today, most public pension plans assume around a 7% investment return rate, while private market watchers forecast a long-term return rate of closer to 6% over the next 20 years.

Policymakers and stakeholders should advocate for further reductions in their plans’ assumed rates of returns future pension benefits and appropriations can be handled with less reliance and exposure to a volatile and opaque global alternative asset market. 

Second, legislators can adopt a funding policy that requires government employers to each year contribute the amount that the plan-designated actuary determines is required to fully fund earned pension benefits in a predefined timeframe – otherwise known as the actuarially determined employer contribution, or “ADEC” rate. The combination of lowering a pension plan’s assumed rate of return and funding public pension contributions at ADEC levels will help ensure that promised benefits are sufficiently accounted for and funded each year. 

Third, as important it is to remember how public pension funds found themselves facing large unfunded liabilities it’s just as important to remember that there is nothing inherently wrong with investing in assets that may advance environmental or social issues. As long as plan fiduciaries can empirically demonstrate how member and taxpayer contributions will return to the fund with interest, taking any investment off the table would be counterproductive at the very least, if not morally wrong given the fundamental fiduciary mission of these retirement plans. 

From being seen by liberals as a tool in the fight for equity to being used by conservatives to protect their preferred industries, investing in environmental and social issues as part of an overall political ESG policy outside of the fiduciary responsibility is unwise. Equating a better future society, subjectively defined, to a stronger pension fund skirts the fiduciary requirements governing public pension fund managers because it takes the objective evidence required to make a sound financial decision out of the equation. Public pension watchdogs and stakeholders must be mindful of these emerging policies. In the interest of a public pension plan’s long-term sustainability, stakeholders should hold those making these multi-billion dollar investment decisions accountable for their actions. There needs to be transparent reporting of the risks taken and explanations of the reasoning behind investment strategies. Making the world a better place does not put money into a public pension fund struggling to meet its funding requirements, nor does it pay for the benefits or cost-of-living adjustments promised to retirees.