A look at some recent stories on ESG (Economic, Social, and Governance factors) and investments for retirement funds: one from a private sector defined contribution plan, and two states running into issues with ESG and their public pension funds. In all three cases, fiduciaries are getting squeezed by third parties (who are not fiduciaries) based on attitudes towards ESG in investment strategy.
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American Airlines, 401(k), ESG and ERISA
Reuters, 11 Jan 2025: American Airlines' focus on ESG in retirement plan is illegal, US judge rules
A federal judge in Texas on Friday said American Airlines (AAL.O), opens new tab violated federal law by basing investment decisions for its employee retirement plan on environmental, social and other non-financial factors.
The ruling by U.S. District Judge Reed O'Connor appeared to be the first of its kind amid growing backlash by conservatives to an uptick in socially-conscious investing.
O'Connor said American had breached its legal duty to make investment decisions based solely on the financial interests of 401(k) plan beneficiaries by allowing BlackRock (BLK.N), opens new tab, its asset manager and a major shareholder, to focus on environmental, social and corporate governance (ESG) factors.
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BlackRock, which on Thursday said it was leaving an environmentally focused investor group under pressure from Republican politicians, is not involved in the lawsuit.
In November, BlackRock and two rival asset managers were sued by 11 Republican-led states who claim the firms violated federal antitrust law through climate activism that reduced coal production and caused energy costs to increase. BlackRock called the claims baseless.
WSJ, 23 Nov 2022: Biden Puts Your 401(k) to ESG Work
The Biden regulatory machine doesn’t rest, even in Thanksgiving week. On Tuesday the Labor Department finalized a rule that empowers retirement plan sponsors to invest based on environmental, social and governance (ESG) factors and put your 401(k) to progressive political work.
The Labor Department casts its rule as a mere clarification of the 1974 Employee Retirement Income Security Act (Erisa), which requires that retirement plan sponsors act “solely in the interest” of participants and beneficiaries. A Trump Labor rule barred retirement managers from considering factors that weren’t material to financial performance and risk.
Asset managers and union pension plans claimed the Trump rule limited their discretion to consider such ESG factors as climate, workforce diversity and labor relations. The Biden DOL says it created a “chilling effect” on ESG investing. Its replacement rule gives plan sponsors nearly unlimited discretion and legal protection to invest based on these often political considerations.
“A fiduciary may reasonably conclude that climate-related factors” including “government regulations and policies to mitigate climate change, can be relevant to a risk/return analysis of an investment,” the rule says. Ditto workforce diversity, inclusion and labor relations since they may affect employee hiring, retention and productivity.
STUMP, Nov 2022: ESG and ERISA: Pity the Poor Tort Lawyers Their Lost Business as Biden Gives a Safe Harbor For Now
The ESG funds already existed, for what it’s worth. They’ve existed for decades. But they were niche, having to sell via retail, attracting customers one-by-one. Some people are willing to pay the extra fees these funds charge, but it also costs more to acquire customers one-by-one.
The big money is attracting big buckets of money at a time — i.e., official retirement accounts through employment. But that’s why we have legislation like ERISA, because yes, we know that big piles of money attract all sorts of players.
One of the results of ERISA is that tort lawyers can seek big paydays via class action lawsuits against ERISA fiduciaries. It keeps the fiduciaries in line, usually the deep-pocket employers, who select the fund managers and funds for private pensions and 401(k)s. In general, for 401(k) funds, the lawsuits were around fee levels being too high. There had been a few lawsuits over default fund choices.
The point of all this is to help the inherent principal-agent problem at the heart of all this — the principal here is the employee who is having deferred compensation invested on their behalf, and multiple agents are acting for them: the employer and the fund managers in particular.
The employer may have something of an aligned interest, but they may care more about their reputation as an “enlightened” player in using ESG funds in their pension. So watch out, those with DB pensions!
As for fund managers, no, they don’t necessarily align their interests with those with 401(k)s. They get their fees as a percentage of the assets under management, usually, no matter the performance. They can lose assets if customers aren’t happy, but many people don’t change their allocations once their money is deposited.
ERISA imposes a fiduciary duty on these players, and in one particular, the employers in selecting appropriate funds for default choices in 401(k)s. Before this latest move by the Biden admin, the fiduciary duty meant the focus was the financial performance of the fund (and thus focused on the investment strategy and the fees charged), and so this kept a rein on how outlandish the funds could get.
The balancing powers were the tort lawyers who could break out class action lawsuits against these sponsoring employers. I have seen what I considered absurd lawsuits over a few basis point difference in fees (0.01 percentage point = 1 basis point — a standard unit for asset management fees).
Given that ESG funds definitely have higher fees, and by necessity will have lower returns than other funds, of course, prior ERISA interpretations of fiduciary duty requiring a focus on investment returns would have deterred sponsors from chasing the ESG dream.
Ohio Public Pensions and ESG
15 Jan 2025, ALEC: New Ohio Law Follows ALEC Model to Protect Pensioners and Taxpayers
In December, Ohio Governor Mike DeWine signed Senate Bill 6, which codified the gold standard of state fiduciary rules to protect public pension beneficiaries and taxpayers. The legislation follows the principles laid out in the ALEC model State Government Employee Retirement Protection Act, one of the ALEC Essential Policy Solutions for 2025.
Senate Bill 6 was sponsored by the late Ohio State Senator Kirk Schuring. His legislation requires that fiduciaries only consider pecuniary factors—those having a material effect on the financial risk and return—when making investment decisions. This standard ensures that funds contributed toward pension benefits are used solely for the financial interests of participants and beneficiaries. Other states including Arkansas, Florida, Kentucky, Montana, New Hampshire, South Carolina, Utah, and West Virginia have implemented similar protections.
Politically motivated investment strategies do not help public pension systems provide for retirement security. In recent years, some investment firms and pension systems have focused on strategies like ESG (environmental, social, and governance) rather than maximizing returns. They have also used their control of proxy votes to influence company decisions in ways that go against the financial interests or workers, retirees, and taxpayers. The latest edition of ALEC’s Unaccountable and Unaffordable reports that state pension liabilities total nearly $7 trillion, or just under $21,000 for every man, woman, and child in the United States. Using these funds for political crusades instead of prioritizing investment returns can exacerbate the problem of unfunded liabilities, requiring additional contributions from taxpayers and pensioners.
As Andy Puzder and Mike Edleson explained in The Wall Street Journal, and as ALEC research shows, politicized investing yields lower returns than investing without political constraints – a story that California knows all too well. CalPERS, California’s largest pension system, decided to divest from all tobacco-related stocks in 2001. Two decades later, the tobacco stock divestment has cost California public sector workers and retirees at least $3.5 billion.
Pensions are designed to securely provide retirement to public employees. Contributions are paid out during employment and benefits are paid out after retirement. To operate according to their design, the funds must be invested with this focus on financial risk and return. Thanks to the enactment of Senate Bill 6, taxpayers in Ohio can be sure that political and social objectives are not being prioritized over the health of public pension plans.
12 Dec 2024, ai-CIO: Ohio Passes Bill Barring State Pension Funds, University Endowments From Prioritizing ESG in Investing, Stakeholder Activism
A bill passed in Ohio seeks to limit the state’s five public pension funds, the workers’ compensation bureau and university endowments in the state from perusing investments influenced by social and environmental policy. Ohio Senate Bill 6, passed on Tuesday, will also aim to ban funds from engaging in shareholder activism.
The bill passed in the Ohio Senate in May 2023, by a vote of 26 to 7. The House passed the bill on Tuesday, 62 to 27, and it now awaits a signature from Ohio Governor Mike DeWine.
The bill cites the fiduciary duty of the governing boards of the pensions, compensation bureau and endowments and requires them to “make investment decisions with the sole purpose of maximizing the return on its investments.”
It goes on to order that each of the named funds’ boards “shall not adopt a policy, or take any action to promote a policy, under which the board makes investment decisions with the primary purpose of influencing any social or environmental policy or attempting to influence the governance of any corporation.”
STUMP, Dec 2024: Pensions Round-Up: ESG, Skipping Payments, Technological Debt, and More!
Poor corporate governance can lead to all sorts of bad results. You want to influence corporate governance as a large investor. It will affect the value of your investment!
I can give all sorts of examples — in terms of corporate governance with poor alignment with investors when you get management capture. (aka the good ole principal-agent problem.)
You want to influence how the top executives are compensated (that’s governance). You want to influence how the board of directors, especially outsider directors, are selected (that’s governance). You want to make sure that interests are aligned and that you don’t get, say, a bunch of people snowed by a charismatic CEO in an area they know nothing about.
Maine PERS Divestment
11 July 2024, Maine Morning Star: Activists and Maine Public Employee Retirement System at odds over fossil fuel divestment progress
Roughly 50 activists and beneficiaries of the Maine Public Employee Retirement System rallied in Augusta on Thursday outside the MainePERS board meeting to demand that its members make more progress in fully divesting from fossil fuels. However, according to MainePERS officials, the system has made the changes required by state law.
“We felt like we were making progress but after this last rebuttal that was released, it’s clear that it was superficial progress,” said Hope Light, campaign manager for Divest Maine, the coalition of MainePERS beneficiaries and climate advocates, associated with groups such as the Sierra Club and Third Act Maine, behind the demonstration.
At the request of the coalition, MainePERS had agreed to look into public equity indexing approaches that balance financial targets and lower fossil fuel exposure, which have been used by other pension funds, such as CalSTRS. However, in a board of trustees public meeting packet released this week, MainePERS concluded that its current passive approach to investing in public equities remains optimal for meeting the system’s investment goals.
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In a presentation to the Legislature’s Labor and Housing Committee about divestment in March, MainePERS officials said the system’s fossil fuel investment exposure fell from 7.8% of the fund’s assets in 2022 to 6.5% in 2023, decreasing by $193 million. MainePERS’ exposure to fossil fuels is likely to decline by a third by 2026 as investments expire, the officials estimated. However, MainePERS CEO Rebecca Wyke said that fully divesting would not be in the best financial interests of beneficiaries.
16 Dec 2024, P&I: MainePERS cuts fossil-fuel holdings but won't divest completely by Jan. 1, 2026, deadline
The Maine Public Employees Retirement System, Augusta, reduced its fossil fuel investments to 6.1%, or $1.21 billion, of total pension assets for the fiscal year ended June 30, down from 6.5% for the year-ago period, said a pension system report describing the progress mandated by a 2021 fossil-fuel divestment law.
Although the law directed MainePERS to divest all fossil fuel holdings by Jan. 1, 2026, the report, like previous annual reports, said total divesting by that deadline would incur significant costs and hamper the $20 billion pension system’s investment strategy.
“Achieving and maintaining a completely fossil fuel-free portfolio by 2026 would require both disposing of significant existing investments as well as making undesirable fundamental changes to MainePERS’ investment approach,” said the report presented Dec. 12 at the pension systems’ trustees’ monthly meeting.
“MainePERS’ holdings of fossil fuel investments are widespread, with a majority of asset classes containing at least some fossil fuel exposure,” the report said.
9 Jan 2025, Maine PERS, Board of Trustees, Public Meeting Packet
Fiduciary Duty of Trustees
As noted above, the MainePERS Board of Trustees owes fiduciary duties to MainePERS’ members, retirees, and beneficiaries.
First, the Board owes a duty of loyalty, which means to follow the exclusive benefit rule established in the Maine Constitution by acting solely in the interests of the members, retirees, and beneficiaries as recipients of retirement or related benefits. This duty includes not using the Board’s position of trust for personal gain or to advance other causes.
Second, the Board owes a duty of prudence. This requires the exercise of reasonable care, skill, and caution. In making investment decisions, prudence requires considering the portfolio as a whole, the role each investment plays in the portfolio, and diversification. See 18-B M.R.S. §§ 804, 902, 903. Additionally, the Board “may incur only costs that are reasonable in relation to the trust property, the purposes of the trust and the skills of the” Board. 18-B M.R.S. § 805.
The fossil fuel divestment statute does not alter these fiduciary duties. Analyzing this and the for-profit prison divestment statute, the Attorney General’s Office explains:
The subject statutes do not affect the Board’s exercise of its fiduciary duties. And they do not require the Board to either cease investing in or divest such holdings unless sound investment criteria and fiduciary obligations require such actions. Both statutes specifically condition their directives on “accordance with sound investment criteria” and “consisten[cy] with fiduciary obligations.” As such, they reiterate rather than modify the Board’s fiduciary obligations as a trustee – both constitutional and statutory.
The Attorney General’s Office further explains:
The Board’s focus should remain on adhering to sound investment criteria and fulfilling its fiduciary obligations. However, if the Board encounters a situation where the application of sound investment criteria and its fiduciary obligations neither favors nor disfavors either of two potential investment options, the Board shall pursue the option that more closely complies with the directives of [the divestment statutes]. (Appendix D). This analysis echoes that provided by the Attorney General to the Joint Standing Committee on Labor and Housing when the bills that became the divestment statutes were under consideration. (Appendix C).
At that time, the Attorney General also alerted the Legislature that fiduciary duties would render the bill’s divestment requirement “essentially hollow.” “Unless a failure to divest an asset would be a breach of the Trustees’ existing fiduciary duties (i.e., not in best interest of the members), any attempt to enforce the statutory requirement to divest would be meritless.” (Appendix C).
Alex Edmans on ESG via InvestOrama
The End of ESG - Alex Edmans (2/2)
On ESG Metrics
So if ESG was just objective, then it'd be really hard to get a competitive edge. You wouldn't even need people, you could just have a computer algorithm doing it. So what I really think is the really exciting potential of ESG, is it's messy. You need to get your hands dirty. These are difficult things to understand, and this is where human experience and business judgment really comes to play. This is why I do believe that ESG can still outperform even in a world in which we have big data and artificial intelligence. […] Anything important about investing is subjective.
On Diversity
There's so many other aspects of a person than their diversity, and in fact, this is actually bad for minorities, because then people think, okay, you're a good director because of your minority characteristic, and this actually underplays the actual experience and challenge that you might be bringing to the board
On drivers of company value
ESG is often put on a pedestal compared to other drivers of company value. ESG is very important. But many other things are important, such as strategy, operational performance, capital allocation, and so on. So why is it that we are just looking at the ESG characteristics of an investment and not all these other characteristics which could be just as or even more important than ESG?
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