Pension Plan Divestment and ESG Investing

In its quest to advise the City Mayor, Boris Johnson, about climate change, the London Assembly recently urged the London Pension Fund Authority ("LPFA") to rid itself of its carbon ("specifically fossil fuels") investments and allocate the proceeds to "responsible funds, which deliver appropriate returns to the taxpayer." They referenced the National Association of Pension Funds ("NAPF") and its recognition that institutions have a role to play in Responsible Investment ("RI") or what the NAPF describes as the "integration of environmental, social and governance (ESG) factors in the investment decision-making process and stewardship activities."

According to Chief Investment Officer, the LPFA, with assets in excess of 4 billion pounds sterling, replied, in a letter to its 80,000+ members, that it takes ESG investing seriously as a long-term vehicle, adding that its "key aim must be to ensure we can continue to pay your pensions as they fall due." Although this jumbo pension plan currently has "less than 1% invested in fossil fuels," it carved out space on the LPFA website to address the topic as follows: "Responsible investment factors, such as low carbon, may be relevant as an additional consideration. However, screening out stocks for investment/divestment on ethical grounds only is in conflict with the Board's fiduciary duty if the decision risks significant financial detriment to the fund."

The concepts of responsible investing and divesting are not new. Pension plans and sovereign wealth funds are a few of the many organizations that have been approached to jettison certain investments. Push back, when it occurs, is based on the notions that (a) entrenched shareholders can do a lot to effect change (b) divestment costs are high and/or (c) selling off a position could violate fiduciary obligations to beneficiaries. In "Selling out of fossil fuels no solution for climate change" (Financial Times, March 22, 2015), Anne Stausboll details the governance stance adopted by the California Public Employees' Retirement System to encompass "advocacy, engagement with companies and investing in climate-change solutions." As its CEO, she suggests that "Walking away by simply selling off assets through divestment will not help."

In 2007, I wrote about my interview with Maria Bartiromo, then CNBC senior anchor, on this topic of whether, how and when to divest. See "Is There Fiduciary Liability Attached to Divestment?" I offered four considerations as repeated below:

  • Selling an investment due to political pressures could end up costing "taxpayers and plan participants in the form of 'unexpected' transaction costs" which in turn could worsen sub-par funding levels;
  • Proceeds from any mandated sales could lead to lower returns than originally projected;
  • Fiduciaries may find themselves accused of breaching their duties unless they can adequately demonstrate the economic rationale for divesting; and
  • Plans, especially those with small staffs, could be overwhelmed with having to spend considerable time and money to get up to speed before making direct ESG type investments.

As with any investment action, there is never a free lunch. Every decision needs to be carefully reviewed.

Interested readers may want to check out the following items:

Bad Disclosures - Recipe For Disaster?

According to "State workers face privatization" by Jason Stein (Milwaukee Journal Sentinel, January 6, 2011), over 300 Wisconsin State Department of Commerce employees may soon be classified differently. The stated goal is to better deploy its $183 million budget to try to create jobs. (Whether you believe that governments are the engine of jobs creation is a post for another day.)

Questions remain about the benefits for identified employees and whether they will be covered by the state's retirement system. A related question is whether the general public will have a true assessment of Wisconsin's retirement plan IOUs if these privatized workers are counted as "public" for some purposes but not for others. In reading the many comments posted for the aforementioned article, emotions are running high about the real costs associated with this decision. Clearly, more information would go a long way to quelling any concerns.

The topic of financial disclosures may soon create real problems for public plans and, by extension, ERISA plans that are sponsored by companies that issue stocks and/or bonds. In today's New York Times, Mary Williams Walsh reports that the U.S. Securities and Exchange Commission ("SEC") may be investigating the large California pension plan known as CalPERS. It's premature and inappropriate to speculate but the inference is that bond buyers may have been in the dark about the "true" risks associated with this $200+ billion defined benefit plan. If true, California could pick up an even bigger than expected tab and municipal security investors could be in a position of having paid too much to own state debt. See "U.S. Inquiry Said to Focus on California Pension Fund."

As recently as 2009, then Special Advisor to California Governor Arnold Schwarzenegger, David Crane, referred to public pension plan reporting as "Alice-in-Wonderland" accounting. He added that "state and local governments are understating pension liabilities by $2.5 trillion, according to the Center for Retirement Research at Boston College." Since these are legal contracts that bind the state, city or municipal sponsor, they are on the hook for bad results, with large cash infusions likely.

It's not rocket science to conclude that other states and municipalities could face the same type of securities regulation inquiry. Indeed, even ERISA plans are vulnerable to allegations of fraud or sloppy reporting if their risk disclosures are incomplete, inaccurate, misleading or all of the above. See "Testimony for Securities and Exchange Commission Field Hearing re: Disclosure of Pension Liability" (September 21, 2010). Investors want to know whether they have a striped horse or a zebra in their stable. They need and deserve a solid understanding of investment risks to which they are exposing themselves. That can only occur if accurate and complete information is provided. To its credit, CalPERS seems to be emphasizing risk-adjusted performance as paramount. A December 13, 2010 press release describes the adoption of a "landmark" asset allocation that emphasizes "key drivers of risk and return."

Email Dr. Susan Mangiero, CFA and certified Financial Risk Manager if you would like information about what a risk disclosure assessment entails for your organization or on behalf of a client(s). You may likewise be interested in one of our workshops for directors, trustees and/or members of the investment committee about performance reporting within a fiduciary and financial risk management framework.

Hegemony in Alternatives Land - Are Pensions Getting the Upper Hand?

According to "Investors warn private equity over cash calls" (March 26, 2009), Reuters reporter Simon Meads writes that private equity firms are facing "intense pressure" from limited partners (pensions, endowments and foundations). Cash strapped themselves, institutional investors are telling asset managers not to come knocking on cash infusion doors any time soon.

Does this phenomenon present a fiduciary conundrum? For one thing, might a limited partner be sued for a contractual breach if they refuse to pony up additional monies? Second, could a dearth of new cash making its way to private equity fund managers end up creating more financial pain for the limited partners? After all, if a private equity and/or venture capital fund finds itself short of the almighty dollar (or other currency), it may be unable to invest in new companies deemed to be high growth and/or be hamstrung from keeping current portfolio companies afloat. On the other hand, limited partners may be reeling from their own pain (whether Madoff induced, stemming from equity losses or something else) and figure that the cost of incremental disbursements outweighs the expense of abstaining.

One thing seems clear.

Institutional investors are demanding more for less. In "Calpers Tells Hedge Funds to Fix Terms -- or Else" (March 28, 2009), Wall Street Journal reporters Jenny Strasburg and Craig Karmin write that this large California giant is "demanding better terms from hedge funds, including lower prices and 'clawbacks' of fees if performance weakens." Said to have been sent to 26 hedge and 9 funds of funds, a March 11, 2009 memo outlines terms, with a proviso that counter terms will be considered.

In a March 6, 2009 article by the same two writers, the deputy chief investment officer for the Utah Retirement System echoes similar sentiments. In his "Summary of Preferred Hedge Fund Terms," Larry Powell calls for lower fees, adding that "management fees should be used to cover operating expenses only, and are not appropriate funding sources for staff bonuses, business reinvestment, strategy expansion, or wealth accumulation by partners." The 4-page letter urges a share structure that transfers "liquidity risk evenly among commingled investors" that could result in how gates, lock-ups and redemption terms apply to short and long-term investors, respectively. Regarding disclosures, Powell describes a minimum laundry list to include items such as:

  • Annual audited financial statements
  • Quarterly information about fees, operational costs, concentration of clients and soft dollar activity
  • Monthly Net Asset Values, return attribution by strategy, geography and/or sector, largest long/short positions, leverage at the fund and strategy level
  • Weekly return attributions and month-to-date estimates of return.

We've heard numerous institutional investors put a stake in the ground for what they perceive to be a more level playing field (their words). Just a few months ago, I led a workshop on risk management and "hard to value" investing red flags to a group of large public plan auditors. Many of the audience members described a "disclose" or "we'll walk" policy now in force with respect to alternative funds. (Hopefully it goes without saying that not every alternative fund is a "hard to value" fund.)

Several things come to mind. Could demands from institutional investors be potent enough, if met, to stave off new regulatory mandates, some of which are outlined in "Does More Financial Regulation Make Us Safer?" (March 29, 2009)? Second, might we see a flurry of alternative fund manager fee-related lawsuits, similar to 401(k) "excessive" allegations that are making their way through the court system?

The match is on - investor versus manager. Who will get the biggest slice of the pie going forward with respect to economic rights?

CalPERS Invests in Infrastructure

According to blogger extraordinaire and Sacramento Bee reporter Jon Ortiz , the California giant will now invest in "PPP" (public private partnership) deals but with strings attached. According to their policy entitled "Infrastructure Program," posted on "The State Worker" and elsewhere, projects to build bridges, roads and other types of infrastructure should avoid displacement of California municipal workers "provided that CalPERS' fiduciary responsibilities are met." Subsequent text adds that "the investment vehicle shall make every good faith effort to ensure that such transactions have no more than a de minimus adverse impact on existing jobs."

Far be it from me to impugn any group of workers, municipal or private. However, one does wonder if CalPERS and infrastructure fund managers will soon find themselves at loggerheads. If I read the policy correctly, it seems to put an awful lot of responsibility on external portfolio managers to address wage differentials (if any exist) for the express purpose of assessing the cost-effectiveness of labor resources. Employment economics is a speciality in its own right. Should infrastructure moneymen (and women) hire outside experts to undertake a comprehensive study to determine whether private versus public workers are best suited for a particular project? How might such fees, paid to labor economists by money managers but passed along to institutional investors such as CalPERS, erode reported returns? Could returns be eroded by so much that the benefits of investing in infrastructure in the first place are more than offset by CalPERS' mandate to avoid loss of state jobs?

According to Brian K. Miller ("CalPERS Changing PPP Language," GlobeSt.com, August 15, 2008), the California Public Employees Retirement System ("CalPERS") altered its policy so as not to be sued by the Professional Engineers in California Government ("PECG"). The American Council of Engineering Companies of California (the private equivalent of the PECG) countered that threat of litigation does no one any good.

Does this type of allegedly veiled political "intervention" sound familiar?

Just a few days ago, Massachusetts State Treasurer Tim Cahill said "no thanks" to Governor Deval Patrick, when asked to allocate pension assets to bonds issued by the state's student loan organization. In "Cahill rejects student-loan proposal" by Casey Ross (The Boston Globe, August 8, 2008), fiduciary concerns are front and center. In "Massachusetts Pension Plan Urged to Invest in School Loans" (August 8, 2008 blog post), I wrote as follows:

Here's the rub. The state pension trustees have a fiduciary duty to make sure that the plan is in good financial shape. Will statutory investing put those fiduciaries at risk for allegations of breach in the event that MEFA bonds sour or perhaps offer a sub-optimal return?

I think the same principle applies to the CalPERS decision, sending mixed signals about competing constituencies - state engineers versus plan participants. Complicating things, could state workers win now by keeping their jobs (for certain infrastructure projects) but lose later on if infrastructure investments fare poorly due to labor-related cost issues and so on?

What a dilemma!

Leverage: Friend or Foe to Pension Investors?



In today's New York Times, reporter Jenny Anderson talks about lackluster returns for some hedge funds. In "Hedging '06: Year to Read the Caveats," she quotes Christy Wood, CALPERS senior investment officer, as saying that this year marks the third year that "the global equity markets and long-only managers outperformed hedge funds" and that "If you threw all these in an index fund net of fees, you would have done better than if you put it in the hedge fund industry."

The article continues that CALPERS has another $3.5 billion to invest, beyond the existing $4 billion in hedge fund investments. Their appeal, says Ms. Wood, is equitylike performance with bondlike risk.

The numbers are compelling. Courtesy of data from Hedge Fund Research, the article describes inflows in excess of $110 billion through Q3-2006, compared with $47 billion last year.

What caught my eye is the quote about leverage and the notion that markets have all but ignored situations like Amaranth and its reported $6 billion loss.

Excerpted from this piece, investment advisor Stewart R. Massey, founding partner of Massey, Quick & Company, is quoted as saying that "If there's a lesson in 2006 - and no one talks about it anymore - it's that leverage is a very dangerous thing" and "there's too much out there."

On the face of it, leverage is not necessarily bad (nor is it necessarily good). However, in bad times, levered investments can cause significant harm to a pension fund portfolio. Let's hope that fiduciaries are asking good questions about leverage and not forgetting that things can sour quickly. Far from an exhaustive list, here are a few basic queries for hedge fund managers.

1. How does your fund measure leverage?

2. What is the fund's average leverage measurement?

3. Are there particular market conditions and/or investment positions that worsen leverage?

4. What is the fund's stop-loss policy as a way to curtail trouble before it's too late?

5. How does the fund value its "hard-to-value" positions and what is the likely impact on reported leverage?

6. Does the fund's leverage vary over time or has it been relatively stable?

7. How does the fund's leverage metric compare with similar strategy hedge funds?

8. How does the fund' return compare with similarly leveraged peers?

9. Does the fund's risk management policy address leverage?

10. Does the fund plan to do anything different going forward that would materially impact leverage? If so, why and what policy changes will occur as a result?