Public Pension Funds Should Avoid Social Investing Strategies

As California’s political leaders continue to attempt to address the complex issue of climate change, some officials have discussed pushing the state’s pension funds to incorporate environmental, social, and governance factors (ESG) into investment strategies in order to help the state reach its climate policy goals. This strategy, called social investing, could pressure or even legally limit California’s state pension plans from investing in industries like fossil fuels that are deemed to be environmentally harmful.

Theoretically, this would shift funds away from polluting industries to align the state’s investments with the climate goals and rhetoric of California’s leaders. However, past pension divestment movements have reaped limited political, social, and environmental benefits—at the cost of large financial losses. California should avoid using ESG standards as a criterion to prioritize investments for its pension funds.

California’s pension plans are among the largest institutional investors in the nation. The California Public Employees’ Retirement System (CalPERS) has over $400 billion in assets, while the California State Teachers’ Retirement System (CalSTRS) manages over $250 billion. These assets are viewed by some as governmental funds that the state legislature has the authority to manage and manipulate.

In a recent interview, Michael Likosky, partner at Advantage Infrastructure Advisors, discussed his thoughts on California Gov. Gavin Newsom’s climate change initiatives and the state’s pension funds. Likosky says that “these funds have enormous investment capabilities which can advance decisions, mitigate climate risks, and also drive capital into opportunities to create sustainable inclusive communities.”

This statement is in line with Gov. Newsom’s Executive Order from 2019, which created a “Climate Investment Framework” that is supposed to “reduce greenhouse gas emissions and mitigate the impacts of climate change while building a sustainable, inclusive economy.”

As Likosky mentions in his interview, Newsom sees California’s pension funds as sovereign wealth funds, which can “drive the institutional investor market and set a gold standard among money managers on climate investment.”

However, there are key differences between pension funds and sovereign wealth funds. The two are funded differently, and should not be used for the same purposes. Pension funds are invested in a trust that has a defined payout target it must hit to ensure retirees are provided their promised benefits. The most fundamental rule of trust law states that trustees must act solely in the interests of the beneficiaries. For a pension fund to focus on social goals rather than retirement promises would be a violation of this rule.

Furthermore, basing investment strategies on ESG standards would likely violate pension fiduciary duties. Pension funds are governed by boards of trustees with a legal fiduciary responsibility that extends only as far as maximizing returns to benefit retirees and future beneficiaries.

The goal of a pension plan is to attract public employees, provide retirement benefits, and be self-financing rather than rely on increasing taxpayer contributions. Legislators and governors typically have nothing to do with investment strategy for these pension plans, nor should they.

A brief from the Center for Retirement Research found that public pension plans that adopted investment strategies prioritizing social interests over returns had consequently lost significant sources of revenue. Connecticut’s pension systems, for example, lost $25 million trying to invest in local businesses. Kansas’ pension plans lost anywhere from $100 million to $200 million due to defaulted loans from an in-state investment program.

In California, moves to divest from tobacco stocks in the year 2000 led to a $3.5 billion decrease in overall funding. The impact of this move on the tobacco industry was minimal, as the stocks simply went to other buyers.

A recent Department of Labor guidance brief on the Employee Retirement Income Security Act (ERISA), a law governing private-sector pensions, ruled that the use of criteria outside of standard return and risk factors, like ESG standards, would be a violation of their fiduciary duty to maximize returns. Although public plans do not fall under ERISA, many plan sponsors do look to those rules for guidance on best practices.

California’s public pension plans are already struggling to achieve sufficient funding levels. CalPERS is only 70 percent funded, while CalSTRS is only 66 percent funded. Under CalPERS’ latest adopted investment strategy, the plan only has a 46 percent chance of hitting its long-term 7 percent target for investment returns (using its own projections).

In order to provide the retirement benefits that have been promised to the state’s pensioners, California’s pension plans should avoid placing too much importance on environmental, social, and governance factors in its investment strategies. Putting a pension fund in a position where it sacrifices its fiduciary duties to its members in order to promote ESG goals would disrespect the pension promises made to generations of Californian public workers and put those pension benefits at risk. California’s leaders should rethink this strategy.