Ben & Jerry’s decision not to sell their ice cream in Israeli-occupied West Bank and east Jerusalem has led to many protests, including some pension funds weighing divestment from parent company Unilever. Here, we dig into the complicated mechanics of pension fund activism:

Public pension fund managers have a legal duty to steadily improve the value of contributions made by public workers and their employers — this is accomplished by making long-term investment decisions that generate maximum investment returns. This is often referred to as “fiduciary duty.” For example, it may be more prudent to invest in a group of 30-year bonds with predictable, modest returns than to invest in a high-risk private equity fund that claims it can provide 10% returns within the next five years.

There are many decisions to make when deciding how to best manage public workers’ money, but the political and social interests of those employees, or the lawmakers who oversee the retirement systems, shouldn’t be a factor when setting investment strategy.

Despite that, many have tried to use pension funds to bring about social, cultural, and political change through a process known as activist investing. In this article, we’ll explain what pension fund activism is, why most states should be wary of it, and the few examples of when it might be acceptable.

What is Pension Fund Activism and How Does it Work?

There are two main forms of pension fund activism: divestment and shareholder action.

Divestment is when a fund sells off any shares or assets in a particular entity—the opposite of investment. This can happen when money managers disapprove of a particular company’s practices, are opposed to an industry, or as a form of protest against a country with ties to a company a fund might have invested in.

One recent example of this has been the divestment of fossil fuel stocks, which more pension funds have engaged in as the effects of climate change have become more apparent across the world. New York State, New York City, the Church of England, San Francisco, and Sweden are just a few entities that have committed to divesting billions of dollars from such companies in favor of alternative energy stocks.

Many of those funds made the decision not from an investment strategy standpoint, but in an effort to reduce their carbon footprint and tackle global warming. The nations on that list decided to do so after joining The Paris Climate Agreement—an international treaty that seeks to have major countries limit global warming by decreasing greenhouse gas emissions.

Some pension funds have also sought to accomplish social goals through shareholder activism. This is when a pension fund holds onto their assets in a company and uses their position as a powerful shareholder to advocate for a desired change.

The California Public Employees’ Retirement System (CalPERS) did this in 2017 when it used its $1 billion in holdings in ExxonMobil stocks to force the oil and gas company to report on environmental risks associated with climate change. Other pension funds have done the same in an effort to increase the gender and racial diversity of companies’ boards of directors.

Activist Investing is Nothing New

Although the rise of climate change advocacy and Black Lives Matter may have put investment activism into the spotlight, the practice has been going on for quite some time. Institutional investors, such as pension funds, in the 1980s began to use their clout to pressure companies into appointing independent directors to oversee issues such as auditing, according to a study in The Journal of Financial Economics.

The researchers found the practice was efficient in implementing such changes, and added the funds appeared to have no other motivation for seeking the alterations other than fund value maximization — or to increase the value of the company they had invested in so they could provide a stronger investment return for their members.

Social activism, though, wasn’t uncommon at the time. State funds in the 1980s sold off investments in companies tied to South Africa to protest apartheid. Similarly, many funds did the same for companies connected to governments suspected of sponsoring terrorist activities following the Sept. 11 attacks.

The 1990s and early 2000s also saw some funds divest from tobacco stocks after cigarette companies were sued for covering up the dangers of smoking, with the biggest one being CalPERS in 2001.

In recent years, pension funds have since faced growing calls not only to divest from fossil fuel stocks and companies that fail to tackle issues associated with institutional racism, but also to sell off any investments tied to firearm companies in light of growing gun violence across the United States.

Why It Might Hurt States in the Long Run

The reasons for pension fund activism may be justified in principle and socially worthwhile. However, the job of a state pension fund chief investment officer is not to be a climate activist or advocate for any other social cause. Their fiduciary duty is to represent the financial interests of public employees’ assets. That is accomplished by making wise investment choices that may sometimes be socially or politically unpopular.

There have been some cases where socially-driven investments decisions have hurt a pension fund—and that has arguably violated the fiduciary duty to generate long-term returns for retirees and active members. For example, CalPERS had determined it had missed out on some $3 billion in returns after its decision to divest from tobacco stocks. The value of state pension plans with divestment requirements are also, on average, 0.4% lower than states without such requirements, according to a study from The Center for Retirement Research at Boston College.

Some have been able to stand up to this pressure. New Jersey Gov. Phil Murphy in 2019 vetoed a bill that would’ve limited the state’s pension plan’s ability to invest in private real estate and private equity. In his veto message, Murphy said the bill could’ve saddled the state with increased fees, and reduced returns for the plan.

Before deciding to do so in late 2020, New York State Comptroller Tom DiNapoli for years fought back against a campaign for the state to divest from oil and gas companies, because he said doing so would have jeopardized the pension fund’s overall health at the time. In the next section, we’ll explain why his reversal could be justified from an investment strategy standpoint.

Sticking to investments with long-term returns is especially vital given that unfunded liabilities across all plans stand at $1.34 trillion, according to Equable’s State of Pensions 2020 December update. Many states are already struggling to close that gap, and divesting from stocks that could generate much-needed long-term returns only serves to make that more difficult.

When Should Pension Funds Engage in Activism Through Divestment?

So should pension funds never engage in activism of any kind? The answer’s complicated and depends on a variety of factors that differ from state-to-state.

When it comes to the divesting from fossil fuels, it can now be squared with a money manager’s duty to grow public workers’ contributions. That’s because at the same time oil and gas stocks are falling, and now seen as poor long-term bets for many investors, investments in alternative energy are now seen as wise, long-term strategies that can maximize returns for pension funds.

This may not have been seen as a wise decision 10 years ago, though, when people like DiNapoli first started facing calls to divest from fossil fuels. The only reason why it’s justified today—from an investment standpoint—is because there are now alternative stocks that can better serve the financial interests of those enrolled in the NYS Common Retirement Fund. An argument could also be made that the implications of climate change on the global economy is also a good reason to divest from fossil fuels, though a focus on investment returns should take precedence over social views.

Other divestment strategies are more complex. Take for example an Indiana bill that would pull the state’s retirement system’s assets out of any company based in China, as well as bar any investments in a company in which China has any direct or indirect economic interest, or has a resident of China (even if they’re a U.S. citizen) on their board of directors.

It would be very difficult to find an investment strategy that could replace the loss on returns generated from the world’s second-largest economy. That said, political concerns about Chinese firms posing a national security threat could reasonably lead a pension fund to not invest or divest on the grounds that there’s too much uncertainty related to forecasted investment returns. State pension boards could withdraw private equity funds from Chinese companies if a forecast about Sino-U.S. relations getting more fraught turns out to be correct.

But those decisions should be made from a financial standpoint and not a political one. And if under those terms a state like Indiana wants to pull its investments from Chinese companies, it needs to find an investment strategy with equal risk and equal prospective returns.

Shareholder Activism: A Rare Success Story 

While shareholder activism poses less investment risk to pension funds, it’s rare that most would be able to obtain the desired change from a company or sector. This is usually limited to states with very large funds with sizable investments—California and New York being the biggest examples.

Both states have previously used their large shares in companies like ExxonMobil, Hewlett-Packard and JPMorgan Chase to replace directors on the companies’ boards and replace them with their preferred picks. In many of those cases, the investors cited concerns of over-sized pay and poor returns as their reasoning for the ouster of certain directors. From a financial standpoint, the pension funds are acting in their official capacity when doing this because they’re looking out for the long-term health of their investments.

When politics or social views get incorporated, though, it becomes more complex. New York City’s pension system has explicitly said it would use its stake in some companies to increase the gender/racial diversity of companies’ boards, which, again, is a laudable objective—but one that is not the responsibility of the fund.

Furthermore, outside of California and New York, there are very few funds that likely have large enough investments in companies to bring about substantial change. A private investor would have more power to bring about these desired outcomes.

Pension Funds Should Educate Their Enrollees on its Decisions

State retirement systems represent millions of public workers, each with a unique set of political and social views. Although New York is a reliably Democratic state, many enrollees might not find issues like climate change or gun control a good enough reason to divest from certain stocks. On the other hand, some might not care about the financial implications of divesting from certain stocks because they care so passionately about a particular issue.

To this end, there needs to be informed consent on behalf of the fund’s enrollees. In most cases, these people find out what’s happening with their pension dollars from headlines and have no say on the matter. Partners should communicate with each other before making significant purchases, like buying property, and retirement systems should let their members know what’s happening with money that’s taken out of their paycheck.

Members need to have the choice to vote on divestment proposals, and accept the financial implications if their fund’s can’t find a suitable alternative investment with comparable returns. They also need to be aware that any choice to divest that leads to an underperforming fund could result in higher contributions taken out of their paychecks, fewer cost-of-living adjustments, and increased state and local taxes.