Pension funds could be a formidable force in getting companies to embrace environmental, social, and governance (ESG) values such as combating climate change or advancing employment equity. Yet such funds must align those goals with their fiduciary duty of protecting the retirement funds of their members. In the U.S., they must also overcome challenges such as gaps in ESG adoption metrics and ambiguity about government rules on such investing. Those were the key takeaways from a two-day conference this spring organized by Wharton’s Pension Research Council, “Sustainable Investment in Retirement Plans: Challenges and Opportunities.”

Sufficient momentum exists: Sustainable investing in the U.S. has grown dramatically over the past 25 years, and $17 trillion — or a third — of the $51 trillion in U.S.-domiciled assets under management are sustainable assets, according to a 2020 report from the U.S. SIF Foundation on trends in sustainable and impact investing. Total assets incorporating ESG principles managed by U.S. institutional investors have also grown appreciably over the years, to $6.2 trillion as of 2020, according to the report.

“Battles rage over how we should define ESG criteria when shaping pension decisions,” said professor Olivia Mitchell.

Investment policies related to climate change and conflict risks in terrorist or repressive regimes have recently been among the top concerns of investors, followed by tobacco use, corporate governance, and sustainable practices in natural resources and agriculture. Nevertheless, investor appetites for ESG principles swing between extremes. “There are many different viewpoints in this debate, and battles rage over how we should define and think about ESG criteria when shaping pension decisions,” said Wharton professor Olivia Mitchell, executive director of the Pension Research Council, in her opening remarks at the conference.

Values vs. Value

A major issue in the realm of ESG investing is determining whether investors are pursuing “values,” such as protecting the environment or working to control gun violence, or “value,” as in protecting the profits from their investments, according to Wharton management professor Witold Henisz, director of the Wharton Political Risk Lab and founder of the ESG Analytics Lab at the School.

He noted that estimates of assets under management that claim commitment to ESG principles range from between a few trillion dollars and $30 trillion to $40 trillion. “That’s astounding, and it could be revolutionary,” he said. “It could help us deal with things like climate risk, racial justice, social justice, and other issues.” On the flip side, “Maybe there really aren’t $30 trillion to $40 trillion of assets chasing ESG, and maybe they’re confused. And some of that confusion relates to what they actually mean by ESG. Do they mean ‘value,’ or do they mean ‘values’? Are they investing for higher returns, or are they investing according to some social or environmental outcomes?”

Justifying ESG investing hasn’t been easy for pension funds and their trustees, said Amy O’Brien, global head of responsible investing at Nuveen, an asset management firm that’s a subsidiary of TIAA: “It’s been hard in some cases to make the business case [for ESG investing]. A lot of pension funds have struggled, at the board level, in finding that right balance between social responsibility and the fiduciary duty to act to maximize return on behalf of our participants.”

Despite this tension, pension funds are ultimately ideally positioned to incorporate ESG, according to conference participants Stéphanie Lachance, managing director of responsible investment at the Public Sector Pension Investment Board in Canada, and Judith Stroehle, senior research fellow at the University of Oxford’s Saïd Business School. “The inherent long-term investment time horizon and the diversified portfolio structures are often seen as the two … principal ESG enablers in pension funds,” they wrote in their paper “The Origins of ESG in Pensions: Strategies and Outcomes.”

Finding the Right Opportunities

For investors, identifying corporations that espouse and act in accordance with ESG principles is a challenge. ESG ratings vary widely, for instance: It’s not uncommon for a company to receive a high ESG rating on some criteria but a low score in others. Investor estimates of expected returns also vary by the metrics they use. “Companies that can be in the top 10 percent for one rater may be in the bottom 10 percent for another rater,” said Roberto Rigobon, professor at the MIT Sloan School of Management and co-director of the school’s Sustainability Initiative. “This creates a complication when you’re trying to decide how to construct a portfolio.”

“The key to cutting through a lot of the confusion is to understand what your objective is as an investor, which may be different from another investor,” said Linda-Eling Lee, head of research for the ESG research group at MSCI, a provider of investment data and analytics services. “Yes, ESG has multiple different dimensions. For example, one of those dimensions can reflect personal values, which are idiosyncratic to the investor.” ESG data points should be viewed as “ingredients that can be assembled to capture different dimensions of ESG,” Lee said. “However, because these are multi-dimensional, you can’t reflect all of the different dimensions at the same time in a single score or one single rating.”

That said, ESG ratings are strongly indicative of how well companies do on several fronts, according to Lee. “We have found that over our 13-year history of ESG ratings, companies with higher ratings are more competitive than their industry peers,” she said. “They tend to have higher profitability, and they pay greater dividends over time. On downside risks, we have been able to find evidence very consistently across different markets and across different time periods that ESG ratings can approximate inferior risk management that can precipitate negative events. We found that the lowest-rated companies over the next three years are three times more likely to experience a very severe stock price drawdown compared to their highest-rated peers.”

Stock prices of companies with high ESG ratings have also shown lower volatility, and such stocks have tended to be potentially less susceptible to systemic shocks in the economy, Lee added: “That was demonstrated in part last year through the COVID crisis, where we did see higher-rated companies perform better, and they were more resilient.” Nevertheless, investment performance over a 13-year period may not predict the future with a great deal of accuracy.

The Challenge With Data

Much can be achieved if data models that capture ESG values and value are refined, Henisz said: “We need third-party validation of proprietary data. We need to prove or test whether ESG investments pay. And when they pay, when do they impact growth? When do they impact cost reductions, productivity uplift, and idiosyncratic or systemic risks? What are the contingencies that drive that? Investor demand? Asset manager incentives, stakeholder interest, the availability of technological options, anti-competitive barriers in the industry, or corporate enterprise risk management? We need to undertake this kind of rigorous assumption using model uncertainty analysis of all ESG studies.”

Even the studies that use the best available data aren’t convincing skeptics, according to Henisz: “The time horizons aren’t long enough, the assumptions aren’t clear, and the processes aren’t transparent. We need to have good data, but we also need to make progress from where we are if we’re going to mainstream this [pursuit of ESG values].”

Pressure from investors “drives change in companies, and it drives value,” said professor Witold Henisz.

“What pension funds want is investments that will do well in the long run, but ESG metrics aren’t necessarily focused on long-run resiliency,” said Mitchell.

Lee acknowledged the need to gather more and better data on ESG adherence by companies. She noted a common perception that ESG data consists primarily of corporate disclosure: “That’s simply not true. We still need to be developing a lot of alternative data sources on ESG information about companies.”

Pressure to Change

Several pension funds and other industry participants have taken decisive steps to persuade companies to commit themselves to ESG principles. For instance, two New York City pension funds recently moved to divest from fossil fuel companies. BlackRock, the world’s largest asset manager, announced that in 2020, it had achieved its goal of having 100 percent of its active and advisory portfolios ESG-integrated. BlackRock CEO Larry Fink also went a step further, asking companies “to disclose a plan for how their business model will be compatible with a net zero economy.”

Such pressure from investors actually works, said Henisz: “It drives change in companies, and it drives value.” However, that terrain can be expensive for investors in terms of fees, he noted, pointing out that while average fees are trending down for mutual funds and ETFs, that’s not the case with funds that pursue “engagement” on ESG principles with companies.

“During times of cost pressure on portfolio managers, it’s easier for fund consultants to highlight the higher cost of ESG, rather than values,” Mitchell noted.

Regulatory Ambiguity

Pension funds also have to overcome governmental challenges before they can embrace ESG investing. As of 2018, only 2.8 percent of 401(k) plans offered an ESG fund option, according to Billy Nauman, a Financial Times reporter and producer of Moral Money, an FT newsletter on ESG and impact investing trends. That low participation can be traced to the changing stances of the U.S. Department of Labor on the appropriateness of social investing in private defined-benefit plans covered by the Employee Retirement Income Security Act of 1974 (ERISA). The most recent rule change came in late 2020, when the department held retirement-plan fiduciaries to a “pecuniary” standard when selecting plan investment options; it didn’t ultimately mention ESG funds specifically. The Biden administration has promised a review of that rule.

“Historically, it’s been unclear how ESG is perceived under ERISA,” said Nauman. “Across administrations, from the Obama administration and now even still, under Biden, it’s murky. And investors or investment management companies aren’t going to jump in until there’s clarity that these products can and will be used and they won’t get sued. Until there’s more clarity around how exactly these will be handled by the regulators in the U.S., we’re stuck in a holding pattern.” [Editor’s note: Following publication, the U.S. Department of Labor on October 13 proposed amending ERISA to enable fiduciaries to consider ESG factors when choosing investments and exercising shareholder rights.]


Published as “A Sound Strategy for Sustainable Investing?” in the Fall/Winter 2021 issue of  Wharton Magazine.