Can Pension Funds Integrate Environmental, Social, and Governance Principles?

This summary of the Pension Research Council Conference entitled Sustainable Investment in Retirement Plans: Challenges and Opportunities was prepared by Olivia S. Mitchell with input from Shankar Parameshwaran.

Many in the financial community believe that pension funds are ideally placed to incorporate environmental, social, and governance (ESG) principles when they make investment choices. Nevertheless, pension managers also face threats if they fail to do so thoughtfully. Foremost among several risks pension funds must consider is climate change, yet managers’ approaches vary in intensity, from analyzing its impact, to engaging with their portfolio managers, to taking legal action, or divesting. Among the top challenges pensions face are making sense of the diverse ratings that guide their investment choices, proactively involving their stakeholders in those decisions, and staying abreast of regulator involvement. These are the main takeaways from a two-day symposium hosted by Wharton’s Pension Research Council in April 2021, entitled Sustainable Investment in Retirement Plans: Challenges and Opportunities.

One paper by Stephanie Lachance, managing director of Responsible Investment Public Sector Pension Investment Board (PSP Investments) in Canada, and Judith Stroehle, senior research fellow at Oxford University’s Said Business School, argues that several key characteristics influence pension fund strategies and behavioral outcomes. The authors use the framing of social origins to look at the historical, organizational, and contextual characteristics to examine the various factors involved, as well as whether they enable or inhibit the integration of ESG issues.

The authors liken the analysis as akin to a funnel, where they first consider the historical origins of pension funds and the roles of regulation, which in turn then condition pension funds’ mandates and legal structures. Further down that funnel are the corporate governance guidelines regulating how pension leadership decides whether and how to implement ESG issues. In turn, these inform their investment strategies and asset mixes. The final level is of collaboration and advocacy, where pension funds can often take public stands around environmental and social issues, including through collaboration with other funds.

One key inhibitor or challenge is that it can be difficult to thoroughly integrate ESG in an investment model. This is because of obstacles in the access to consistent, complete, and comparable ESG information. Indeed, solving the data comparability problem will be key to ESG integration at investment firms and more specifically, pension funds, in their view. Additionally, asset owners and asset managers will need to be better integrated when they take a long-term investment horizon.

Sizing up ESG risks

When pension managers design their strategies to incorporate ESG principles, they must weigh a range of risks. Laura Starks, finance chair and co-executive director of the Social Innovation Initiative at the University of Texas at Austin, and Zacharias Sautner, finance professor at the Frankfurt School of Finance & Management, analyze those risks which relate to reputation, human rights, capital management, litigation, regulation, corruption and climate change. Clearly each of these is critical, but the authors contend that climate risk looms the largest for pension funds. This is because pensions are particularly vulnerable to ESG risks due to the long-term nature of their investments. Specifically, when wealth protection becomes important, pension managers tend to want to avoid downside risk. In her presentation here), Starks points out that “pension funds face large liabilities towards their beneficiaries and the failure to meet those liabilities carries significant penalties.” Underfunded pensions, especially defined benefit plans, are more exposed to the repercussions of downside risks such as sharp declines in asset values, the authors emphasize.

What makes it worse is that it is difficult for pension funds to overcome those risks with conventional mitigation tools. One main reason, explain the authors, is that climate risk can adversely affect asset values, particularly for long term investors like pension funds, yet it is difficult to price and hedge. This problem arises because of the systematic nature of climate risk, because there is insufficient disclosure by the funds and the firms whose securities they are holding in their portfolios, and because it is difficult to find suitable hedging instruments. Not surprisingly, institutional investors, corporate executives and policymakers have expressed rising concern regarding climate risk and climate risk disclosure.

How investors approach climate risk

Pension funds and other institutional investors use a variety of approaches to get their arms around climate risk, as revealed by a survey by Starks, Sautner, and Philipp Krueger, a professor of responsible finance at the University of Geneva; these survey results were published in The Review of Financial Studies in February 2021. Of the 439 investors surveyed, analyzing the carbon footprint of portfolio firms was the top preoccupation (38% of respondents), and 29% of them worked actively to reduce the carbon footprint of those firms. Only a fifth of the investors used divestment as a way to avoid climate risk in their portfolios. Instead, they favored engagement with their portfolio companies, and 43% of respondents said they held discussions with the management of those firms on the financial implications of climate risks. They also took action by voting against management on proposals over climate-risk issues at the annual meeting (30% of respondents), publicly criticizing managements on climate-risk issues (20%) and taking legal action against managements on climate-risk issues (18%). Only 16% of the investors had no form of engagement with their portfolio firms about climate risk.

Analyzing stranded asset risk was the second biggest concern for the investors surveyed (35% of respondents); stranded assets are typically those that once had value but no longer produce income because of changes in technology, consumption patterns, or regulation. One quarter of the respondents listed coal producers as the portfolio segment with the highest stranded asset risk, followed by unconventional oil producers (21%) and conventional oil producers (16.7%). The higher the carbon intensity in portfolio firms, the more pension managers must pay for protection against downsides through put options. These downside protection prices also change depending on regulatory certainty, likely to be most severe for large carbon emitters. Some 100 firms account for 71% of the global industrial greenhouse gas emissions, including Saudi Aramco, Shell, ExxonMobil, Chevron and Coal India. Of course, the underlying question everyone seeks to answer is whether or current equity valuations fully reflect those risks. If not, pension funds and other institutional money managers will be hampered in their ESG efforts when they lack market transparency and pricing of these risks.

Cutting through ratings noise

Institutional investors could potentially sharpen their portfolio choices by using the ESG ratings provided by a range of private providers, but this could prove challenging, according to Roberto Rigobon, professor of applied economics at MIT. He is also co-director of Sloan Sustainability Initiative, where he leads Sloan’s Aggregate Confusion Project, which aims to improve the quality of ESG measurement and decision-making in the financial sector. Echoing others’ views of the confusing quality of ESG data, he finds that the ratings of the exact same company in the exact same year are often all over the place. Top 10% companies for one rater could well be at the bottom 10% for another rater.

In other words, these ratings prove to be very noisy measures, which has launched his research seeking to understand the effect of ESG investing on stock returns with imperfect ratings (video here). Using data provided by eight rating agencies between 2014 and 2020, he captures the coefficients that triggered changes in outcomes and ranked the raters by the “noise” they generated. He believes that the noise across rating agencies can reveal if a pension manager should underweight rating agencies projecting more noise, and overweight those with less noise. He concludes that European investors have been incorporating ESG principles for some time, while those in the U.S. are fast catching up. By contrast, Japanese money managers are at the beginning of that journey.

A voice for pension beneficiaries

Pension funds hold about US $50 trillion in assets under management, yet in many cases, pension participants and beneficiaries are not directly involved in any of the strategic choices made by these funds. This is the conclusion reached by Maastricht University’s Rob M.M.J. Bauer, a finance professor, and Paul M.A. Smeets, a professor of philanthropy and sustainable finance. In particular, they note, beneficiaries have mostly not taken part in the debates about sustainable investments when nonfinancial preferences tend to play a prominent role.

The authors’ discussion at the conference (video here) taps some unique data from a Dutch pension fund to report on a survey of what members actually want. Their research shows that consumers of financial services who strongly identify with the service providers can be more loyal employees, and they conclude that a better understanding what beneficiaries want is important to bring confidence back to the financial sector. Nevertheless, reasons that the process has not yet become widespread have to do with legal interpretations, cultural and societal perspectives, participants’ low financial literacy levels, pension funds’ capacity constraints, habit, and, often, decision makers’ unwillingness to engage.

A potential sign of change is that millennials have become increasingly active in pressing decision makers on global challenges such as climate change, inequality, and human rights’ violations. Bauer and Smeets believe that this cohort will increasingly demand a voice regarding their asset allocations, without which pension systems may lose the intergenerational commitment needed to provide adequate and sustainable retirement solutions for the next generation. Ultimately, trustworthiness is a pension fund’s most valuable asset.


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