Does Investing in ESG Hurt Pension Plans?
Studies focused on public pensions do not tell us much about 401(k)s and ESG.
Earlier this month, I had the privilege of testifying in front of the House Education and Labor Subcommittee on Health, Employment, Labor, and Pensions, which convened to clarify regulations on how 401(k) plans (among other Erisa-covered plans) should consider environmental, social, and governance information in selecting their investments.
Members of Congress (and a witness) skeptical of ESG investing repeatedly cited a study from the Center for Retirement Research at Boston College to bolster their view that ESG investing would hurt 401(k) plan participants. The paper claims that "state mandates and ESG policies reduce returns by 70 to 90 basis points" in public pension plans.
While interesting, the Boston College paper does not offer the kind of evidence that critics of ESG investing suggest it does. In large part, this is because public pension plans have a variety of investment mandates that do not reflect the kind of the ESG analysis that private plans might wish to use if given more regulatory clarity.
Despite the shocking top-level results, the findings do not support the notion that 401(k) plans should avoid considering ESG information. We continue to believe that it will help participants if the Labor Department adjusts regulations to clarify the role of ESG in 401(k) and other defined-contribution plans.
The key issue is that the Center for Retirement Research paper treats state mandates (such as divesting from tobacco companies) and approaches that incorporate ESG analysis to maximize risk-adjusted returns as the same. Further, the study does not provide evidence that retirement plans deliberately incorporating ESG information and analysis to maximize risk-adjusted returns and avoid ESG risks have in fact performed worse than plans that do not.
The authors do try to draw a distinction between ESG policy and ESG mandates at times in their paper, but even in that variable they concede that "ESG policies for public plans run the gamut," meaning they capture a variety of approaches. They also find that only 8.5% of plans (out of a sample of just 176 plans) offer ESG-only policies, so they may not have had enough variation to draw their conclusions.
This study is also very out-of-step with other findings on ESG and returns. For example, Morningstar's 2021 Sustainable Funds U.S. Landscape Report, which was published in January 2022, found that slightly more than half of sustainable funds--which use ESG information to inform investing—finished in the top half of their Morningstar Category. In previous years, we found that sustainable funds were considerably more likely than similar conventional funds to perform in the top half or quartile of their category.
Similarly, I find that a more-precise measure of ESG investing shows no difference in returns between public pension plans. To its credit, the Center for Retirement Research at Boston College makes its database on public pension plan returns available for research. Using this database, I examined plans that had signed the Principles for Responsible Investment, in which signatories acknowledge that "ESG issues can affect the performance of investment portfolios" and commit "to incorporate ESG issues into investment analysis and decision-making processes." I found that the five- and 10-year returns for plans that have signed the PRI and those that have not were quite similar. I looked at these results using an asset-weighted approach, a straight average, and an ordinary least squares regression controlling for the allocation to fixed income and the natural log of a plan's assets.
The results are easy to summarize: There was scarcely a difference in returns. The results were not practically significant, and they certainly weren't statistically significant. Many of these plans signed the principles recently, so we may need to wait longer for more evidence on some of these points. However, plans that have moved toward incorporating more ESG information into their investing approaches have not sacrificed returns.
Private-sector plan sponsors appear to have shied away from considering ESG information and analysis, in part because of regulatory uncertainty.
In doing so, sponsors have left the U.S. defined-contribution system tilted toward investments with more ESG risks. Specifically, in our Retirement Plan Landscape Report we found that just 4% of investment options and 2% of assets are in strategies with the lowest levels of ESG risk, but 10% of all strategies rated by Morningstar are in this category.
Unless retirement plan sponsors are convinced that ESG risks are overstated, they may wish to re-examine their investment choices using an ESG lens. In sum, regulatory uncertainty appears to have a real-world impact--exposing retirement savers to more risks than might be prudent. Further, the evidence that skeptics provide to show that plans should not consider ESG information does not appear to hold up.