A major barrier to understanding the legal obligation of pension fund fiduciaries relating to ESG integration seems to be the confusing language that shades the boundary between taking into account or engaging on financially relevant ESG factors on the one hand and promoting ethical or social behaviour for its own sake on the other. The law however is relatively clear.
If ESG factors relate to financial performance or financial risk mitigation, taking them into account is not only allowable, but may be legally required.
The legal analysis starts with purpose. The purpose of a pension fund is to provide financial benefits in the form of lifetime retirement income security. Accordingly, where ESG factors are relevant to that purpose — financial risk or reward — they are proper components of the fiduciary’s analysis of competing investment choices.
In that context, they are not merely collateral considerations or tie-breakers. Indeed, ignoring ESG factors that are relevant to financial purpose, may be a violation of fiduciary duty.
For that reason it may not be helpful to refer to ESG factors as “non-financial” factors. This is because if ESG factors are not financial factors, then they cannot be advancing the primary purpose of a pension plan to provide financial benefits in the form of lifetime retirement income. Generally, non-financial factors shouldn’t be considered. But when ESG factors inform financial performance assessment, sustainability or risk, they are ipso facto financial factors and can be, and where they are known and relevant, must be taken into account by pension fund fiduciaries.
But what about the non-financial interests of the beneficiaries? What about a plan for the Cancer Society or some other socially engaged enterprise?
One of the hallmarks of fiduciary or trust law is to treat the interests of the beneficiaries as paramount. But this does not mean pension fiduciaries may exercise their investment discretion to take into account non-economic factors, whether by presumption or even by reaching out and conducting a vote or survey of plan participants.
By way of example, one cannot presume that a pension fund for employees of the Cancer Society or the Heart and Stroke Foundation can simply adopt an investment policy to exclude investment in tobacco products.
It is one thing to ban tobacco investment by the Cancer Society in relation to its donated funds, since the purpose of those funds is to support the goals of the Society, i.e., to reduce the incidence and impact of cancer. It is quite another thing for the Cancer Society’s pension fund to adopt such an investment policy for its pension fund. That’s because the primary purpose of the Society’s pension fund is not to reduce the incidence and impact of cancer, but rather to provide financial income security to its employees in retirement.
This is not to say that the Society’s main pension plan documents could not be drafted in such a way to impose such limits to achieve the other purpose; but that other purpose would have to be secondary, and it would have to be legally authorized by something other than an investment policy statement.
So how does that legal imperative fit with notions of principles of responsible investment, socially responsible investing, impact investing and broader ESG factor integration?
In situations where ESG considerations are used to enhance financial results or mitigate financial risk, ESG factor integration is not only consistent with fiduciary duty, but arguably is a requirement for proper discharge of fiduciary responsibility.
One significant problem in the discourse about ESG, has been the tendency to think about ESG factors as non-financial factors.
However significant advances in financial analysis research appears to demonstrate that a recalibration of the usual financial metrics is underway. One study conducted in 2015 that combined the findings of about 2,200 individual peer reviewed studies demonstrated that the business case for taking ESG into account in investing is empirically well founded.
Roughly 90 per cent of the researched studies found a non-negative relationship between ESG and corporate financial performance (predominantly measured by stock returns). The large majority of studies reported not only a positive correlation with returns, but that the positive ESG impact on corporate financial performance appeared to be stable over time.
Unfortunately, very few of these studies disentangle motive. But they do suggest that integrating ESG considerations into financial analysis results in strong empirical evidence of outperformance. In other words, ESG factors should be considered and used as financial factors.
On the other hand there are a few studies which have looked at investment results where the financial risk and return objectives appear to be secondary to achieving a positive social or environmental purpose.
Not surprisingly, where ESG factors are not taken into account as financial factors, but for other reasons, the results appear to be less consistent. Investment motivated by non-financial ESG considerations are a mixed bag of values based considerations and moral and philosophical perspectives, with focal points that relate to many different concerns such as climate, employment opportunity, human rights, or alleviation of poverty, and many include exclusionary perspectives on gambling, alcohol or tobacco.
Where the motives underlying ESG investment policy are primarily non-financial, it is not surprising that the empirical evidence, although difficult to isolate, provides a less clear-cut picture than it does for ESG integration motivated by financial goals.
Several jurisdictions are now considering or have passed legislation to require pension fund fiduciaries to indicate whether they consider ESG factors, and if so, how. One good piece of legal advice is never say “never”.
Pension fund fiduciaries who say such factors are never taken into account may simply be making an admission that they do not fully understand their legal duty as pension fund fiduciaries. And that is true even where the fiduciary is merely passively invested in mutual funds, including those adopted for money purchase arrangements. In that case the disclosure statement might be as simple as “We consider the extent to which our investment managers incorporate and engage on ESG factors, as one of many criteria in the investment manager selection process.”
As mentioned above there is no end of confusing language around ESG factor integration to the point that a fiduciary might conclude that a proper purpose is to promote ethical or socially responsible behaviour — when that is rarely going to be accepted as proper for pension fund fiduciaries.
On the other hand, pension fund fiduciaries are frequently able to achieve positive collateral effects by complying with their legal obligation to focus on using ESG factors to achieve financial purposes.
The bottom line is that a proper perspective on ESG for pension fiduciaries is one that sees it as financial insight. As a result, fiduciaries, fund managers and their consultants should be demanding better and more fulsome ESG disclosure.
They should also be considering appropriate ways to engage on ESG issues to enhance financial performance or manage financial risk. The motive ought to be to deal with ESG factors just like any other consideration in the financial risk-performance-assessment matrix.
Fiduciaries and their advisors who understand this will no doubt gain more confidence in devising and disclosing appropriate ESG investment policy that first and foremost serves their fiduciary duty to plan beneficiaries. And who knows, it may also have other collateral environmental or social benefits.
Randy Bauslaugh leads Canadian law firm McCarthy Tétrault’s national pensions, benefits and executive compensation practice in Toronto.
