Unlocking Pension Funds for Impact Investing
In October 2015, the impact investing industry took a momentous step forward.
Department of Labor Secretary Thomas Perez repealed restrictive guidance that prevented pension funds from engaging in impact investing. In doing so, the Secretary sent a clear signal that pension funds may consider environmental, social, and governance factors when making investments, and explicitly recognized that such factors can be key to maximizing long-term returns for pension fund beneficiaries.
For the first time since 2008, when pension plan managers evaluate comparable investment options, they can consider whether an investment may positively impact the community. This shift paves the way for organizations to advance their social responsibility goals, and it unlocks capital for entrepreneurs and businesses focused on social change.
Background: Forty Years of ERISA
The Employee Retirement Income Security Act of 1974 (ERISA) is a federal law that sets minimum standards for most voluntarily established pension and health plans in private industry to provide protection for individuals in these plans. ERISA requires plans to provide participants with plan information, including important information about features and funding; establishes fiduciary duties for those who manage and control plan assets; requires plans to establish a grievance and appeals process for participants to obtain benefits from their plans; and gives participants the right to sue for benefits and breaches of fiduciary duty.1 2 © 2016 EMPEA ERISA is enforced by the U.S. Department of Labor (DOL), which interprets the law and provides guidance on its application to investment fiduciaries and plan participants. Under ERISA, employee pension plan managers must make decisions that minimize risk of large losses and exclusively benefit plan participants and their beneficiaries. At the time it was enacted, ERISA considered investment in privately held companies to be inherently high-risk, which restricted access to a significant asset class and negatively impacted fund returns
Over the years, the DOL has issued a number of Interpretive Bulletins that are intended to clarify ERISA’s fiduciary rules regarding the qualification and selection of pension plan investments. In the late 1970s, the DOL issued an amendment to ERISA’s so-called “prudent man rule” and allowed pension plans to invest up to 10% of their assets in venture funds and private equity. This change invigorated the investment community and paved the way for rapid growth across numerous sectors of the economy—and was extremely lucrative for pensioners, as well.
1994: The “All Things Being Equal Test”
In 1994, the DOL further broadened opportunities for pension plan investments by clarifying how ERISA’s fiduciary rules apply to the practice of economically targeted investing (ETI).2 Like standard investments, ETIs prioritize financial return, but they may also offer environmental, social, or governance benefits for society at large. In its expanded interpretation of ERISA, the DOL stated that ETIs are not incompatible with ERISA’s fiduciary obligations. In fact, ERISA requirements do not prevent plan fiduciaries from investing in ETIs if the ETI is aligned with the investment policy of the plan and the expected rate of return is on par with comparable alternatives. The result was that pension plan managers could include investments in their portfolio that also aligned with their organization’s social responsibility objectives.
2008: A Step Backwards
During the economic downturn of 2008, another Interpretive Bulletin was issued that modified the DOL’s earlier stance.3 It stated that pension plan fiduciaries may not prioritize non-economic objectives over an investment’s return, and they may not make decisions based on factors that do not directly impact the plan’s economic interests, except under rare circumstances and with specific documentation. Fiduciaries were advised against pursuing investment strategies that consider environmental, social, or governance factors, even when used to evaluate economic risk and return against other investments. This change sent a chilling message to pension plan managers and slowed the momentum of impact investment adoption.
Numerous stakeholders—investors, entrepreneurs, policymakers, and advisory organizations—have since worked toward policy reform that removes barriers to impact investing, such as ERISA’s 2008 modification. In particular, the US National Advisory Board for Impact Investing (US NAB) advocates for opportunities that tap the power of markets to solve social problems. The US NAB, comprised of leaders from the impact investing community, was co-chaired by Matt Bannick of Omidyar Network and Tracy Palandjian from Social Finance, and is now led by Darren Walker from the Ford Foundation. Last year, the organization issued a comprehensive report entitled “Private Capital, Public Good: How Smart Federal Policy Can Galvanize Impact Investing” that has fueled the conversation around ERISA and its negative effect on impact investing.
Today: A New Era for “Win-Win” Investments
The DOL’s latest Interpretive Bulletin has again cleared the way for pension plan investments that provide both economic and social benefit.4 Under the leadership of Secretary Perez, the DOL has reconsidered its 2008 guidance and concluded that it unduly discouraged pension plan fiduciaries from considering ETIs as part of their investment portfolio.
Secretary Perez states that the new guidance “confirms the department’s long-standing view, as laid out in the 1994 interpretation, that fiduciaries may take social impact into account as ‘tie-breakers’ when investments are otherwise equal with respect to their economic and financial characteristics.” The new bulletin makes it clear that once the economic merits of an investment are established, plan managers may consider socially beneficial factors and remain compliant with ERISA’s fiduciary obligations.
In addition, the DOL confirms that ERISA does not regulate how fiduciaries apply social, environmental, or governance factors in their evaluation of an investment. Pension plan managers are free to determine the appropriate criteria, tools, metrics, and analyses used to evaluate an investment’s social benefit, as well as its risk or return as compared to equivalent investments. Plan managers are also no longer required to supply additional documentation or evaluation beyond standard fiduciary requirements.
Perhaps most significantly, the DOL’s new bulletin acknowledges that environmental, social, and governance issues may have a direct relationship to the economic value of an investment, and thus can be appropriate factors in evaluating the economic merits of competing investment options. In these cases, social responsibility factors are not simply “tie-breakers” that influence decision-making between otherwise equal investments, but are actually inherent to the economic success of the investment itself. This speaks to the heart of impact investing.
The US NAB and impact investing community believe that moving from a narrow focus on short-term returns to a wider perspective that takes social, environmental, and governance factors into account will produce sustainable, positive long-term results for both individuals and societies.
The Sweet Spot: Investment + Social Results
Investors, entrepreneurs, and pension plan participants can look forward to increased opportunities for driving both investment returns and positive social change. As Secretary Perez states, “Today, we finally catch up to the breathtaking change we’ve seen in this space over the last few decades. By restoring the 1994 guidance, we bring ERISA investors together with economically targeted investment opportunities—allowing the capital to meet the opportunity, allowing the money to meet the marketplace.”5
About the Author
Will Fitzpatrick is Council to Omidyar Network