Articles, Research & Spotlights 

• Threats to California Public Pension Reforms
• Washington’s Unprecedented Move Will Increase Pension Costs
• San Diego Needs to Manage Pension Costs
• How Are Public Pension Costs Shared Between Employers and Workers? 

News in Brief
Quotable Quotes
Data Highlight
Reason Foundation in the News
Contact the Pension Reform Help Desk

Articles, Research & Spotlights

California Bills Would Increase Taxpayers’ Costs and Public Pension Debt

In 2012, California lawmakers, headed by then-Gov. Jerry Brown, committed to important pension reforms that would place the state’s massive system of pensions on the path to full funding. At the time, California’s pension debt had ballooned to over $200 billion, and governments at all levels were seeing required cost increases cut into their annual budgets. The reform, known as the Public Employees’ Pension Reform Act (PEPRA), slowed the growth of ongoing costs by placing prudent limits on the benefits promised to new workers. With California pensions around 80% funded by the latest reporting, the state still has a long way to go to reach the intended endpoint of PEPRA reforms. However, lawmakers are beginning to undermine these cost-saving measures. Two bills currently under consideration, Assembly Bill 569 and Assembly Bill 1383, would remove the PEPRA provisions that protect government budgets and taxpayers from unfunded pension promises. Instead of reopening the floodgates to more pension debt, California policymakers need to stay the course on the landmark PEPRA reform.
TESTIMONY: Reason Foundation Comments on Assembly Bill 1383 – PEPRA Repeal

Washington Lawmakers Passed a Ticking Time Bomb for Pension Solvency and the State Budget

Washington is one of the best states when it comes to pension funding, but a new short-sighted bill puts years of prudent funding policies at risk. Engrossed Substitute Senate Bill 5357 seeks to reduce immediate costs on public employers by increasing the assumed rate of return for the state’s pension systems and taking a holiday on paying off existing debt. The problems with this approach are twofold: there appears to be no basis for an increase in investment returns, meaning that this change will likely increase costs in the long run and shift them to future taxpayers, and the existing debt was only one or two years from being fully paid off. In this commentary, Reason Foundation’s Ryan Frost explains that all public pensions have been downgrading their market return assumptions, and Washington would be the first to raise its assumed rate of return. Making this move may reduce costs today, but it will ultimately prove extremely costly for governments and taxpayers.

San Diego Doesn’t Have to Accept Spiraling Public Pension Costs

San Diego is unfortunately re-entering a public pension crisis, despite significant past efforts to resolve it. A court decision forcing the city to reactivate its defined benefit pension system has brought back the inherent structural weaknesses that previously led to crippling levels of public pension debt. But Reason’s Mariana Trujillo explains that escalating pension costs are not a foregone conclusion. Successful reforms in other cities and states demonstrate that these risks can be contained. They’ve achieved this by adopting risk-sharing approaches that more fairly allocate financial obligations between public employees and their employers.

Sharing Defined Benefit Pension Costs: A Survey of Public Sector Practices

Pensions generally require contributions from both employers and employees, but not all pension plans distribute these contributions equally between the two parties. New research from Reason Foundation’s Rod Crane examines the employee/employer contribution share for 230 state and locally administered public pension plans. The results show that, on average, employees tend to bear about half of the normal cost of pension benefits when debt-related costs are not included. However, with employers typically covering the remaining costs, as well as any additional debt-generated expenses, governments bear on average 75% of the total annual costs. While these results vary significantly from plan to plan, pension debts have imposed a substantial fiscal burden on government employers.

News in Brief

Partisan Politics Shapes Pension Fund Voting

Using newly mandated Securities and Exchange Commission filings, a study from Northwestern University examines how political affiliation affects the voting outcomes of U.S. public pension funds. The paper uses the political party of a state’s governor to apply a loose political leaning label for a pension board. While this method may not be a perfect predictor of a board’s political leaning, it does help identify some potentially useful correlations. When it comes to decisions on staff compensation, Democratic-aligned funds are ~five percentage points more likely to vote against management and respond strongly to proxy advisor recommendations. In contrast, data indicate that Republican-aligned funds—especially in states with anti-ESG, or environmental, social, and governance, laws like Florida and Texas—anchor their voting behavior to firm performance and are less influenced by proxy advisors. The study also finds that underfunded public pension plans are more likely to engage in share lending—potentially diluting governance influence—though this is driven by funding status, not political alignment. Read the full report here.

Quotable Quotes on Pension Reform

“Having said all of that I also don’t think we should defend things the way they’re working just because it’s the way it’s been done […] You know when I was first State Treasurer I inherited what I thought was a broken dysfunctional pension system. And I fixed it and it was super hard…all constituencies in my party and the entire legislature in Rhode Island, which was mostly Democrats, told me to leave it alone, that politics are too tough. leave it alone […] But I couldn’t…I just couldn’t sleep at night.”
—Gina Raimondo, former U.S. Secretary of Commerce and Rhode Island governor, quoted in “Raimondo Spoke to Harvard Students About Her Success in Rhode Island” GoLocal Prov News, April 14, 2025. 

“First priority is to keep funding the pension system, so people have, at a minimum, their pension.”
—Rep. Mikie Sherrill (D-NJ), quoted in “What’s the potent sleeper issue in this year’s NJ governor’s race? COLAs” North Jersey, April 28, 2025. 

Data Highlight

Each month, we feature a pension-related chart or infographic. This month, Reason’s Rod Crane examines how public pension costs are shared between employers and employees. Using 2023 data, the chart shows that employees cover an average of 51% of normal costs (the estimated cost of benefits earned) but only 25% of total costs when unfunded liabilities are included. The full commentary is here.

Reason Foundation in the News

“Public pension systems should keep politics of all kinds out of their investments to serve their core duty of maximizing investment returns to provide workers with the retirement benefits they’ve been promised while minimizing financial risks for taxpayers. The modern guardrails and reporting standards in this bill can significantly strengthen these vital systems.”
— Zachary Christensen, Pension Integrity Project Managing Director, quoted in “Runestad introduces bill to ban ‘financial DEI’ investing for Michigan’s public pension funds” Michigan Senate Republicans, May 8, 2025.

“The benefit changes back then helped bend the cost and liability curves and built in some risk protections around new hires, but they didn’t fundamentally pour a bunch of money in to solve the current underfunding. It was a Phase 1 reform and then their leadership team left and they stopped pushing additional phases.”
— Len Gilroy, Reason Vice President of Government Reform, quoted in “New Mexico’s Pensions Remain Problematic” Rio Grande Foundation, May 12, 2025.

“Connecticut still has $40 billion in unfunded pension liabilities and another $20 billion in unfunded retiree healthcare liabilities to pay—the second highest in the country in per capita terms, equivalent to $16k per resident. Interest on that debt compounds at 6.9% annually. Any pause or reduction in pension contributions carries long-term costs.”
— Mariana Trujillo, Reason Foundation Policy Analyst, “Opinion: Why Connecticut Risks Return to Fiscal Chaos,” Hartford Courant, May 8, 2025.

The post Pension Reform News: Threats to California’s public pension reforms appeared first on Reason Foundation.

Articles, Research & Spotlights 

• Pensions Not the Solution for Retaining Employees in Alaska
• Very Few Public Employees Qualify for Pensions
• Public Employees Prioritize Pay Over Retirement Benefits
• Public Pensions Are for Retirement, Not Fostering Local Economies

News in Brief
Quotable Quotes on Pension Reform
Data Highlight
Contact the Pension Reform Help Desk

Articles, Research & Spotlights

Alaska Pension Proposal Unlikely to Fix Recruiting Woes

To address the growing challenges of attracting and keeping police officers, firefighters, teachers, and other public workers, Alaska legislators considered bringing back a similar public pension to the one abandoned over 15 years ago. Testifying on Senate Bill 88 before the House State Affairs Subcommittee, Reason Foundation’s Pension Integrity Project detailed the potential $9 billion in additional costs that this move could add to future budgets and what impact policymakers could expect the bill to have on recruiting and retention. There is little evidence that the pension changes would be enough to counter ongoing national and state trends in worker behavior, which show higher turnover rates and less long-term loyalty to individual jobs. As a result, it is hard to justify the possible $9 billion price tag of SB 88.

Nearly Half of Public Employees in Defined Benefit Pension Plans Will Never Receive a Payout

Public pensions have been typically designed to maximize retirement benefits for employees who stay for 30 years, often to the detriment of the more representative employees who usually work for a single employer for only a few years before changing jobs. Many public pension plans fail to provide benefits that would help make these workers self-sufficient in retirement. Examining the steep benefit requirements of public pensions, Reason Foundation’s Rod Crane explains that pension vesting policies and frozen assets that do not grow with inflation do most public workers a major disservice in building their retirement security. In fact, research shows that only about 35% of hired government workers earn a pension that is not significantly reduced by inflation or forfeited entirely through demanding vesting requirements.

The Key to Attracting Public Workers Is Pay, Not Pensions

All government employers are adjusting to the growing challenges of an evolving workforce. New hires are less likely to stick around for their entire career, and most of today’s workers will work for many different employers over their lives. Lawmakers in several states are promoting defined benefit pensions as the solution to counteracting this trend, but research shows that this approach will have little to no impact on the decisions of young employees. In this column for Governing, Reason Foundation’s Jen Sidorova examines several recent studies that suggest there is no correlation between the type of retirement plans offered (a pension, defined contribution plan, or other alternative plan) and the level of employee retention a public employer can achieve. Instead, studies show that public workers are more likely to respond to salary increases and other improvements to job satisfaction.
Interview: The Key to Attracting Public Workers Is Pay, Not Pensions. -Jen Sidorova

Public Pension Funds Should Avoid Local Economically Targeted Investments 

Policymakers often view public pension assets as an opportunity to foster growth in their local economies, but as Reason Foundation’s Steve Vu points out, this is a dangerous distraction from the role of these funds. Retirement savings placed in a public pension fund are gathered from employees and employers (taxpayers) under the expectation that these funds will be managed with the singular goal of maximizing investment returns at an acceptable level of risk. While it may be tempting to direct these pension funds in ways that might benefit one’s local economy, history shows that these investment decisions come with significant drawbacks and financial risks.

News in Brief

Establishing a Uniform Framework for Fiduciary Duty in Public Pension Funds

A University of Colorado Law Review paper by Danilo Risteski examines the impact of state-level environmental, social, and governance (ESG) regulations on public pension funds, as pensions have been increasingly used to promote political agendas of all sorts. Texas passed anti-ESG laws prohibiting investments in companies it claimed were boycotting fossil fuels and discriminating against the firearms industry, while Maine mandated divestment from fossil fuels to prioritize environmental concerns. These political approaches complicate compliance for investment firms and risk compromising retirees’ benefits. The paper argues for standardizing fiduciary duties across states to focus on beneficiaries’ financial security rather than political goals. To achieve this, Risteski recommends that state legislatures adopt laws similar to the Employee Retirement Income Security Act of 1974 (ERISA), ensuring a uniform, retiree-centered framework for public pension funds. This would involve making investment decisions based solely in terms of risk-adjusted returns and long-term financial stability. The full paper can be found here.

States Adjust COLA Policies to Balance Costs and Sustain Public Pensions

A recent National Association of State Retirement Administrators report evaluates how states have altered pension cost-of-living adjustments in response to evolving economic conditions. The report highlights that 17 states have changed cost-of-living adjustments (COLAs) for current retirees since 2009. Kentucky and New Jersey suspended annual COLAs until specific funding thresholds are met, while Alabama and Texas implemented ad hoc COLAs requiring legislative approval. These cost-saving adjustments reflect a broader trend aimed at ensuring the long-term sustainability of public pension plans. By tying COLAs to factors like plan funding levels or specific inflation indices, states aim to manage fiscal burdens and extend the longevity of their pension funds. The full paper can be found here.

Quotable Quotes on Pension Reform 

“The public was completely unaware of this. … You’ve potentially got the legislature making some decisions that have direct financial implications for the city, and there’s been no local discussion, no assessment of what it would cost the city.”
— Bureau of Governmental Research Executive Director Rebecca Mowbray on the undoing of 2016 cost-saving reforms intended to make the firefighters’ pension financially sound, quoted in “New Orleans firefighter pension controversy is back eight years after landmark settlement,” Nola.com, May 11, 2024.

Data Highlight

Each month, our team of analysts generates a pension-related chart or infographic of interest. This month, we are showcasing a graph from Reason Foundation’s Rod Crane on the impact of inflation on the purchasing power of pension benefits. Crane argues that benefits accrued in traditional defined benefit plans can quickly lose value over time, which significantly cuts into retirement for many workers who leave for other job opportunities after a few years. You can access Crane’s full analysis here.

The post Pension Reform News: Impact of pensions on recruiting and retaining public workers appeared first on Reason Foundation.

Morningstar recently updated its findings with 2022 data and found continuing support for ESG: Public pension funds voted in favor of 88% of ESG proposals in 2022.

The Morningstar report examines proxy votes of 28 public pension funds in 2022. The previous year’s analysis included 29 pension funds, which were included based on “sufficient proxy-voting records.” For 2022, the Teacher Retirement System of Georgia is not included in the report, and a previously anonymous Ohio pension fund now appears as the State Teachers Retirement System of Ohio.

Publicly traded companies hold annual shareholder meetings in which shareholders can vote on various proposals, such as who is on the board of directors. Increasingly, ESG-related proposals are filed and voted on. For example, in the 2022 proxy season, both Tesla and Berkshire Hathaway voted on proposals related to reporting on diversity, equity, and inclusion (DEI) efforts. All the public pension systems in Morningstar’s analysis voted for these proposals at considerably higher rates than general shareholders.

In 2022, public pension plans' support of ESG proposals was again higher than sustainable funds' (74%) support for ESG proposals and far above general shareholders' support (56%).

For public pension funds, the danger with ESG activism, whether in proxy voting or investment strategy, is the potential reorientation of public funds away from focusing on funding earned retirement benefits of public workers and engaging in inherently political activities. ESG standards and proposals often involve social causes and controversial political topics, including energy policy, climate change, abortion, gun control, and foreign policy.

The non-pecuniary nature of ESG resulted in Vanguard pulling out of the Net Zero Asset Managers (NZAM) initiative (a group of asset managers committed to net zero greenhouse gas emissions by or before 2050). In an interview earlier this year, Tim Buckley, The Vanguard Group CEO, said the company is "not in the game of politics" and plainly stated, "Our research indicates ESG investing does not have any advantage over broad-based investing."

The Morningstar report observes the partisan nature of ESG, finding that support for ESG proposals moves up as a state's partisan leaning moves more toward the left, using FiveThirtyEight's Partisan Lean Score for states. But proxy-voting records indicate that most states—right and left—have public pension plans that lean into ESG priorities. Only one public pension plan, the State Teachers Retirement System of Ohio, had lower support than general shareholders for ESG proposals.

Interestingly, Morningstar's report reveals that even in Republican-leaning states, public pension funds supported ESG proposals at a rate of 66%, 10% higher than general shareholders.

These results show the divergence between public pension funds and general shareholders' support for proposals across environmental, social, and governance subcategories. The magnitude of this divergence varies depending on the subcategory within ESG.

If a clear bias exists in how public funds are being managed, it is essential for the public to know and for policymakers to address the practices. Public pension funds should be focused on fully funding retirement benefits promised to public workers and minimizing financial risks for taxpayers. Through transparency, policymakers can help prevent politically driven investing and proxy voting by public pension plans. The public should be able to view proxy votes well before they are cast and access annual reports showing all of a pension plan's proxy votes. This transparency would put the behaviors and decision-making driving these public pension funds out in the open.

The post Public pension systems continue to support ESG proposals appeared first on Reason Foundation.

The report concludes:

The results of the analyses demonstrate that the cumulative value of the company equity portfolio of pension funds would have been higher if they had divested from the energy sector ten years ago. The 22 average difference between the reference portfolio and the ex-energy portfolio is 13 percentage points. Even in a three-year perspective, the cumulative value of the ex-energy portfolios is only 2 percentage points smaller than the value of the original portfolios. However, share prices in the energy sector increased significantly. For the six funds analyzed using data obtained from the Bloomberg database, the total value of the ex-energy portfolios would have been $424.6 billion, while the value of the reference portfolios was $402.8 billion.

If the conclusion of this report held true over a long historical period spanning decades, it would be logical to discourage energy stocks. Of course, the period of analysis matters, and relying on short-term data to rationalize divestment decisions is unwise for public pension funds. The report even admits that looking at the most recent three years of results, the value of this hypothetical ex-energy portfolio is 2% lower than the original portfolios.

The poor performance of energy portfolios over the last decade is not surprising. This timeframe (2013 to 2022) includes a significant drop in the price of oil. Over the previous 10 years, West Texas Intermediate (WTI) crude oil prices declined dramatically, going from $124 per barrel to $78 per barrel in inflation-adjusted dollars.

Therefore, not surprisingly, when looking at the energy sector by industry, it’s clear that the oil and gas sectors were a consistent drag on performance over the 10 years the report chose.

New York University Stern Professor of Finance Aswath Damodaran provides data on the five-year average of alpha generated in 96 different industries for the last 10 years. Damodaran also provides annual figures from 2002 to 2012. Alpha is a measure of risk and market-adjusted returns on a stock. A positive alpha indicates the investment has outperformed the market when adjusting for risk, whereas a negative alpha means the investment has underperformed.

However, the last 10 years, particularly for commodities, do not dictate the future performance. The global energy market, like other commodities, tends to go through drawn-out periods of highs and lows, commonly known as “supercycles,” so 10-year snapshots of these alphas likely don’t tell the whole story. 

From 2003 to 2012, for example, energy sector industries nearly universally generated positive alphas year-over-year. Note that Damodaran’s data is formatted a bit differently in this older historical period: Alpha is reported as an annual figure, and the industry categories are somewhat different.

Only power and foreign utilities generated negative alpha values over this period, Damodaran finds. This broader history is essential to keep in mind when looking at post-hoc critiques of investment decisions or analyzing future investment decisions.

There are also suggestions the energy sector may be turning around. Jeff Currie, global head of commodities research at Goldman Sachs, believes we are in a commodities supercycle. In a Dec. 2022 report, Currie and colleagues wrote, “From a fundamental perspective, the setup for most commodities next year is more bullish than it has been at any point since we first highlighted the supercycle in October 2020.”

In a lecture published in Jan. 2023, Currie stated his belief that the market is in the second inning of a commodities supercycle, stating that they “probably have the strongest outlook of any asset class.”

Over the past five years, oil and gas production and exploration have generated a positive alpha of 5.7%. Coal and related energy had the 10th highest alpha of 96 industries, at 11.1%. Consistent with Currie’s thesis, metals and mining had the highest alpha average of the last five years.

As with any market forecast, Currie’s thesis may be wrong. But looking back on limited data from a short period, as the Stand.earth report does, shouldn’t be the basis for calling for hypothetical divestment from an entire sector of the economy.

Most importantly, public pension funds should not make ideologically or politically motivated divestment decisions and should focus on their fiduciary duty to make investments in the best financial interest of their members.

The post Calls for public pension systems to divest from energy sector are shortsighted appeared first on Reason Foundation.

Articles, Research & Spotlights 

• Florida takes another step to improve its DC plan
• Research shows salaries, not pensions, help recruit and retain teachers
• The push to bring back COLAs is ill-advised
• Higher education pensions offer blueprint for state and local retirement plans

News in Brief
Quotable Quotes on Pension Reform
Data Highlight

Articles, Research & Spotlights

Florida Continues to Improve Its Defined Contribution Plan

As a follow-up to the pension reform bill passed last year, Florida lawmakers enacted another improvement to the state’s default defined contribution (DC) plan for teachers, police, and other public employees. Following a 3% increase in employer contributions in 2022, this year’s legislation—Senate Bill 7024—adds another 2% employer contribution. Together, the contribution increases bring the state’s DC plan close to industry standards and ensure that Florida’s primary retirement plan for new hires can provide adequate benefits to retirees while stemming the growth of risky and unsustainable public pension liabilities. Reason’s Zachary Christensen explains what the law’s changes mean for taxpayers and public workers, noting improvements and also features that will work against Florida’s goal of fully funding its pension system.

Research Suggests Public Sector Should Reexamine How Pensions Impact Recruiting and Retaining Teachers, Public Workers

Several proposals to undo essential pension reforms have been introduced in recent years, with proponents presenting these rollbacks as a solution to the growing challenges of recruiting and retaining public workers. But several recent studies suggest that retirement plans, whether they are a defined contribution, pension, or any other type of retirement structure, likely have little effect on the choices of these workers, particularly teachers. Reason’s Jen Sidorova summarizes three recent academic studies that should provide useful context to policymakers. The first study finds that a pension benefit enhancement granted to St. Louis teachers reduced retention by motivating teachers to retire earlier. The second study looks at teachers in Tennessee, finding that pensions were not a significant driver of retention or teacher quality. The third examines the impact of pension changes on teacher retention in Texas, finding that a cost-reducing reform had a negligible effect on the availability and quality of the labor force.

The Costs of Proposals to Add or Restore Cost-of-Living Adjustments for Public Retirees

Responding to a sudden jump in unexpected public pension costs, many states elected to reduce or eliminate their cost-of-living adjustments (COLA) for retirees in the early 2010s. With inflation soaring and remaining at levels not seen for decades, some states are considering bringing these inflation protection benefits back. But it is unwise for public pension systems to add on more unpredictable and costly liabilities when they are already struggling to fully fund existing pension promises. Reason analyst Steve Vu examines developments in New Jersey, Washington state, and Rhode Island, which have all seen significant legislative efforts to bring back COLAs.

States Should Look to Institutions of Higher Education to Improve Retirement Plans 

As state and local governments grapple with the challenge of shaping retirement systems to serve a more mobile, modern workforce, the best examples may be right within their institutions of higher learning. Reason’s Rich Hiller touches on the history of retirement plans for colleges and universities, which have relied on the flexibility and portability of defined contribution (DC) plans for decades. Employers in higher education recognized the need for a retirement that accrues and stays with professors as they move from one university to another. With the modern workforce changing jobs more frequently, a similar approach may be a good option for government employees.

News in Brief

Study Examines How U.S. Pension Plan Managers View Risk and Inflation

Ortec Finance, an international software company specializing in risk and return management, released a report examining the mindset of those managing U.S. public pensions. To evaluate the current and potential situation government pensions find themselves in, they surveyed 50 plan managers. When asked about current investment strategies, 94% of respondents said that their plan increased its risk profile over the last year, with 16% saying they saw the risk increase “significantly.” And 81% expect to see their plans dive deeper into risk over the next year. Overall, the sentiment among plan managers is that they are prepared for the challenges imposed by inflation, but they intend to prepare for and monitor increases in volatility. Most, 90%, of the respondents anticipate spending money on stress-test tools over the next two years. Ortec Finance concludes that uncertainty is quite high for U.S. public pensions, which raises alarms about their chances of meeting their liabilities. The full report is available here.

Report Reviews the Impact of Inflation and COLAs on Public Pension Plans

The latest brief from the National Association of State Retirement Administrators (NASRA) highlights different types of cost-of-living adjustments (COLAs) that pension plans use and how they impact pension plans and retirees. They note that some states have automatic COLAs, which means they are set for annual adjustments. Other states use an ad hoc COLA, which requires a yearly review and passage of legislation. They identify that most states, 32, have adjusted their COLA at some point in the last 14 years. The report estimates that inflation protection can be costly, with a 3% COLA adding an estimated 26% to overall costs. They also study the loss in purchasing power that retirees have experienced over 20 years, which has left retirees with 62% of the value of their original benefit. The full brief is available here.

Quotable Quotes on Pension Reform 

“[W]ith annual pension contributions by schools and teachers already having risen by 70% since 2001, pension administrators may wonder how much more they can demand. Schools must pay for buildings, books, and yes, teacher salaries—not merely fund pension benefits for already-retired teachers.” 

—American Enterprise Institute Senior Fellow Andrew G. Biggs in “Teacher Pension Systems Are Increasingly Underfunded, Making Teachers Vulnerable and Salaries Less Attractive,” Brookings, June 14, 2023

“This year we achieved pension reform, helped pass term limits, and enacted the biggest tax cut in state history.”

-—North Dakota Gov. Doug Burgum in “Doug Burgum: Why I’m Running for President in 2024,” The Wall Street Journal, June 6, 2023

Data Highlight

Each month we feature a pension-related chart or infographic of interest generated by our team of Pension Integrity Project analysts. This month, analyst Jordan Campbell created an animated visualization that compares market results from Vanguard’s total stock market index and their environmental, social, and corporate governance (ESG) stock ETF over the last 16 months. You can access the visualization here.

The post Pension Reform News: Florida increases contributions, recruiting and retaining teachers, and more appeared first on Reason Foundation.

Articles, Research & Spotlights 

• Major pension reform passes in North Dakota
• New York City’s pensions sued over ESG divestment
• Fiduciary duty should protect pensions from politics and ESG
• The potential costs of undoing pension reform in Alaska
• Retirement plans are ineffective at recruiting and retaining teachers
• How to fix Mississippi’s pension contribution problem

News in Brief
Quotable Quotes on Pension Reform
Contact the Pension Reform Help Desk

Articles, Research & Spotlights

North Dakota Enacts Landmark Public Pension Reforms

To address North Dakota’s growing $1.8 billion in pension debt, state lawmakers passed a landmark reform that will put the North Dakota Public Employees Retirement System, NDPERS, on the path to full funding and reduce the growth of liabilities in the future. House Bill 1040, signed by Gov. Doug Burgum, updates the state’s pension funding policy to no longer shortchange payments on the pension promises made to public workers and retirees. HB 1040 also sets the state’s existing defined contribution (DC) plan as the exclusive retirement plan for all new hires in the future, eliminating the chances for new runaway pension costs. The Pension Integrity Project provided actuarial modeling and technical assistance to the interim retirement committee and several committees during the legislative session.

Pension Plan Members Sue New York Pensions Over ESG Divestment

Some members of the New York City Employees’ Retirement System, the Teachers’ Retirement System, and the Board of Education Retirement System have filed a lawsuit against their pension plans, claiming they have violated their fiduciary duty in their investment decisions. The public plans, covering the city’s teachers and public employees, divested roughly $4 billion from fossil fuel assets in 2021, with the intent to achieve net-zero emissions in their investment portfolios. The plaintiffs claim that because this investment decision was based on factors other than return projections, the divestment breached the fiduciary agreement administrators have made with those contributing to the fund. Reason’s Ryan Frost details why this could be the first of many legal challenges aimed at public pension systems that are encountering growing pressures to throw their assets behind political and environmental causes.

Strengthening and Reaffirming Fiduciary Principles in Public Pensions

With politicians and groups on both the left and right calling for public pensions and funds to engage in environmental and social activism, fiduciary duty is more critical than ever. A new Reason Foundation policy brief by actuary Larry Pollack details the principles that have long protected pension trustees from motives beyond their strictly defined interests. Pollack examines recent cases of politicians attempting to use public funds to promote or punish industries to further their interests, not those who paid into the funds. The paper also outlines ideas to strengthen the rules applied to fiduciaries, which would improve protections from outside parties seeking to use public pension funds as their vehicles of influence.

Webinar: Can investing public pension assets to further nonfinancial goals be consistent with fiduciary principles?

Related Commentaries: Some critiques of anti-ESG proposals miss the mark

California legislature shouldn’t politicize public pensions

The Costs and Risks of Proposed Public Retirement Changes in Alaska

Going into the next legislative session, Alaska lawmakers will continue to deliberate on several proposals to bring back pensions for the state’s teachers, public safety, and other public workers. Reacting to an explosion in unexpected costs, Alaska elected to close its public pensions, which are still underfunded by more than $6 billion, to new workers in 2005. Several state bills under consideration would undo this pension reform and expose Alaska to the risk of more debt and runaway costs. In partnership with the Alaska Policy Forum, the Pension Integrity Project has deployed its actuarial modeling of the state’s two pension plans, the Teacher Retirement System, TRS, and the Public Employees’ Retirement System PERS, to examine the potential immediate and long-term costs that these legislative proposals would impose on Alaska’s budgets. The analysis suggests this move could generate $8.6 billion in additional costs in the coming decades.

Commentary: Alaska’s defined contribution plan is better for most workers than the defined benefit plan

Studies Suggest Pension Benefits Don’t Help Recruit or Retain Teachers

Pensions are often touted as an effective means to help public schools recruit and retain teachers, but recent studies suggest that retirement plans are not much of a draw to this evolving workforce. According to an online poll of over 2,000 teachers, early-career teachers were largely indifferent to the type of retirement plan offered by their employers. The teachers surveyed were more concerned with salaries and health insurance. In this commentary, Reason’s Jen Sidorova identifies some takeaways that policymakers can apply to the challenge of attracting and keeping good teachers.

Mississippi Needs to Fix the Way it Pays for Public Pensions

Responding to ongoing increases in required public pension contributions, Mississippi lawmakers considered legislation requiring legislative approval for further contribution hikes. While the challenges of ever-growing costs for public pensions are serious, restricting contributions is the opposite of what is needed in states with underfunded retirement plans. Sidorova highlights this challenge in Mississippi, noting the state’s contribution policy needs to be more, not less, reflexive to fluctuations in pension costs if the state is going to meet its obligations to public workers.

News in Brief

Report Shows Continued Drop in Pension Return Assumptions

The latest annual report from the National Association of State Retirement Administrators (NASRA) shows state pension systems are reducing their expectations of investment returns. In 2001, the median investment return assumption for all state pension plans was 8%. Over the last two decades, that median assumption has dropped to 7%, with the average rate now down to 6.93%. Public pension plans are responding to multiple decades of investment returns coming in below their previously assumed returns, and market forecasts are predicting low probabilities that their assets will achieve such lofty targets in the coming years. As return rate assumptions continue to fall, pension plans can expect their estimated unfunded pension liabilities to increase. The full brief is available here.

Quotable Quotes on Pension Reform 

“We thought given the significant market changes in light of inflation and interest rates, and the general view that these market changes are likely to persist for at least the intermediate term, now would be a good time to revisit asset allocation,” 

—Interim Executive Director of Florida’s State Board of Administration Lamar Taylor, in “Pension Funds Consider Unloading Stocks, Adding Credit,” The Wall Street Journal, May 5, 2023.

“What we’re seeing is people want to manipulate retirement funds and their trust funds for future generations, to step through that and feel it’s their money…I see portfolio managers who admit they now have bilingual brochures: one for red states and blue states. That’s really sad.”

—Chief Investment Officer of the California State Teachers’ Retirement System Christopher J. Ailman at the 2023 Milken Institute Global Conference in “Milken Institute Global Conference Live Blog,” Pensions & Investments, May 3, 2023.

The post Pension Reform News: ESG divestment lawsuit, fiduciary principles, and more appeared first on Reason Foundation.

The lawsuit, filed by four members of the plans, claims the divestment decision inserted political beliefs into investment decisions and thus violated the pension plans’ core fiduciary responsibility to maximize investment returns at prudent levels of risk for the plan’s beneficiaries. The lawsuit says that putting net-zero emissions goals, which means removing an equal amount of CO2 from the atmosphere as released into it, ahead of investment goals breaks the fiduciary agreement in favor of political and social interests.

This lawsuit could be the first of a larger movement of public pension plan members responding to the significant expansion of public pension funds into the broader environmental, social, and governance (ESG) investment movement. For example, climate activists and policymakers in California routinely push for legislation to force the state’s pension plans, California Public Employees’ Retirement System (CalPERS) and California State Teachers’ Retirement System (CalSTRS), to divest from funds and companies involved with guns, fossil fuels, and other hot-button issues. 

The problems with CalPERS’ strategy received significant attention when a Wilshire Associates report found:

“The California Public Employees’ Retirement System (CalPERS) has lost $3.581 billion in investment gains by divesting from tobacco stocks, which amounts to about 1% of current assets, during a 17-plus-year period ending June 30, 2018, shows a new report by Wilshire Associates, the pension system’s general investment consultant.”

More recently, California Gov. Gavin Newsom signed Executive Order N-19-19, which describes his goal “to leverage the pension portfolio to advance climate leadership.” 

Inserting politics into public pensions is a bipartisan issue. For example, a 2021 Texas law prohibits investing with companies that “boycott” energy companies. As a result, “The Teacher Retirement System of Texas has divested part of its massive pension fund from 10 financial firms that the state comptroller singled out for ‘boycotting’ the oil and gas industry,” the Texas Tribune reported in February. 

As actuary Larry Pollack stated in a recent Reason policy brief, “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 plaintiffs in the New York case—Wayne Wong v. NYCERS, TRS and BERS—say the “defendants have breached their fiduciary duties and abused their control over plan assets…in a misguided and ineffectual gesture to address climate change.” 

They also point to other New York pension funds, such as the system that administers benefits for New York state’s first responders, choosing not to divest from fossil fuels. Police and fire representatives stated during a 2021 divestment discussion that assets of their pension funds belong “to the active and retired police officers who have worked and sacrificed to earn their pensions” and that “[o]ur views on any social or political issue cannot enter into the equation.” 

If this lawsuit is successful, it could reinforce the understanding and limits of fiduciary duty in public pension funds, which has been rapidly eroding in recent decades due to various state and federal legislative actions. A decision for the plaintiffs would make clear that these public pension funds are “not to be used as a slush fund to advance goals unrelated to the providing of pension benefits.”

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“We cannot state that ESG investing is better performance-wise than broad index-based investing,” Buckley said. “Our research indicates that ESG investing does not have any advantage over broad-based investing.” 

Buckley’s statements followed Vanguard’s withdrawal from the Net Zero Asset Managers (NZAM) initiative—a group of 301 asset managers that says it is “committed to supporting the goal of net zero greenhouse gas emissions by 2050 or sooner, focused on lowering carbon emissions in their portfolios.”

Previously, Vanguard had thrown its support and market influence—managing over $8 trillion in assets—behind the initiative. Now the company appears to be adopting a more neutral approach that still allows inclined investors to pursue ESG strategies if they choose. In December, Reuters reported:

“We have decided to withdraw from NZAM so that we can provide the clarity our investors desire about the role of index funds and about how we think about material risks, including climate-related risks—and to make clear that Vanguard speaks independently on matters of importance to our investors,” Vanguard said in the statement.

In his interview with the Financial Times, Buckley stated, “Politicians and regulators have a central role to play in setting the ground rules to achieve a just transition to a lower carbon economy,” but Vanguard is “not in the game of politics.”  

The shifts and statements come at a time when government funds and institutional investors find themselves in the middle of a political tug-of-war, with many parties seeking to influence the investment decisions of public pension systems and others by injecting objectives that extend beyond the standard considerations of returns and risk. Of the so-called “Big Three” asset managers—Vanguard, BlackRock, and State Street—Vanguard has been the least enthusiastic in its embrace of ESG.  

Vanguard operates 28 sustainable funds, compared to BlackRock’s 282. An analysis of 2021 proxy voting from Morningstar found that Vanguard’s average percentage of votes in favor of key ESG shareholder resolutions was 51%, considerably lower than BlackRock’s 74% and State Street’s 66%. 

Buckley clarified the reasoning behind Vanguard’s relatively lower support for ESG shareholder resolutions in the interview. “It would be hubris to presume that we know the right strategy for the thousands of companies that Vanguard invests with,” Buckley said.  “We just want to make sure that risks are being appropriately disclosed and that every company is playing by the rules.” 

Vanguard’s measured approach to ESG is consistent with the company’s history of focusing on offering low-cost, passive investments to the public. The company further innovated the investment landscape by offering low-cost, passive index investments, giving small individual investors access to parts of the market usually exclusive to institutional investors, all without high fees or massive commitments of assets. The competitive effects of Vanguard’s products are likely an important driver behind expense ratios, the percentage of a fund’s assets used to cover costs of operating and maintaining the fund, coming down across the market. According to a recent report by Morningstar, asset-weighted passive funds have experienced a 66% decrease in fees since 1990. This trend is a boon for investors seeking to minimize expenses, but it has put serious pressure on asset managers to cut costs. 

For many asset managers, including some working with public pension systems, ESG funds are a hack to help relieve them from these competitive pressures. In 2019, Michal Barzuza, Quinn Curtis, and David Webber wrote a Southern California Law Review paper arguing that appealing to the social values of millennial investors (i.e., ESG) gives these potential clients a reason to choose them despite their disadvantage in higher fees. “With fee competition exhausted and returns irrelevant for index investors, signaling a commitment to social issues is one of the few dimensions on which index funds can differentiate themselves and avoid commoditization,” they wrote. 

ESG investment vehicles have higher expense ratios than their non-ESG alternatives. Morningstar’s research found in 2021 a considerable “greenium” upcharge for ESG funds. Although fees reached an all-time low in 2020, the average expense ratio for sustainable funds was 0.55% on an asset-weighted basis, notably higher than the 0.39% ratio for conventional funds. 

In part, this might be attributable to the generally smaller size of these funds or just the back-end work involved in constructing and maintaining these indices. Still, higher expense ratios necessitate higher returns to maintain parity. In prior years this worked out well for ESG indices because they tended to be weighted heavier in tech, which performed well. As interest rates began to rise in 2022 and energy prices rose, the relative performance of ESG indices has waned. 

The chart below shows the percentage change in the Vanguard Total Stock Market Index Fund ETF (VTI) and the Vanguard ESG U.S. Stock ETF (ESGV). The standard index VTI has an expense ratio of 0.03%, and ESGV has an expense ratio of 0.09%. 

While some asset managers may view ESG funds as an opportunity to differentiate themselves from competitors and help alleviate cost pressures—and are free to do so in the market‚ for many individual investors and public pension systems, it is likely worth noting that Vanguard’s position appears to be one that does not put ESG interests above other priorities.

Editor’s Note: Vanguard Charitable is a contributor to Reason Foundation.  

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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.

The post Fiduciary principles need to be reaffirmed and strengthened in public pension plans appeared first on Reason Foundation.

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.

Full Policy Brief—

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

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Three ESG advocates recently teamed up to use the Harvard Law School Forum on Corporate Governance to promote their paper “The Liability Trap: Why the ALEC Anti-ESG Bills Create a Legal Quagmire for Fiduciaries Connected with Public Pensions.” However, the report’s authors base their conclusions on an overly broad understanding of the anti-ESG proposals being considered and consequently mischaracterize some of the impacts these policies would have.

The study’s authors, David H. Webber (Boston University), David Berger (Wilson Sonsini Goodrich & Rosati), and Beth Young (Corporate Governance & Sustainable Strategies), critique two American Legislative Exchange Council (ALEC) policy proposals. 

The first is the “State Government Employee Retirement Protection Act,” which, as approved as ALEC model legislation in 2022, would direct government pension plan fiduciaries to consider only pecuniary factors in their investment decisions. These factors must have a material effect on the risk and return of an investment based on appropriate investment time horizons consistent with the pension plan’s investment objectives and funding policy. 

This piece of model legislation excludes non-pecuniary, environmental, social, political, or ideological goals or objectives. It directs fiduciaries that they cannot consider risks or return factors that primarily relate to events that involve a high degree of uncertainty in the distant future and events that are systemic, general, or not investment specific. It also prohibits the voting of shares held by these pension plans to promote non-pecuniary or non-financial goals. 

The second proposal is the “Energy Discrimination Elimination Act,” which was rejected by ALEC as model legislation in Jan. 2023. This proposal would have generally prohibited state and local government agencies and funds from investing in identified financial service companies that boycott either fossil fuel-based energy companies or companies that do not commit or pledge to meet environmental standards beyond applicable federal and state law. Despite its rejection as an ALEC model in January, other organizations are promoting similar policies. 

If Webber, Berger, and Young focused on this “Energy Discrimination Elimination Act” proposed model only, their critique would have more merit. But they often combine and conflate the two bills in arguing the two ALEC draft bills should both be rejected: 

“The boycott bill and the fiduciary duty bill dramatically increase liability risk for plan fiduciaries and service providers without providing any corresponding or even off-setting benefits to fiduciaries or their members. They will reduce the number of service providers willing to work with such pensions, increase liability, insurance, and investment costs for taxpayers, and fund participants and beneficiaries. They should be rejected.”

The principal arguments in support of their position include the following:

• The distinction in the ESG bill between “pecuniary” and “non-pecuniary” is blurry and self-contradictory. 
• Using the concept of “materiality” for determining pecuniary factors conflicts with other securities and U.S. Supreme Court decisions. 
• The boycott bill suffers from similar and self-contradictory requirements.
• The bills effectively transfer proxy voting rights to politicians, ensuring the politicization of such voting rather than restricting it.

According to “The Liability Trap” authors, ESG considerations are good for investing, and the two model policies offered in the draft bills limit investment opportunities and put fiduciaries in jeopardy of breaching their legal obligations. However, instead of providing a separate systematic and objective review of the two very different policy proposals, the authors constantly conflate the two draft bills while ultimately arguing for greater access and use of public pension dollars by private fund managers. Due to their failure to recognize the fundamental differences between the two model bills, many of the points made are relevant to one but not the other, yet they reject both as if they are the same.

The heart of the argument against anti-ESG legislation is that the policies in question “proceed from the erroneous assumption that investors’ consideration of systemic risks … is improper.” By claiming that ESG skeptics ignore basic systemic risks facing investors, some ESG supporters attempt to offer a counter-narrative made to imitate an objective, technical critique without sounding political. 

What policymakers should recognize is that clarifying a public fiduciary’s responsibilities is an attempt to improve fiduciary investment risk management. It reflects the risks associated with the lack of transparency around much of today’s subjective environmental, social, and governance (ESG) goal-setting and reporting, the inaccuracy of many long-term models, the premiums placed on ESG investments by money managers, and a host of other issues that surround many ESG investment products, services, and strategies that are considered by public pension fiduciaries with little to no public oversight. 

Systemic risk is an established concept in investing that the ALEC bills’ proponents would generally recognize as a prudent consideration, but not all ESG factors are universally defined, much less understood universally as systemic risk factors. “The Liability Trap” authors prove this by acknowledging that “the line between governance and ‘environmental, social, or political,’ as well as the definition of governance itself, can shift over time.” Although the authors attempted to highlight a contradiction in the ESG model policy text, they inadvertently stated the obvious. Of course, things change as new information comes in to validate or invalidate criteria for investment risk management.  

The ESG fiduciary policy in the “State Government Employee Retirement Protection Act” does not change that dynamic one bit, but it does make public fiduciaries “show their work” when it comes to investment decisions.

“The Liability Trap” authors argue that the definition of a “pecuniary factor” is too vague to administer because the list of non-pecuniary factors is too long, and the definitions of pecuniary and non-pecuniary do not mirror each other. But there are plenty of legal terms that are asymmetrical. The fact is that the term “pecuniary” is well understood in the public pension and investment world, and the test for fiduciaries is to make sure it is present when acting. If it is not there, they should pause and conduct the necessary due diligence to find it if it exists.

The argument that the securities law definition of materiality is in conflict with that of the “State Government Employee Retirement Protection Act” is simply misleading. Different bodies of law can have different meanings for terms of art. The fiduciary body of law can use materiality in a different way than securities law. They need not and probably should not be identical. It is not problematic that a fiduciary actor requires a different level of materiality than what a company must use when disclosing financial information to shareholders.

Requiring a fiduciary responsible for public dollars to adhere to objective criteria set within a specified time frame and to remain oriented towards achieving the pecuniary goals of the pension trust is the most basic policy plan sponsors can set. That does not mean factors like rising sea levels or prolonged droughts are barred from consideration by public fiduciaries when weighing investment opportunities. If climate change and fossil fuel investments can be demonstrated to have pecuniary effects in the investment time frames specified, then the fiduciary should feel comfortable acting in accordance with those factors. If not, then greater due diligence is needed before acting. 

The argument against the need to show objective due diligence is predicated on the logic that, first, an investment can and should be used to make the world a better place. Second, if the world is a better place, it must have a vaguely measured positive impact on pension risk and return. For these important public funds, more evidence is needed than mere speculation. The use of mere speculation is already prohibited under general fiduciary standards. The model ESG policy is trying to shine a light on something that already should be part of every public pension fiduciary’s playbook.

Being a fiduciary of public funds is not a position to be taken lightly. Being elected or appointed as a trustee puts you at the helm of hundreds of millions, if not tens of billions, worth of taxpayer and pensioner dollars. Any decision to allocate those funds in any way should be held to higher standards than the decisions of those who manage their own funds or the funds of a client with an appetite for risk. 

The ALEC model, “State Government Employee Retirement Protection Act,” ESG fiduciary policy understands the unique and inherent gravity of public pension funds and aligns public policy to ensure decisions are objective and pecuniary as required by the fiduciary “sole interest” standards. However, the authors claim that clarifying public fiduciary policy like this will make it more difficult to make important investment decisions. In “The Liability Trap,” th authors jump from one scenario to another, emphasizing contradictions where there are none and offering hypotheticals to test the logic of the pecuniary standard, but ultimately offer little in the way of evidence for their hindrance claim.

For example, the authors cite Russia’s invasion of Ukraine as a governance risk that would be prohibited from consideration under the proposed fiduciary policy. However, as part of their argument, the authors make the error of describing the internal governance of investment firms instead of the governance structure of a public pension trust. 

So, what would Russian divestment mean for a pension investment fiduciary? The model ESG fiduciary policy only requires that public pension trustees understand what the companies they are investing in are doing. If trustees find out that the company or fund is being managed in a way that doesn’t align with the pecuniary risk and return objectives of the pension trust, then they must divest and look for alternative investments. The investment company or fund, on the other hand, can keep doing what they are doing, but if it cannot justify the quality of its investment offering as supporting the pecuniary interest of the retirement plan, then they run the risk of losing the business. That is as it should be.

According to the “State Government Employee Retirement Protection Act,” mode fiduciary policy, it doesn’t matter what the fiduciary’s subjective intentions are as long as the decision is justified under the pecuniary standard. Public fiduciaries don’t have to ignore a company’s statements, nor are they prohibited from considering any specific type of reporting from a company. The model fiduciary policy frees trustees to continue to do so, and prudence demands that they listen to those sources. But a public fiduciary should not stop there. They must make an objective assessment about whether those non-pecuniary, ESG-based business decisions are valid enough to warrant an investment based on the pecuniary standard. 

With the report’s authors conflating the prohibitions included in the model boycott bill with the limits placed on public trustees and investment managers in the model ESG fiduciary bill, “State Government Employee Retirement Protection Act,” they incorrectly conclude that the fiduciary bill would limit investment opportunities. 

However, the lack of clarity around objective ESG factors leads the report’s authors to argue that constraints on using ESG factors will hinder a fiduciary’s ability to manage long-term risk and return strategies while simultaneously arguing that it also slows them down and prevents them from being nimble for short-term investment management decisions. One could easily interpret the authors’ argument to be that pension fiduciaries must have unfettered discretion to manage the investments of a trust. Without universal standards based on pecuniary factors, how can public pension plan sponsors have confidence that the plan’s very real pecuniary objectives aren’t just strived for but actually met?

A public pension plan sponsor that creates the pension trust has every right to set the rules governing how fiduciaries go about their business. That’s the nature of being a plan sponsor—they get to set the rules under which plan fiduciaries must do their job. It is untenable to argue that once you start a pension plan, you lose complete control and can never ask whether it is being managed properly. 

Having said that, this is one of many red herrings offered by “The Liability Trap’s” authors. The fiduciary policy in question does not require freezing investment approaches in place. It simply requires justification for the discretionary management decisions being made and proof that they stay within the set of fiduciary boundaries.  

In the end, the report’s authors mistakenly see the two ALEC drafts, the boycott bill, and the fiduciary bill, as one entity with identical implementation and impact. Their belief is that value isn’t always pecuniary, but this perspective leaves far too much opportunity to insert controversial political or social considerations into investment decisions. They use qualitative examples to argue against adding a pecuniary limit and, in doing so, imply that those examples couldn’t exist in the free market under the fiduciary bill. By extending the timeframes for potential returns or finding ways to expand the scope and magnitude of an issue, anything can be considered an ESG investment. The authors insinuate that public pension trustees, for example, should be free to do whatever they feel is right when it comes to managing public funds, despite the potential negative outcomes of those actions being fully borne by retirees, active members, and taxpayers. In doing so, they exhibit a fundamental misunderstanding of the relationship between governments and their public pension trust.

As the investment world continues to see new products, services, and philosophies directed at influencing policy, public pension system trustees and their government sponsors would do well to seek out ways to increase the prospect of investment returns to fund promised pension benefits, not try to solve society’s problems. The State Government Employee Retirement Protection Act would be a great first step in that direction for any state and shouldn’t be lumped together with other proposals.

The post “The Liability Trap” authors’ critique of pension fiduciary model misses the mark appeared first on Reason Foundation.

Environmental, social, and governance issues are commonly packaged together in investment discussions through the ESG acronym, but a closer examination of these components raises questions about the value of grouping these things together.

It is evident that the concept of ESG investing owes its existence to politics by simply looking at its components. Why else would environmental, social, and governance criteria be lumped together other than for political positioning? Why not past, present, and future?  Or animal, vegetable, or mineral? 

Some idealists with a political agenda made the determination that these separate elements, ESG, were, in total, critical for long-term investing success, as well as other broader goals. They were also successful in positioning these three elements as a singular, necessary approach to investing success. ESG opponents then emerged, and the debate commenced. Through years of engagement, even opponents contributed to the idea that these three elements should be treated as one. Their position then became one where absolutely no credence could be given to any ESG investing criteria.

A prudent person, on the other hand, can see elements in standalone environmental, social, and governance issues that should be considered when public pension systems are making investment decisions. That same prudent person would also see that not every one of these issues should be applied to each and every investment decision. In fact, it is just as foolish to eliminate all such criteria from investing as it is foolish to include all such criteria. 

Fortunately, public pension fund trustees must follow prudent fiduciary standards, which set boundaries on how investment decisions are to be made. Given this, public pension fund trustees are afforded a perfect path to avoid the purely political argument that ESG investing has become. Fiduciary standards require that pension fund trustees make investment decisions based on providing the best possible financial outcomes consistent with the pension plan’s objectives for the plan’s participants and for the plan itself. 

All-in or all-out ESG investing is not sound, prudent fiduciary policy.  Therefore, public pension fund trustees should make investment decisions based on practical and sound financial criteria, not based on political ESG classifications that prioritize other factors above returns and volatility. The likely outcome of prudent decision-making is that some decisions will be made that align with the ESG approach, and others will not. All of these decisions, however, must be made for the good of the pension plan’s members and not to satisfy political agendas. 

The practical approach to responsible public pension system governance is there, fiduciaries just need to follow it.

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In This Issue:

Articles, Research & Spotlights 

• Designing an optimized retirement plan for today’s public workers
• North Dakota considers pension reforms
• How ESG policies impact institutional investors
• State pension systems expand high-risk, high-reward investments

News in Brief
Quotable Quotes
Data Highlight
Contact the Pension Reform Help Desk

Articles, Research & Spotlights

Designing an Optimized Retirement Plan for Today’s State and Local Government Employees

The discourse about public retirement policy often revolves around a binary choice between defined benefit (DB) pension plans and 401(k)-style defined contribution (DC) plans. Each has its own unique advantages and drawbacks, but both lack the flexibility to match many unique personal situations. A new paper from Reason Foundation’s Pension Integrity Project proposes that public retirement benefits need not be limited to these two choices any longer. In the new report, public retirement benefit experts and senior fellows Richard Hiller and Rod Crane introduce the Personal Retirement Optimization Plan—or PRO Plan—for the public sector. The PRO Plan adds the element of a guaranteed retirement benefit to a DC foundation to build a more secure, customizable, and portable retirement for public workers. The PRO Plan is built around the objectives of risk-managed retirement income adequacy, and unlike traditional public pension plans, does not impose funding risks on government employers. Testing this newly proposed PRO Plan design, Hiller and Crane find that the costs of providing guaranteed annuitized benefits through the PRO Plan would be much lower than an individual purchasing these benefits on their own.

• Full Report—The Personal Retirement Optimization Plan: An Optimized Design for Government Employees
• FAQ: Frequently asked questions about the PRO Plan
• Webinar: Experts discuss the need for the Personal Retirement Optimization Plan

Evaluating North Dakota’s House Bill 1040

Facing $1.8 billion in unfunded pension liabilities, and projections that the pension fund will be depleted within 80 years, North Dakota policymakers are seeking comprehensive reform of the North Dakota Public Employees Retirement System (NDPERS). The newly introduced House Bill 1040 would address many of the issues that have been plaguing the system for decades. Firstly, it would fix the state’s systematic funding deficiencies by switching from a statutory to an actuarial contribution policy. This would ensure that state and local governments are making the payments needed to fulfill all pension promises by a predetermined date. Second, the reform would provide new hires, beginning in 2025, a defined contribution (DC) plan that meets a high standard of benefit design. Reason Foundation’s analysis of House Bill 1040 finds the proposed reforms would effectively halt the accrual of new unfunded liabilities with new hires, and would reduce long-term costs of the pension plan by responsibly paying down its legacy debt.

• Testimony to North Dakota House Government & Veterans Affairs Committee
• Examining the Benefits of House Bill 1040
• The Public Pension Gold Standard, North Dakota’s HB 1040, and the Status Quo
• Does HB 1040 Meet the Objectives of Good Pension Reforms?

The Mechanics of ESG-Driven Divestment, Engagement, and Proxy Voting

Environmental, social, and governance (ESG) policies can take many different forms and are applied by a wide variety of organizations, but the foundational goal is to influence investors’ and corporations’ decision-making. In this commentary, Jordan Campbell examines two main avenues used to leverage this influence and how groups are trying to reshape the market through divestment and corporate engagement. Although there is no clear impact of ESG divestment practices, there has been a noticeable rise in ESG engagement practices, namely proxy voting. Data indicates that public pension funds have outpaced other institutional investors—and even ESG-focused funds—in throwing support behind ESG resolutions.

In Search of Higher Returns, Public Pension Systems Dive Deeper into Alternative Investments

Public pension plans saw significant investment losses in 2022, and economic forecasts indicate that more market turbulence is in store for 2023. Facing this increasingly unpredictable and volatile investment environment, and under pressure to achieve often overly-optimistic investment return assumptions, many public pension plans continue to dive deeper into high-risk, high-reward strategies. Reporting on these trends, Reason’s Steve Vu highlights several states, including New York, California, Texas, Ohio, Iowa, and New Mexico, where policymakers are loosening up limits and increasing targeted allocation in alternative investments like private equity, private credit, and real estate.

News in Brief

End-of-Year Update Describes a Tough 2022 for Public Pensions

An update to the State of Pensions report by Equable Institute summarizes the funding status of 228 state and locally administered pension plans at the end of the 2022 calendar year. Their calculations indicate that the aggregate funded ratio of these plans dropped from 83.9% funded the previous year to 77.3% in 2022, marking a significant reversal of the investment gains gathered during a record-breaking year of returns in 2021. They estimate an average return of -6.14% for the last year, which falls dramatically below the average plan assumption of 6.9%. Analysis in the report finds that—facing ongoing challenges in 2023—most state retirement systems remain fragile to a volatile and increasingly unpredictable market. The full update is available here.

Brief Examines Pension Contribution Behaviors of Governments

A new brief by the National Association of State Retirement Administrators (NASRA) focuses on the contributions that state and local employers made to fund the pension benefits promised to public workers through 2021. They find that of the more than $10 trillion in pension revenue generated since 1992, $2.5 trillion came from employer contributions, $1.1 trillion came from employee payments, and $6.5 trillion (64%) came from investment returns on those gathered funds. The brief recognizes the efforts of governments to reach actuarially determined contribution rates, finding that the average percentage of actual to actuarial contributions to be 99.3% in 2021, the best rate since 2001 and a major improvement from the below 80% paid in 2012. The brief attributes much of this improvement to reforms of contribution policies and supplemental payments from general government funds. The full brief is available here.

Quotable Quotes on Pension Reform

“There’s going to be acute fiscal pain and pressure the more you ignore the cost…If you’re not paying it down, you’re chasing it.”

—Leonard Gilroy, managing director of Reason Foundation’s Pension Integrity Project, on unfunded pension liabilities in “State Pension Plans Were Hammered in 2022. Next Year Will be Worse,” Politico, Dec. 28, 2022.

“Chicago government-worker pensions are massively underfunded. So in typical Chicago-land fashion, the City Council is betting on casino revenue to plug the pension gap. Do taxpayers and workers feel lucky?… The police and firefighter pension funds are only about 20% funded—among the worst in the country—even though 80% of city property tax dollars go toward pensions. The city’s annual pension payments have risen by $1 billion over the past three years.”

—The Wall Street Journal Editorial Board on the move to build a casino to generate tax revenue dedicated to the police and fire pension funds in “Chicago’s Big Pension Gamble,” The Wall Street Journal, Jan. 2, 2023.

Data Highlight

Each month we feature a pension-related chart or infographic of interest generated by our team of Pension Integrity Project analysts. This month, analyst Jordan Campbell, using Morningstar data, created a visualization comparing how public pensions and other institutional investors voted on ESG shareholder proposals. You can access the graph here.

Contact the Pension Reform Help Desk

Reason Foundation’s Pension Reform Help Desk provides technical assistance for those wishing to pursue pension reform in their states, counties, and cities. Feel free to contact the Reason Pension Reform Help Desk by e-mail at pensionhelpdesk@reason.org.

Follow the discussion on pensions and other governmental reforms at Reason Foundation’s website and on Twitter @ReasonPensions. As we continually strive to improve the publication, please feel free to send your questions, comments, and suggestions to zachary.christensen@reason.org.

The post Pension Reform News: Modernizing public sector retirement plans, North Dakota reforms, and more appeared first on Reason Foundation.

While these ESG policies are often subjective and political, proponents tend to claim that they are an objective lens to value firms and allocate investments. The evidence for this claim is weak, however.

For many activist investors and politically-motivated institutional investors, investment performance may not be the main priority. ESG can be used to provide activist investors a framework to reshape how finance and investing relate to business into something that better conforms with their visions of the world. There are generally two approaches for these groups: divestment and/or engagement. 

Divestment 

The theory behind divestment is that by selling or avoiding the purchase of so-called ‘bad’ companies and industries, these firms and industries will be punished with a higher cost of capital. The cost of capital is the required rate of return or profit a firm must earn on capital investments to satisfy its owners and creditors. Companies can raise capital from equity by selling ownership or debt by taking a loan from a creditor. A higher cost of capital reduces the number of new investment opportunities available to a business.  

The latest Global Sustainable Investment Alliance report put ESG investments at 36% of all managed assets. According to the Global Fossil Fuel Divestment Commitments Database, 1,556 institutions have now divested from fossil fuels. These institutions include Harvard and Oxford Universities, several New York City pension funds, and the Norwegian Sovereign Wealth Fund. 

The actual impact of these divestment strategies is not clear. The cost of capital in the oil and gas industry has declined over the past decade, which is in line with the general decline in the total market. Conversely, the cost of capital did jump considerably in the green and renewable energy industry in 2021, but there is a fair amount of volatility across all sectors year-to-year. 

Examining the impact of divestment, Jonathan Berk and Jules H. van Binsbergen, professors from Stanford's Graduate School of Business and the University of Pennsylvania's Wharton School, respectively, were not able to find a meaningful impact of ESG investing on capital costs within the energy markets. "When calibrated to current data, we demonstrate that the impact on the cost of capital is too small to meaningfully affect real investment decisions," Berk and Binsbergen write. Instead, the authors suggest socially conscious investors should focus on changing corporate policy. 

Engagement 

Changing corporate policy through shareholder influence and proposals is the engagement side of environmental, social, and governance strategies. Publicly traded companies hold annual shareholder meetings in which shareholders can vote on various proposals in proxy voting. ESG proposals in proxy votes are increasingly common and supported by large asset managers. 

One of the better-known examples of engagement occurred in 2021 in association with the oil company Exxon Mobil. A green activist hedge fund, Engine No. 1, which says it seeks "to create value by helping companies transform their businesses to be sustainable," gained support from asset managers, including BlackRock, Vanguard, and State Street, and elected three supported directors to Exxon's board. Four directors were nominated by Engine No. 1.  

However, this election was not an isolated occurrence. According to Morningstar, an investment research and management services firm, there were 273 ESG shareholder proposals in 2022. Notably, the number of proposals that pass has steadily increased over the last three years. Twenty resolutions passed in 2020, 36 passed in 2021, and 40 passed in 2022.  

The support for these resolutions is highest with institutional investors, particularly public pension funds. While general shareholders supported 63% of ESG resolutions, according to Morningstar, public pension funds supported 90%—which was even higher than the rate of ESG-focused funds. The Teachers Insurance and Annuity Association of America (TIAA) supported 92%, BlackRock supported 74%, and State Street supported 66%. Vanguard was the only asset manager of the "big three" to support ESG shareholder resolutions less than the general shareholder, voting in favor of 51% of proposals, Morningstar found.  

Unfortunately, there are no standardized disclosures or reporting for public pension proxy votes. Morningstar looked at 65 public pensions but could only locate records for 34 (29 were included in its analysis). Only one-third of these public pension plans had their records available online. Six percent charged a fee to provide their proxy-voting records, and five percent declined to give them. The lack of reporting on proxy votes among public pension systems should be viewed as a red flag suggesting these funds may be avoiding transparency and accountability.  

While the actual impact of divestment strategies appears tenuous, there are an increasing number of ESG shareholder resolutions with considerable support from institutional investors, particularly public pension funds.  

It is inappropriate for public entities to engage in political, non-pecuniary investment activities, regardless of whether it occurs through divestment or shareholder proposals. Public pension plans have a duty to base their investment decisions on pecuniary factors, such as investment performance and financial risk. Reason Foundation's Pension Integrity Project recommends that policymakers help prevent politically-driven investing and proxy voting by public pension systems by allowing the public to view all of the system's proxy votes well in advance of them being cast, as well as by requiring an annual report showing all of a public pension plan's proxy votes.

To serve the public workers relying on public pensions and to protect taxpayers, who are ultimately liable for paying for them, there must be complete transparency and appropriate rationales for proxy votes and divestment decisions made by public pension systems.  

The post The mechanics of ESG-driven divestment, engagement and proxy voting  appeared first on Reason Foundation.

According to Department of Labor (DOL) statements, the rule “removed barriers to considering [ESG] factors in plan investments” and will provide more flexibility in “exercising shareholder rights.”

But those critical of using ESG factors to make public pension systems’ investment decisions believe this move exposes retiree savings to oftentimes unexpected or counterproductive social and political agendas when risks and returns should be the sole investment factors. This new rule sets the stage for state governments to establish their own standards, which could prompt state legislatures to set up guardrails against political investing.   

Institutional investors, corporations, credit rating agencies, and governments are increasingly adopting an ESG framework into their investment decision-making. The idea behind ESG is to create a more accurate accounting of the negative externalities—be they environmental or social caused by industries, businesses, and individuals and to use this knowledge to positively influence the future. This ESG framework is implemented in a variety of ways.  

ESG investment policies typically seek to avoid assets that are deemed to be harmful to the environment. Some institutional investors adopt and promote ESG principles in hopes of influencing the companies they invest in. ESG ratings are applied to companies to measure—albeit arbitrarily—the negative impact they may impose on various environmental and social areas. All of this is increasingly present in both the public and private sectors. 

Traditionally, those who are tasked with managing collective retirement funds, including either a 401(k) plan or a pension plan, have what is called a fiduciary responsibility to the members of those plans. Fiduciary responsibility is the focused objective of managing and growing investment funds at acceptable levels of risk. Any other interest or objective is supposed to fall outside of the fiduciary’s purview, making it out of bounds for any consideration in investment decisions.  

For privately-run retirement plans, these standards are set by the Department of Labor through ERISA. In the waning months of the Trump administration, the Labor Department issued a rule that reinforced the traditional understanding of what a plan sponsor can consider when making investment choices for its members, specifying that making choices based on ESG factors would be out of bounds. The department also released a proposal that would significantly restrict retirement plan administrators from directly influencing equities through stockholder voting—a process called proxy voting—on ESG-related issues. 

In response to these protections from 2020, the Biden administration’s DOL has reversed course. Through the implementation of this latest rule, specific restrictions on making ESG considerations a part of investment decisions have been removed, allowing 401(k) plans under ERISA to insert ESG metrics into their risk and return evaluations. The rule also reverses the restrictions on proxy voting that were applied in 2020, opening up possibilities for retirement plans to use stakeholder positions to shape the decisions of the companies they are investing in, even if the matter is unrelated to economic outcomes. 

According to a statement on by United States Secretary of Labor Marty Walsh, the rule will “end the chilling effect created by the prior administration on considering environmental, social, and governance factors in investments.”

Walsh added, “Today’s rulemaking is an important step toward a more secure financial future for America’s workers and their families.”

However, his position remains politically polarizing, most evident in the response from Republican senators who have submitted a resolution to reverse the rule. 

What will these latest developments mean for employees and retirees who are counting on their pension plans to act on their behalf as fiduciaries? It indicates that the federal government is not going to get in the way of retirement plan managers who choose to insert political, inconsistent, and often controversial ESG factors into their decision-making. Those looking for protection from politically motivated shirking of fiduciary responsibility will have to turn to state governments. 

With a lot still to be determined in the world of retirement plans and fiduciary responsibility, the full impact of the DOL’s latest rule remains unclear. At the very least, it sets the stage for more debate on the matter, which will ultimately take place at the state level. State policymakers have already begun to set strong definitions of what a fiduciary can consider in making investment decisions.  

For public pension funds, which are not bound by ERISA and therefore largely unaffected by the Labor Department’s recent rule, state policymakers should consider legislation to keep activist campaigns away from taxpayers’ money in keeping apolitical funds from politicization. Setting clear boundaries for what a public pension can consider when making investment decisions—the approach taken by Florida’s State Board of Administration and proposed in a piece of legislation in Michigan—is the optimal way to protect these funds from activism from any political side. 

The post The Department of Labor’s new ESG rule puts the onus on states  appeared first on Reason Foundation.

In This Issue: 

Articles, Research & Spotlights  

• A blueprint for protecting public funds from ESG and politicization 
• Arizona’s innovation for multi-employer pension plans 
• Challenges in inflation protection for Texas teachers 
• Retention trends in the public workforce suggest the need for portability 
• What U.S. pensions can learn from the U.K. margin call 

News in Brief 
Quotable Quotes on Pension Reform  

Articles, Research & Spotlights 

Reason’s New Blueprint for ESG-related Legislation

Reason Foundation’s Pension Integrity Project has developed an ESG Blueprint to help policymakers seeking sound and effective policies for managing public funds, particularly public pension funds. The website provides an overview of what ESG is, its potential impacts on public pension systems, and model legislation to strengthen the boundaries of fiduciary responsibility, ensuring that policymakers keep public funds out of political influence campaigns. Reason’s ESG blueprint is available here, and our full archive of ESG-related analysis is here. Recent pieces include:

Arizona Creates Prefunding Program for State Retirement System

Many state-run public pensions are multi-employer plans, meaning local cities and counties participate and contribute to a single fund and share liabilities. This allows smaller governments to reap the investment benefits of a larger asset-pooled plan, but it can also mean less flexibility in paying down the unfunded pension liabilities that are impacting annual budgets. State legislators in Arizona recently passed a bill that aims to improve this flexibility for employers participating in the Arizona State Retirement System (ASRS). As outlined by Reason’s Ryan Frost and Truong Bui, Senate Bill 1082 offers a vehicle for local governments to apply extra payments to a separate account, which can be used to offset rising contributions at a later time. This is an innovation that other state-run multi-employer plans should consider employing. 

Is Texas’ Definition of an “Actuarially Sound” Public Pension System Outdated?

With high inflation continuing to degrade the value of fixed pension benefits, there is significant attention being placed on the cost-of-living adjustment policies that are supposed to cushion the blow from retirees’ losses of purchasing power. In Texas, there is a strict hurdle set in law that must be achieved before giving retired public workers a so-called “13th check.” The state must be able to demonstrate that it is “actuarially sound.” Reason’s Steven Gassenberger explains the current understanding of this hurdle, noting that it would be prudent to adjust this standard with shorter debt-payment requirements. 

More Portable Retirement Plans Would Help Public Employers Attract and Keep Workers 

Increased rates of resignation in the post-pandemic world are a continuation of a decades-long evolution in the modern workforce, with the current generation of workers switching jobs at much higher rates. This phenomenon is even more pronounced among public workers and teachers. Examining some of the latest shifts in public employee retention, Reason’s Jen Sidorova offers ways that policymakers can shape retirement benefits to better fit today’s workers, including shorter vesting requirements and increased portability. 

The U.K.’s Margin Call Offers Warning Signs for Public Pension Funds in the U.S.

A sharp increase in bond yields recently put United Kingdom pensions in a difficult position where they needed to sell off assets, resulting in what was called a ‘doom loop’ scenario that prompted intervention from the Bank of England. Reason’s Swaroop Bhagavatula looks at how this market scare was associated with liability-driven investing (LDI), which is a strategy not often used by pensions in the United States. Still, there are some valuable lessons that can be applied, namely avoiding over-leveraging and maintaining adequate levels of cash to manage any major market shocks. 

News in Brief 

Paper Rediscounts Public Pension Liabilities 

A paper from economics professors Oliver Giesecke and Joshua Rauh of Stanford University asserts that public pension liabilities should be discounted in a way that reflects the guaranteed nature of these promised benefits, which would mean using zero-risk rates based on treasury yields. Their analysis of 647 state and local pension plans in 2021 finds that, while these plans report unfunded liabilities of just over $1 trillion and an aggregated funded ratio of 82.5%, rediscounting the same plans to the proposed specifications would mean unfunded liabilities of $6.5 trillion and a funded ratio of 43.8%. The full paper is available here, and an interactive dashboard of its results is available here. 

New Survey Asks Public Employees How The Current Market Has Impacted Their Retirement 

MissionSquare Research Institute has published results from a survey of 1,003 state and local government workers focusing on how current market turbulence has impacted the perception of retirement security as well as saving behavior. The survey indicates that most (84%) of respondents feel anxious about their personal financial security. Nearly half (48%) have reduced the amount they save for retirement, naming high inflation as the cause. Over half (58%) of the polled public workers indicated that the retirement plan offered to them was a factor in their decision to stay in the job, while 33% said that this made no difference. The full report is available here. 

Quotable Quotes on Pension Reform  

“In some cases, the [midterm election] campaign rhetoric not only dismissed the danger of climate change, it went so far as to mischaracterize a strategy we believe in strongly: examining the risk factors of the environment, of social inequality, and of good governance […] But let’s be clear: Applying the lens of ESG is not a mandate for how to invest. Nor is it an endorsement of a political position or ideology. Those who say otherwise are actually advocating for investors like CalPERS to put on blinders…to ignore information and data that might otherwise help build on the retirement security of our 2 million members.” 

—CalPERS CEO Marcie Frost quoted in “CalPERS CEO Pushes Back Against Politicization ESG Investing,” Pensions & Investments, Nov. 16, 2022 

“Regardless of your view on climate change or inclusion or human rights, Mississippi’s pension system, taxpayer dollars, and college savings programs are the wrong place to experiment with investment strategies that push balance sheets to the side. Moreover, many of the policies ESG promotes tie directly to higher costs for consumers, a weaker Mississippi job market, increased inflation, and smaller investment returns – all while undermining the free market and our economic liberty.” 

—Mississippi Treasurer David McRae in “Guest Column: Protecting Mississippi’s Finances,” The Vicksburg Post, Nov. 2, 2022 

“It does limit us…We, I believe, have been successful in trying to minimize any kind of cost that might bring to you, but eventually, it’s going to bite us in the butt if we continue. So we just have to be careful and prudent about it…Our bank list is getting short.” 

—Lamont Financial Services Founder Bob Lamb on Louisiana Treasurer John Schroder pulling the state’s investments from BlackRock over their ESG approach in “Pulling Louisiana’s Investments Could ‘Bite Us in the Butt,’ Adviser Tells Treasurer,” Louisiana Illuminator, Oct. 18, 2022 

Contact the Pension Reform Help Desk 

Reason Foundation’s Pension Reform Help Desk provides technical assistance for those wishing to pursue pension reform in their states, counties, and cities. Feel free to contact the Reason Pension Reform Help Desk by e-mail at pensionhelpdesk@reason.org.  

Follow the discussion on pensions and other governmental reforms at Reason Foundation’s website and on Twitter @ReasonPensions. As we continually strive to improve the publication, please feel free to send your questions, comments, and suggestions to zachary.christensen@reason.org. 

The post Pension Reform News: ESG blueprint, Arizona’s pre-funding, and more appeared first on Reason Foundation.

• Clarify Fiduciary Rules and Responsibilities

Require pension and state trust fiduciaries only base investment decisions on pecuniary factors like investment performance and risk, not nonpecuniary factors like politics, ESG, etc.

• Require Advance Proxy Vote Notice and Annual Reporting

Surface activism in proxy voting by allowing the public to view proxy votes well in advance of being cast, as well as requiring a compiled annual report of all proxy votes annually. 

• Require Limited Partner Status Reporting

Help mitigate activism through alternative asset managers like private equity and hedge funds by requiring the annual reporting of limited partners and all committed and allocated capital.

• Require Investment Fee Reporting

Reporting of investment fees will allow for more transparency around the cost and benefit of generally higher-risk alternative investments like private equity and hedge funds.

• Require Pension/Trust Board Meeting Transparency

Ensure taxpayers and stakeholders have access to major planning and investment decisions by requiring materials and meetings are broadcast, published and granted open access to all stakeholders.

Step #2: Set Up Systemic Oversight

• Institute a Pension Oversight Board

Creating a dedicated agency or center of excellence to oversee all public retirement systems in your state, both state and local, regarding their actuarial soundness and compliance with state reporting requirements.

• Require XBRL Reporting Standards

Because government financial reports are mostly published in PDF format and are hard to analyze, compare and aggregate, transitioning to a more data-friendly XBRL format would make government finance more transparent.

• Require Public Trustees to be Insured

Unlike in the private sector, public pension trustees are not required to carry liability insurance. Requiring coverage against claims brought alleging a wrongful act in relation to their role as fiduciaries ensures the appropriate amount of accountability.

Step #3 – Install Protective Policies

• Remove Investment and Actuarial Management Privileges

Return important fund management duties to taxpayers by suspending management privileges until sound funding policies and metrics are achieved.

• Mandate “Excess Value” Consultant Compensation

Pioneered by the Public Employees Retirement Association of New Mexico, this limited partnership compensation method replaces the widely used carried interest compensation formula with one based on absolute returns, completely removing any consideration of the risk associated with such an asset.

Steps to protect public finance from ESG activism

The post Steps to protect public finance from ESG activism appeared first on Reason Foundation.

Greenwashing and Marketing

Both Goldman Sachs and Deutsche Bank’s DWS are currently facing U.S. Securities and Exchange Commission (SEC) probes over the alleged “greenwashing” of their investment funds, according to The New York Times. Greenwashing is a term used to describe firms or investment funds that make unsubstantiated or misleading claims to appear more environmentally and ESG-friendly. The Times reports:

ESG reporting has emerged as a top priority for the SEC under the agency’s chair, Gary Gensler. Earlier this year, the commission proposed changes that would require more disclosure from companies to investors about the risk that climate change and new government policies on it might pose to their operations. And last year, the regulator set up a special ESG task force to focus on whether Wall Street firms and companies were misleading investors about their investment and business criteria in the environmental, social and governance area.

The investigation into Goldman’s mutual funds appears to be related to the new enforcement initiative. Last month, the investment advisory arm of Bank of New York Mellon paid $1.5 million to settle an investigation by the SEC. into allegations it had omitted or misled investors about its ESG criteria for assessing investments. The SEC is also looking into Deutsche Bank.

The Deutsche Bank/DWS investigation may be related to whistleblower Desiree Fixler’s claims that ESG assets under management were inflated. Fixler told the Financial Times, “I still believe in sustainable investing, but the bureaucrats and marketers took over ESG and now it’s been diluted to a state of meaninglessness.”

Last year, Tariq Fancy, the former head of sustainable investing at BlackRock, questioned the legitimacy of ESG investments in an op-ed for USA Today:

I led the charge to incorporate environmental, social and governance (ESG) into our global investments. In fact, our messaging helped mainstream the concept that pursuing social good was also good for the bottom line. Sadly, that’s all it is, a hopeful idea. In truth, sustainable investing boils down to little more than marketing hype, PR spin and disingenuous promises from the investment community.

Consistent with Fancy’s claim that ESG is little more than “PR spin,” many other critics contend the ESG signaling and actions from some of the largest asset managers are partly attempt to attract younger investors—who may be attracted by the idea of “socially conscious” investing. A Southern California Law Review paper by Michal Barzuza, Quinn Curtis, and David Webber in 2019 argues that:

…index funds must seek out differentiation in the market where they can find it. Using their voting power to promote their investor’s social values, and doing so publicly and loudly, is a way for these funds, which otherwise risk becoming commodities, to give millennial investors a reason to choose them.

Higher Fees For ESG-Related Funds

The asset management industry has experienced declining management fees since the 1990s, in what is commonly referred to as “fee compression.” A July 2022 analysis from Morningstar showed that for asset-weighted passive funds, fees have “declined 66% since 1990.”

But in many cases, ESG investments are proving to be an opportunity for funds to charge higher fees. The Economist looked at three very similar exchange-traded funds (ETFs) managed by BlackRock: Core S&P 500 (IVV), ESG Screened S&P (XVV), and ESG Aware MSCI USA (ESGU). Despite very similar composition and synchronized performance in 2022, the ESG ETFs had 2.7 to 5-times higher expense ratios, the percentage of a fund’s assets used to cover operating expenses.

Whether this difference is due to the relative size of these funds and the back-end work involved in constructing the index, it is a persistent pattern. In 2021, Morningstar found a significant so-called “greenium” upcharge for ESG funds. While Morningstar found fees were at record lows in 2021, the asset-weighted average expense ratio was 0.55% for sustainable funds—significantly higher than 0.39% for traditional funds.

Politicizing Public Pensions and Taxpayers’ Dollars

Higher fees and marketing strategies are not parts of the environmental, social, and governance-related sales pitches made to investors. Instead, ESG advocates and asset managers make the case that environmental, social, and corporate governance considerations are in the best interest of investors. BlackRock CEO Larry Fink, for example, wrote in his 2022 letter to “CEOs and chairs of the companies our clients are invested in”:

Stakeholder capitalism is not about politics. It is not a social or ideological agenda. It is not ‘woke.’ It is capitalism, driven by mutually beneficial relationships between you and the employees, customers, suppliers, and communities your company relies on to prosper.

Despite Fink’s framing, ESG policies often take sides on some of the most contentious contemporary political issues, including energy, environmental policy and climate change, foreign policy, abortion, guns, workplace issues, and more. ESG often moves these issues from legislative, judicial, and political spheres into financial markets and corporate boards, increasingly politicizing what might previously have been non-political organizations and institutions focused on their core missions and products.

To claim otherwise presupposes that ESG considerations are an objectively better way to operate and evaluate firms. Thorough analyses, like research by the University of California-Los Angeles Professor Bardford Cornell and Aswath Damodaran, a professor at New York University, concluded: “evidence that investors can generate positive excess returns with ESG-focused investing is weak.”

Still, to be clear, private individuals and institutions are free to allocate their assets in whatever ways they see fit. Public sector financial assets are a different story. Public pension funds have a fiduciary duty to manage assets in ways that ensure the funds can meet the retirement needs of their members. For public pension systems, political activism of any stripe, as my Reason Foundation colleague Richard Hiller notes, is “inconsistent with these fiduciary responsibilities and retirement plan objectives.”

The over $5 trillion in state and local public pension investment assets should not be treated as money that is up for grabs or that can be leveraged for political causes by politicians, system administrators, and subgroups of plan participants. Unfortunately, however, government entities across the board are increasingly becoming activists on political issues.

On ESG, two major groups in climate activism are the Ceres Investor Network and Climate Action 100+. Eleven public pension plans, eight state treasurer offices, and three state investment boards have signed on as members of Ceres, which describes itself as “a nonprofit organization transforming the economy to build a just and sustainable future for people and the planet.”

Similarly, 16 public pension plans, three state treasurer offices, and four state investment boards are members of Climate Action 100+, which says it “is an investor-led initiative to ensure the world’s largest corporate greenhouse gas emitters take necessary action on climate change.

A report from Morningstar found that public pension funds supported ESG shareholder resolutions at a greater rate than ESG-focused funds in 2021. Among key ESG shareholder resolutions in 2021, the report found:

Perhaps not surprisingly, public pensions based in Democratic-leaning states tended to vote in favor of ESG resolutions more often than those based in Republican-leaning states—the former had an average 98% support rate across public pension funds compared with the latter's 80%. Public pensions located in split states landed in between, at 85%. The less predictable outcome may be that all three groups came out well ahead of general shareholders' average 63% rate of support across key shareholder resolutions and didn't look too different from the 85% rate of support seen from ESG-focused funds.

The report also found that policymakers and taxpayers should: “Insist that public pension funds provide better transparency on their voting policy, votes, and voting rationale.”

As the financial industry receives increased scrutiny related to its ESG practices and likely inflated claims, the involvement of public pension systems becomes better known, and some politicians push to make ESG-related investments and issues mainstream public issues, there could be a reckoning ahead. Given the size of the ESG asset management industry, ESG investments and practices are likely to continue to be a significant part of financial markets and the business world for the foreseeable future. However, all parties involved should embrace a serious review of existing approaches and increased transparency, especially when it comes to public pension systems and taxpayers' dollars.

The post Scrutinizing high ESG fees, greenwashing and the politicization of public pension funds appeared first on Reason Foundation.