Environmental, social and governance are words you might have heard a lot about lately. Ontario legislators now require pension plan administrators to disclose if and how they’re incorporating them into their investment decision-making process. Due to previous adoption, foundations, endowments and religiously-affiliated investors have plenty of experience in the matter, but many institutional investors are wondering how they’ll satisfy the new requirement.
Not long ago, the message from legislators was clear and unambiguous. The law stipulates, through the Income Tax Act, that the primary purpose of registered tax-exempt pension plans is to provide lifetime pensions. However, when it comes to investing the plan assets, the law hasn’t traditionally said much.
Plan administrators have a good understanding of the the prudent investor rule. The challenge now is to reconcile their long-standing investment approach with the new disclosure requirements. How will they affect results over the long term? That’s just one of the questions amid the debate over how the regulator’s requirement reconciles with Ontario pension plans’ primary responsibility to maximize returns for the benefit of their members and beneficiaries.
What has changed?
While the investment process has incorporated environmental, social and governance factors for years, much of the recent discussion has been around at what level it should do so. At the business level, there has long been an understanding that environmental, social and governance factors have a material impact on performance and share price. Company executives who aren’t giving them proper attention (or adopting tactics to avoid them in order to pass the cost on to society) can and will experience detrimental consequences. Examples abound where such irresponsible behaviour has destroyed the environment, caused public relations to deteriorate and reduced demand for the product or service the firm is offering. That’s in addition to the legal action offenders may face.
The firm’s executives must balance the tradeoff between managing these factors and remaining competitive. Importantly, as stakeholders take interest and apply greater scrutiny to these issues, it puts pressure on the company to improve its standards. The spotlight gives executives a bigger payoff from tackling and mitigating those issues, which allows them to justify the allocation of resources to the shareholders they answer to.
For some time, money managers investing in companies have also been considering environmental, social and governance factors when making investment decisions. It’s short-sighted to evaluate the prospects for a company without considering such aspects as the potential litigation costs and the long-term impact on the society they’re a part of.
Given the societal context that lends support to responsible investing, legislators are, not surprisingly, pondering whether environmental, social and governance factors are in the best interest of pension beneficiaries. Hence, the recent requirements that took effect earlier this year.
What do I need to do?
Committees must consider what the requirements mean and how to react to the new legislation, which is where we turn to the regulator for guidance. In its guidance, the Financial Services Commission of Ontario makes clear that “all investment decisions that are made by the administrator (or its delegates), including the decision whether to incorporate ESG factors, must be made in accordance with the administrator’s fiduciary duties.”
The first hurdle relates to defining environmental, social and governance factors. Neither Ontario’s Pension Benefits Act, nor the regulations define the term. FSCO expects you, as an administrator, to define what the term means to you before disclosing your policy toward investing the plan assets around the defined factors.
FSCO goes on to stress caution “to ensure that its approach to incorporating ESG factors does not conflict with its fiduciary duty, as may be the case with ethical screens.” Your duty as fiduciary is to act in the best interest of the beneficiaries. What FSCO is suggesting in interpreting the legislation is that investing with other goals in mind, as noble and moral as they may be, creates a conflict of interest — perceived or real — that you must disclose to the beneficiaries.
By disclosing whether the plan administrator is using the plan assets to further some secondary objective other than simply providing retirement benefits, we’re aligning with the beneficiaries’ right to know.
The bottom line
When you’re a pension administrator making decisions on behalf of the members, you have a fiduciary responsibility to serve members and do what’s best for their retirement. You may feel the move by Ontario regulators is an endorsement to invest with your moral compass, but that’s not the case. Don’t confuse this disclosure requirement with the requirement to act. Your investment responsibilities haven’t changed.