The images of floods, forest fires and heat waves over the past few years is putting climate change front of mind for many, including pension plan sponsors and administrators.
It’s become increasingly clear that environmental, social and governance factors are emerging as an important area of concern for pension plan administrators and, by extension, the boards and pension committees that exercise oversight over the investment of the assets of employer-sponsored pension plans.
Ontario is currently the only Canadian jurisdiction with a statutorily-mandated ESG disclosure requirement — it requires the statement of investment policies and procedures for the pension plan to disclose whether ESG factors are incorporated into the plan’s investment strategy and, if so, how it’s done.
The federal government has signaled that it’s studying measures to encourage federally regulated pension plans to consider ESG factors in their SIPP, including the possibility of a similar requirement for federally regulated plans to disclose through their investment and risk management strategies whether, and how, they consider ESG issues.
Perhaps most significantly, the Canadian Association of Pension Supervisory Authorities has formed a committee focused on integrating ESG factors in pension plan supervision. Its mandate is to develop a principles-based guideline on the integration (i.e., the interpretation, role and use) of ESG factors in pension fund investment and risk management. Like other guidance from the association on pension plan governance and prudent investment practices, the new guidance on ESG factors — which is expected to be released in 2022 — is likely to be very influential in terms of providing guidance to pension plan administrators on how they should approach ESG risks and opportunities and clarifying how ESG is part of the fiduciary framework within which they operate.
When the Ontario requirement to address whether and how ESG factors are incorporated in the SIPP was introduced in 2016, the Ontario pension regulator released guidance on meeting the new requirement, which addressed issues like what’s meant by the term ESG factors, possible approaches to incorporating ESG factors and what the regulator’s expectations were in terms of meeting the new requirement in both scenarios — i.e., when ESG factors aren’t incorporated and when they are.
The guidance was admittedly broad, given that it wasn’t intended to prescribe the approach that plan administrators should take on this issue, but instead emphasized the need for expert advice and the overall context of meeting the plan administrator’s standard of prudence in investment, including the administrator’s responsibility to understand, monitor and mitigate risk.
While administrators were encouraged by the Ontario regulator to document their decisions and approach on integrating ESG factors, some plan administrators viewed it merely as a statement to include in their SIPP rather than an integral part of their investment strategy or investment manager selection process. Of course, the large institutional pension funds, cognizant of the investment risks and opportunities associated with ESG issues, already had well developed policies and processes in this area.
There’s now a growing awareness of the broad economic risks posed by climate change as well as considerable evidence of a correlation between strong ESG performance and positive financial returns. In January of this year, the Office of the Superintendent of Financial Institutions released a discussion paper on navigating uncertainty amid climate change, which identified a number of climate-related risks, including physical, transition and liability risks that create various financial risks for pension plans which in turn may affect the performance of a pension fund’s investment portfolio.
In addition, many plan administrators can now conceive of a situation where they could face claims arising from plan members — and potential liability for — the failure to take material ESG risks into account. Such risks will likely include, but not be limited to, climate change-related risks.
With new regulatory guidance on the horizon and an increasing regulatory emphasis on risk management, now’s the time for a more thoughtful approach to the integration of ESG factors. For some plan administrators, the starting point may be tabling ESG as an agenda item at the pension committee or board level and seeking expert guidance on ESG investment processes, data and strategies as they relate to the pension plan.
It may also mean engaging in a fact-finding process with their external investment managers to understand the ESG strategies and processes their investment managers currently employ. With a greater understanding of the implications of ESG and the various approaches that may be adopted to address ESG factors, plan administrators will be in a better position to articulate a clearly defined ESG policy for the pension plan.
Once the administrator develops an ESG policy or framework for the pension plan, like other components of the SIPP, the policy should then be documented and monitored. Documenting the plan administrator’s decision as to which ESG factors will be considered and how they’ll be applied to the investment process and investment decisions demonstrates prudence on the part of the plan administrator. Ensuring the policy is capable of being adhered to by the administrators and its delegates (i.e., external investment managers) and is implemented consistently is sound pension governance and contributes towards effective risk management.
If a plan administrator provides transparency to members around this issue and discloses how ESG factors and strategies are being applied within the context of making investment decisions for the pension plan, it may help to avoid the significant reputational risk that can arise from plan member concerns, or legal claims, that ESG considerations haven’t been properly taken into account.
Ultimately, the plan administrator is responsible for the prudent investment and management of the pension fund and is subject to a fiduciary duty of care to act in the best interests of plan members and beneficiaries. Within this context, it’s difficult to see how some application of ESG factors can be ignored.