November 22, 2016

Respected Center for Retirement Research at Boston College Says Pensions Wrong Arena for Social Investing

“While social investing raises complex issues, public pension funds are not suited for this activity.” – Center for Retirement Research at Boston College

Last week, the Center for Retirement Research at Boston College released a new report examining the merit of using pension funds as a vehicle for social investing.  The paper looks at two fundamental questions: can ESG (environmental, social and governance) investing achieve the same returns as conventional allocations, and are public plans the appropriate forum to advance these goals.

The simple answer to both: No.

The Center for Retirement Research found what the professional investment community and Divestment Facts has known for years: making financial decisions for political purposes is not effective and impacts those dependent on the investment’s returns.  From the report:

“While social investing raises complex issues, public pension funds are not suited for this activity. The effectiveness of social investing is limited, and it distracts plan sponsors from the primary purpose of pension funds – providing retirement security for their employees. Additionally, such activity involves a principal-agent problem since decision makers do not bear the risk of potential losses; rather, any losses will accrue to future beneficiaries and/or taxpayers.”

Though activists have ignored data and cherry pick timelines in order to make divestment look like the financially savvy thing to do, more prudent and long-term investors recognize that banning an entire sector is no way to manage a portfolio. As the report notes, “modern portfolio theory states that investors should diversify their asset holdings over a variety of securities so that their returns do not move in lockstep.”

As we know from Univ. of Chicago Law School Prof. Fischel’s study analyzing the impact of divestment on returns, the energy sector serves to diversify a portfolio and act as a hedge to maximize financial performance.  Without that exposure, Fischel found that a portfolio could lose more than 20 percent of its value over a 50-year timeframe.

The Center for Retirement Research found similar financial outcomes for portfolios that divested or focused on ESG investing.  The below table (excerpted from the report) shows clearly that conventional mutual funds outperformed ESG mutual funds over a one, five and ten year timeframe.

As seen in states like Vermont and California, there is an increased political push to force divestment on public pensions with legislation. This report found that such efforts are extremely detrimental to these pensions, and thus the beneficiaries, as “average annual returns of plans in states with divestment requirements are estimated to be 40 basis points lower than plans in states without such requirements.”

The report also determined a partial cause for these losses: high management fees by ESG fund managers. From the report:

“Part of the reason [for lower returns] is that the fees in the ESG funds are roughly 100 basis points higher than their Vanguard counterparts, which may reflect the additional resources required to perform the screening.”

And what are these losses amounting to? According to the report, “the academic literature suggests that ESG screening is likely to have very little impact on the target company and that the impact on the pension fund depends on the scale of the screening.”  In translation, a state that goes down this path must be willing to forgo returns for pensioners to make a political statement that ultimately does nothing to impact targeted companies or the environment.

The report also points out the complexity of ESG investing, as the definition and focus is continually shifting.  What is important from an ESG standpoint this year may no longer be of interest five years down the road.  This leads to active managing and constant screening of investments.  As Prof. Hendrik Bessembinder found in his research, management and transaction fees are incredibly expensive, and could rob an endowment or pension of millions of dollars and up to 12 percent of its total value over a 20-year timeframe.

It is also important to remember the real purpose of the pension—to deliver benefits to pensioners.  According to the Center for Retirement Research, ESG investing presents a conflict of interest:

“Social investing in public plans highlights a classic principal-agent problem in economics. The principals in this case are tomorrow’s pension beneficiaries and/or taxpayers: the people with skin in the game. The agents are the fund boards or state legislatures that make investment decisions on behalf of the principals. In theory, agents are supposed to act solely in the interests of the principals. In reality, especially in public plans, conflicts of interest may arise if state legislatures make investing decisions for political reasons. If social investing produces losses, tomorrow’s taxpayers will have to ante up or future retirees will receive lower benefits. The welfare of these future actors is not well represented in the decision-making process.” (emphasis added)

It’s clear that the symbolic act of divesting may generate some feel good headlines and may be applauded by activists, but at the end of the day, it inflicts more harm than good.