Defined benefit pension plans and defined contribution pension plans are uncertain about how to incorporate environmental, social and governance issues into their investment processes in a way that’s consistent with fiduciary duties, according to a new white paper from the Association of Canadian Pension Management.

“Sustainable investing, including ESG, is an area where some investment risks that have been acknowledged for decades are now becoming more acute (e.g., climate risk),” said the white paper. “How pension plans can, and should, account for ESG risks in light of the fiduciary duties applicable to pension fund investing is an issue that pension plan administrators globally are struggling to manage. This paper attempts to assist Canadian pension plan administrators understand their fiduciary duties relating to investments and ESG and how to implement an appropriate ESG strategy as fiduciaries.”

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Under Canada’s existing legal framework, incorporating ESG considerations in investment decisions isn’t prohibited or required by existing legislation, nor is there an accepted definition of what constitutes ESG factors or considerations. The only pension plan sponsors that must unequivocally abstain from incorporating ESG factors is at plans where governance rules expressly prohibit or directly restrict the plan sponsor from divesting investments that are based on ESG factors or set parameters for the investment of the portfolio, which is a rarity in Canada.

Canadian pension plan sponsors aren’t alone in their confusion. In the U.S., rules established under President Joe Biden’s administration don’t permit pension funds to consider non-pecuniary factors, including some ESG factors, in investment decisions. However, in March 2021, the Department of Labor released a statement saying the rules would no longer be enforced because they had a chilling effect on plan sponsors integrating ESG factors in investment decisions, even where they did have a pecuniary impact. Plan sponsors in the U.K., however, have considerably more leeway regarding ESG integration in the investment process.

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“. . . In 2018, the U.K. investment regulations were amended by the Pension Protection Fund. . . . This amendment expressly requires that statements of investment principles include the trustees’ policies in relation to ‘financially material considerations over the appropriate time horizon’ and ‘non-financial matters,’ both of which include ESG considerations.”

In Canada, where similar rules requiring the annual publication of ESG-related non-financial disclosures will soon come into force, the ACPM said it believes it’s “vitally important” for pension plan sponsors to establish clear guidelines on ESG implementation.

“It is vitally important that the organizational purpose and objectives of implementing an ESG factor/program be clearly articulated and the fiduciary guidelines recognized. A clearly defined purpose will help guide the numerous decisions that will need to be made in developing an ESG program, monitoring the ESG program (within the broader portfolio management) and making the necessary adjustment or modifications to the ESG program over time.”

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The ACPM also indicated it doesn’t believe plan sponsors should be too concerned about balancing the various elements of ESG. Instead, the white paper advised plan sponsors to balance the overall framework with other important investment factors.

“One must be alert to the potential that the new investment criteria . . . , because of its new role and potentially lack of understanding, has an outsized influence on the overall investment decision-making. Balance is key. There will be some over/under emphasis that will be adjusted over time.”

According to the ACPM, establishing more detailed ESG constraints will limit investment managers’ opportunities, while looser ones may result in more divergence in how asset managers incorporate ESG considerations. “This is a challenge and there is no one best approach. The investment governance process will have to establish the criteria and then monitor and adjust over time as necessary.”

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