ESG or politics in China-TSP investing halt?

The Trump administration has not embraced ESG investing much in recent years through guidance and executive orders. But industry experts note that it did use some ESG principles when directing the board overseeing the nation's largest retirement system to halt long-standing plans to shift federal employees' retirement assets into an index fund that includes Chinese companies.

Following two letters from administration officials on May 11 urging it to reverse course, the Federal Retirement Thrift Investment Board, Washington, voted unanimously on May 13 to pause the shift of the $593.7 billion Thrift Savings Plan's I Fund benchmark to the MSCI ACWI ex-U.S. Investible Market index from the MSCI EAFE index. Board members first approved the move in 2017 and reaffirmed the decision late last year.

The board oversees the TSP, the retirement system for 5.9 million federal employees and members of the uniformed services.

The new index would provide participants with greater exposure to emerging markets and Canada and offered a higher return/lower risk profile than the current index, Michael D. Kennedy, chairman of the FRTIB, told lawmakers last year after some raised objections.

TSP's I Fund had $54.3 billion in assets as of Dec. 31.

The letters — one from Larry Kudlow, director of the National Economic Council, and Robert O'Brien, national security adviser, to Labor Secretary Eugene Scalia, and the other from Mr. Scalia to the FRTIB's Mr. Kennedy — referenced "national security and humanitarian concerns for the United States" as reasons why the board should stop the shift.

In an email to Pensions & Investments, a Labor Department spokeswoman said the administration is concerned about inadequate investment disclosures and protections provided under Chinese law. Moreover, "national security concerns about certain Chinese companies increase the risk of sanctions, public protests, trade restrictions, boycotts, and other punitive measures that could jeopardize the companies' business and profitability."

The spokeswoman added: "These national security concerns carry particular weight in the unique context of a federal retirement plan that includes over a million uniformed military members."

The administration's citing of humanitarian concerns in the two letters, in particular, caught the attention of some in the ESG community.

"I would encourage the administration to think more holistically about ESG factors, not just related to China but related to climate, inequality, human rights, corporate governance," said Heather Slavkin Corzo, Washington-based head of U.S. policy for the Principles for Responsible Investing.

"It's good that they're using ESG principles here but … I have no confidence that this going to carry over into any of the other activities,"

Bryan McGannon, Washington-based director of policy and programs at US SIF: The Forum for Sustainable and Responsible Investment, said that while there were ESG principles — such as humanitarian and corporate governance concerns — referenced in the administration's letters, the motives were political.

"These political decisions are not about enhancing the value of the international fund and strengthening the value for the Thrift plan participants," Mr. McGannon said. "ESG considerations, on the other hand, are looking at these criteria in order to make those long-term value decisions."

George Michael Gerstein, co-chairman of the fiduciary governance group at Stradley Ronon Stevens & Young LLP in Washington, said public pressure on plan fiduciaries is not uncommon and it makes sense for board members to recalibrate their decision in light of the "apparent issues between the U.S. and China relationship right now."

"If it's being signaled that there are going to be issues in the foreseeable future, then … you can imagine that would make markets much more volatile; it may suppress equity values in China," Mr. Gerstein said.

Samuel Halpern, principal at Prudent Expert LLC, a sole proprietorship that specializes in expert witness and advisory services in Luray, Va., wondered whether other "plan fiduciaries making investment decisions should consider humanitarian concerns like the ones those letters cited." (See related Letter to the Editor, page 11.)

He also pointed to the Trump administration's ramped up criticism of the Chinese government in recent months and whether its direction to the board conflicts with the Thrift board's independence after its May 13 decision.

"My concern is whether the current instruction from the Trump administration and then the board's decision complying with it is consistent with long-standing principles of fiduciary responsibility in investment decision-making," he said.

When outlining why he felt it was prudent to pause the I Fund shift implementation, Mr. Kennedy, at the board's May 13 meeting, didn't reference the administration's letters but instead focused on the potential COVID-19 impacts on markets and newly nominated FRTIB members.

In early May, President Donald Trump nominated three people to the five-member board who could — if the nominees earn Senate confirmation — bring about a new majority.

Several current board members, including Mr. Kennedy, who would be replaced by one of Mr. Trump's nominees, said at the May 13 meeting that they'd like to defer the I Fund decision until the new board is confirmed.

No hearings for the nominees have been scheduled and the Senate calendar remains in flux due to the pandemic and the November elections.

The new index had an exposure of about 8% to Chinese companies as of Sept. 30, according to an Aon Hewitt Investment Consulting study presented to the board in October. Aon recommended the board switch to the MSCI ACWI ex-U.S. IMI index in 2017 and reiterated that recommendation in October. The current I Fund index has no exposure to China.

After bipartisan calls last year from Capitol Hill to reverse course on the I Fund shift, the board reaffirmed its 2017 decision. The planned I Fund shift implementation had been expected to start around June 1 and take about 90 days, Mr. Kennedy said at the May 13 meeting.

Now it's unclear when or if it will ever happen.

The White House did not respond to a request for comment on its views concerning ESG investing and the TSP decision.

When asked how retirement plan fiduciaries should weigh ESG principles when making investment decisions, the Labor Department spokesman said fiduciaries "can never sacrifice participants' financial interests to promote other non-pecuniary goals or considerations, but rather must act with undivided loyalty to the plan and its participants. The participants' financial interest in a secure retirement must always come first."

In 2018, the Labor Department published a field assistance bulletin on ESG investing that was similar to Obama administration-era guidance that said ESG issues can be material to investment performance in ERISA-governed plans.

However, the 2018 bulletin told plan fiduciaries to not "be too quick to assume that any ESG consideration is economic," explained Michael P. Kreps, Washington-based principal at Groom Law Group.

Mr. Gerstein added that the bulletin "cautioned fiduciaries from making too many assumptions or leaps of faith" when claiming their ESG investments are being made because of materiality.

The 2018 bulletin didn't "change anything substantially except for it put a little more caution into an already extremely cautious field in the 401(k) space so that (fiduciaries) may not even want to come close to incorporating ESG in these plans because of the threat of a lawsuit," Mr. McGannon said.

Added Ms. Slavkin Corzo: "What we've seen from the DOL is a clear attempt to put out policy that would have a chilling effect on fiduciaries with regard to ESG strategies."

Separately, Mr. Trump in 2019 signed an executive order directing the Labor Department to review energy investment trends in ERISA-covered plans and the department's proxy-voting guidance with the end goal of boosting U.S. production of crude oil and natural gas, Mr. Kreps said.

Matt Orsagh, Charlottesville, Va.-based senior director of capital markets policy at the CFA Institute, said the Trump administration, which has "been a bit more hostile" toward ESG investing "comes from a misunderstanding of what ESG really is, but that's not unusual."

He referenced workshops the CFA Institute and Principles for Responsible Investment hosted around the world in recent years that showed different firms and organizations have different interpretations of ESG. Moreover, roughly a quarter of people at the workshops equated ESG integration to negative screening, or screening out undesirable securities from an investment universe, Mr. Orsagh said.

In good news for the ESG community, the Securities and Exchange Commission's investor advisory committee on May 21 approved a recommendation urging the commission to update its reporting requirements for issuers to include ESG factors.

Ms. Slavkin Corzo said the recommendation, if enacted, could improve investors' access to consistent and comparable ESG data.

"In order to make investment decision that integrate ESG factors, investors need the data and they need to be able to do apples-to-apples comparisons," Ms. Slavkin Corzo said.