Fiduciary principles need to be reaffirmed and strengthened in public pension plans

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Other people’s money: Can investing public employee pension assets to further nonfinancial goals ever be consistent with fiduciary principles?

Executive Summary

Fiduciaries are people responsible for managing money on behalf of others. The fundamental fiduciary duty of loyalty evolved over centuries, and in the context of pension plans sponsored by state and local governments (“public pension plans”) requires investing solely in plan members’ and taxpayers’ best interests for the exclusive purpose of providing pension benefits and defraying reasonable expenses. This duty is based on the notion that investing and spending money on behalf of others comes with a responsibility to act with an undivided loyalty to those for whom the money was set aside.

But the approximately $4 trillion in the trusts of public pension plans may tempt public officials and others who wish to promote—or, alternatively, punish those who promote— high-profile causes. For example, in recent years, government officials in both California and Texas, political polar opposites, have acted to undermine the fiduciary principle of loyalty. California Gov. Gavin Newsom’s Executive Order N-19-19 describes its goal “to leverage the pension portfolio to advance climate leadership,” and a 2021 Texas law prohibits investing with companies that “boycott” energy companies to send “a strong message to both Washington and Wall Street that if you boycott Texas Energy, then Texas will boycott you.” Both actions and others like them, attempt to use pension assets for purposes other than to provide pension benefits, violating the fundamental fiduciary principle of loyalty.

The misuse of pension money in the public and private sectors has a long history. The Employee Retirement Income Security Act (ERISA), signed into law by President Gerald Ford in 1974, codified fiduciary principles for U.S. private sector retirement plans nearly 50 years ago and is used as a prototype for pension fiduciary rules in state law and elsewhere. Dueling sets of ERISA regulations issued within a two-year period during the Trump and Biden administrations consistently reinforced the principle of loyalty. State legislation and executive actions, however, have weakened and undermined it, even where it is codified elsewhere in state law.

Thirty million plan members rely on public pension funds for financial security in their old age. The promises to plan members represent an enormous financial obligation of the taxpayers in the states and municipalities that sponsor these plans. If investment returns fall short of a plan’s goals, then taxpayers and future employees will be obligated to make up the difference through higher contribution rates.

The exclusive purpose of pension funds is to provide pension benefits. Using pension funds to further nonfinancial goals is not consistent with that purpose, even if it happens to be a byproduct. This basic understanding has been lost in the recent politically polarized public debates around ESG investing—investing that takes into account environmental, social, and governance factors and not just financial considerations.

It is critically important that fiduciary principles be reaffirmed and strengthened in public pension plans. The potential cost of not doing so to taxpayers, who are ultimately responsible for making good on public pension promises, runs into trillions of dollars. Getting on track will likely require a combination of ensuring the qualifications of plan fiduciaries responsible for investing, holding fiduciaries accountable for acting in accordance with fiduciary principles, limiting the ability of nonfiduciaries to undermine and interfere with fiduciaries, and separating the fiduciary function of investment management from settlor functions like setting funding policy and determining benefit levels.

Introduction

State and local governments that sponsor defined benefit pension plans—and often the employee members of those plans—contribute money to a trust from which promised pension benefits are ultimately paid. Pension benefits are earned over members’ careers, during which the trust is funded. The assets in those trusts must be invested until promised benefits are paid.

The amount of money in state and local pension trusts is enormous, approximately $4 trillion as of June 2022. This figure is equivalent in dollar amount to:

• More than 15% of annual U.S. gross domestic product; or
• Close to 12% of the December 31, 2022 market capitalization of the S&P 500; or
• Close to 10% of the December 31, 2022, total market capitalization of all U.S.-based public companies listed on the New York Stock Exchange plus the Nasdaq Stock Market plus the OTCQX U.S. Market (the tier of stocks traded “over-the-counter,” as opposed to on an exchange, that is subject to the most stringent level of regulatory requirements), according to Siblis Research.

These large pools will continue to be held in pension trusts and must be invested over many decades. As state and local pension plans were, as of fiscal year-end 2021, underfunded in aggregate by somewhere between $1.1 trillion and $6.5 trillion, these asset pools should grow in the future.

The boards of trustees of those pension plans are most often responsible for overseeing investments, though in some cases, oversight is the responsibility of a single government official or a separate entity of investment professionals. Those responsible for investments are “agents” acting on behalf of member and taxpayer “principals.”

People responsible for overseeing the investment and disposition of trust money on behalf of others are known as “fiduciaries.” In 1928, Benjamin Cardozo (later a Supreme Court justice), explained the nature of fiduciary responsibility as requiring “something stricter than the morals of the marketplace. Not honesty alone, but the punctilio of an honor the most sensitive … undivided loyalty … a level higher than that trodden by the crowd.”

In the public pension plan universe, fiduciaries overseeing investments directly—either managing the money or appointing those who do—are sometimes not free to act in accordance with the fiduciary principles of loyalty and prudence that have evolved over centuries in the context of other types of trusts. Legislative and executive actions may restrict their ability to do so.

Even absent such restrictions, public pension fiduciaries operate in an increasingly political and contentious environment, and one where pension funding comprises a growing share of government budgets. Fiduciaries thus face pressure to aim for high returns that may incline them toward riskier investments—with higher hoped-for future returns paired with lower current contributions—than they would choose if they were simply investing a pot of money to achieve reasonable returns with a prudent amount of risk. This pressure to aim for higher returns probably accounts significantly for the more aggressive portfolios seen in public sector plans versus private sector plans, despite both types of plans being subject to similar fiduciary rules.

This brief is mostly concerned with applying fiduciary principles that evolved over centuries in nonpolitical contexts, where the interests of trust principals are paramount.

In the context of public pension plans, those fiduciary principles form the relevant basis for judging the appropriateness of taking nonfinancial factors into account in investing pension assets. The extent to which plan investment fiduciaries are able to adhere to those principles forms the proper basis for judging the appropriateness of restrictions imposed by legislation or executive actions.

It is important that the fundamental principles of trust law that have shaped pension conduct not be weakened in the face of the conflicts and temptations that are bound to arise in investing $4 trillion on behalf of 30 million plan members. To understand why fiduciary principles evolved as they did, it is helpful to start by considering why the money is set aside in the first place.

Recent controversies around the investing of pension assets in both the public and private sectors highlight the extent to which fundamental fiduciary principles have been forgotten or lost. It is critically important that those principles be reaffirmed and strengthened so the large sums that accumulate in pension plans are used for their intended purpose on behalf of the principals for whom the money is set aside, and not used as a slush fund to advance goals unrelated to the providing of pension benefits.

When it comes to public pension investment management, policymakers and fiduciaries who sincerely want to serve their constituents and fulfill their responsibilities would do well if, through all the noise, they test all decisions against the fundamental duty of loyalty that requires investing solely in plan members’ and taxpayers’ best interests for the exclusive purpose of providing pension benefits and defraying reasonable expenses.

The plain implication is that investing pension assets to further nonfinancial goals is not consistent with fiduciary principles. The exclusive purpose of investing pension assets must be to provide pension benefits and defray reasonable expenses—nothing else. This doesn’t preclude the possibility that pension plan investments might further a nonfinancial goal, but it cannot be the purpose for making the investment, or for any other fiduciary decision.

The guidance under ERISA that applies to private sector plans has managed to remain true to that principle through competing sets of regulations issued during the Trump and Biden administrations in a span of just two years.

Public pension plan legislation and official acts, on the other hand, in the ongoing wars over ESG, have undermined it. Both sides of increasingly acrimonious arguments pay lip service to those principles while often acting to weaken and undermine them.

Reversing this trend would be helped by: (1) allowing only well-qualified people with investment knowledge to become investment fiduciaries, codifying their responsibilities, and making them personally liable so they can be held accountable; (2) institutionalizing the inability of politicians and other government officials to require or pressure plan fiduciaries to act contrary to fiduciary principles; and (3) walling off the fiduciary function of investing plan assets from the settlor functions of setting benefit levels and contribution policy, to insulate fiduciaries from the pressure to invest more aggressively than a “prudent expert” might.