ESG Investing Goes Under the Microscope in CalPERS Debate

While many in the wider retirement planning industry have rightly been focused on the final stages of the GOP tax cut legislation, George Michael Gerstein, ERISA council with Stradley Ronon, has been following another important story.

As he tells PLANADVISER, there is a hot debate going on between the lobbying and advocacy organization known as the American Council for Capital Formation (ACCF) and the California public employee’s pension fund known as CalPERS. Readers will likely know of CalPERS as one of the largest public pension funds in the world, but for its part, the ACCF has had an active history in Washington dating back to its first advocacy effort in support of the Revenue Act of 1978, which cut capital gains taxes.

The debate involves the proper use of environmental, social and governance (ESG) investments within the context of institutional tax-qualified retirement investing. While ERISA attorneys and asset managers broadly agree that ESG is rapidly becoming a cornerstone issue for defined contribution (DC) and defined benefit (DB) plan sponsors—and most other categories of institutional investors for that matter—the ACCF says there is evidence that the leaders of CalPERS are not adhering to the federal government’s strict rules putting limits on the use of non-financial factors when investing employees’ tax-qualified retirement assets.

The whole saga started when the American Council for Capital Formation (ACCF) published a sharply written report alleging that, as the group puts it, “CalPERS has prioritized relatively poor performing Environmental, Social and Governance [ESG] investments at the expense of other investments more likely to optimize returns,” and for the sake of politics no less. ACCF summarizes its charges as follows: “The board uses its size and its beneficiaries’ money to wage war on companies not aligned with its political views, and influences other large institutions and influential proxy advisory firms to fall in line alongside it—or run the risk of losing out in billions of dollars in annual fees and business transactions.”

ACCF seeks to tie a drop in plan health at CalPERs to greater use of ESG: “Over the past ten years, CalPERS has increased its ESG investing and activism while converting a $3 billion pension surplus in 2007 to a $138 billion deficit today … This performance lag comes as the value of the S&P 500 index has increased by more than 275 percent over the past eight years. CalPERS’s environmental-related investments comprised four of its nine worst performing private equity funds last year, accounting for more than $600 million in committed capital.”

There is considerable detail in the ACCF report digging into these allegations, but they all more or less turn on the notion that the CalPERS leadership has prioritized the symbolism of committing to ESG investments over the fiduciary duty to pursue the most financially prudent course with employee dollars. According to ACCF writers, “none of the system’s leaders put their own money into environmental investments … Yet large passive funds such as BlackRock, State Street and Vanguard—which manage trillions in pension fund and 401(k) dollars—are being influenced to support these political initiatives.”

Naturally CalPERS rejects these accusations, and the fund’s board put out its own analysis responding directly to the ACCF. The CalPERS analysis charges that ACCF’s report fails to tell the whole story of CalPERS’ use of ESG. They also suggest ACCF fundamentally misrepresents what ESG investing programs can be. 

“ACCF cites four environmental investments as proxies to feebly argue its anti-ESG message. They’re correct—these private equity funds haven’t done well,” CalPERS writes. “But here’s the context that was willfully ignored: These are just four funds totaling about $600 million out of about 240 in a $26.4 billion private equity portfolio. And this: Private equity earned 13.9 percent last fiscal year, 11.5 percent for the preceding five-year period, and 11.3 for the preceding 20-year period. In fact, our private equity program has produced higher returns for the CalPERS fund than any other asset classes. ACCF’s analysis of the poor performance of five public solar companies falls victim to the same dismal logic. At nearly half of the entire CalPERS fund, our public market holdings represent the vast majority of all listed global companies—around 10,000—and largely follows a passive, index-like investing approach. We don’t stock pick or try to time the market. What we do pick is a long-term investing strategy—with a 50- to 60-year horizon—and we stick to it.”

CalPERS also takes some digs at ACCF’s objectivity on this matter, or alleged lack thereof: “As MarketWatch notes, ACCF is funded in part by the Koch Brothers and energy companies like Exxon, Chevron, and Occidental [all of which, by the way, we own]. That’s why it’s not surprising that one of its four recommendations is that public pension funds insist that outside managers not vote for proposals that require additional disclosures beyond those mandated by regulatory authorities. That tired and tortured argument really means this: ACCF wants us to act like the index funds we invest in—passive and silent.”

Continuing the debate, ACCF has now responded with yet another analysis (the third in this process), suggesting the initial CalPERS response, too, fails to acknowledge key facts. Readers will have to review all three publications and draw their own conclusions, but offering his take on the back-and-forth, Gerstein says there are some potentially important lessons to be abstracted here for the future of ESG in the retirement planning industry, both in the public and private markets.

“Fiduciaries of plans of all sizes and types who are thinking of moving into utilizing more ESG investments should take note of how this debate unfolds,” Gerstein says. “I think to some degree this argument shows the good will amongst some members of the public and political class is not enough, from a fiduciary standpoint, to justify on its own the use of ESG investments. Fiduciaries must be able to explain and clearly articulate why the investments they choose are consistent with their fiduciary duties to pursue strong financial performance.”

Gerstein observes that under the new rules established late in the Obama administration, ESG investments are absolutely fair game and there is an important acknowledgement that ESG factors do directly impact financial performance of mutual funds. But it also must not be imagined that the Obama administration gave plan fiduciaries free reign to ignore negative drags on performance, whether the source of the drag is related to ESG methodology or any other source.

At a high level, Gerstein is certainly to be counted among the general advocates of ESG-minded investing, suggesting this ongoing debate is “important and healthy.” He suggests ESG is, unfairly, still “associated with this idea that it is pure political activism, without a tangible tie to improved investing performance.”

“The truth about ESG today is something quite different,” he concludes.  “There is very clear reporting from many highly respected sources that shows challenges like climate change, resource scarcity, political instability and the like, will be very impactful to the future performance of long-term investments that are being made and debated today. ESG investing can actually be a primary part of the analysis because it can affect the actual performance, but this analysis must be objective and it must put participant’s financial benefit first.”