How Emerging Financial Risks Could Affect Public Pension Fund Assets

The debate over whether state public pension administrators should consider the financial implications of environmental, social, and governance (ESG) factors in their investment decisions has been contentious in recent years. One reason is because ESG can carry different implications and definitions depending on the context and intended outcome.

In some instances, policymakers interpret ESG as an “impact investing” strategy—that is, investment decisions made with the goal of achieving certain social or environmental outcomes. In others, however, ESG factors can refer to risks that have long been elements of financial risk analysis—in both the public and private sectors—and where the focus is on managing those risks. These differing and at times conflicting interpretations can drive confusion and politicization that may mask the fiscal prudence of employing such factors in risk assessments and investment strategies.

Of course, public pension fund fiduciaries—trustees and administrators who manage funds—have long had broad latitude to consider emerging economic trends and financial factors to minimize risks and maximize returns. In the past, some pension fund boards adopted “socially responsible investment” policies to divest from entities based on social or moral principles, resulting in divestments from tobacco companies and foreign governments based on geopolitical concerns. The current discussions highlight a persistent debate over the best approaches to ensuring that pension funds can provide promised benefits to retired public workers.

However, pension administrators are increasingly using ESG indicators as part of a measured investment approach that takes into account the material impact of such factors on companies, industries, or particular asset classes and evaluates how these impacts could affect long-term financial stability. This includes identifying and monitoring material financial risks or outcomes caused by factors such as changing environmental conditions or demographic shifts.

At the same time, state policymakers in recent years have largely approached ESG through a “social impact” investment lens, with some states adopting policies either prohibiting or requiring certain ESG-related investments. Since 2021, lawmakers in four states—Colorado, Illinois, Maine, and Maryland—have enacted legislation encouraging their public pension fund officials to consider such factors in investment decisions. In contrast, 16 other states have adopted laws discouraging such considerations; Oklahoma and Florida, for example, have adopted legislation requiring plan investment managers to cease investing in firms that incorporate ESG policies into their practices.

Experiences in several states demonstrate how these different approaches can lead to varying outcomes. A review of recent legislation illustrates how overly prescriptive statutory changes to investment policies can act as a blunt tool that may result in immediate, upfront transaction costs that are typical of any investment portfolio changes. There are also additional unintended administrative and financial challenges that can occur regardless of whether such policies support or discourage ESG considerations. And, at times, such legislative approaches could put pension trustees at odds with their core fiduciary duties.

Prescriptive statutes that require or ban ESG divestments come with costs and complications

Maine became the first state to enact legislation in 2021 requiring divestment of state pension assets from all fossil fuel holdings, with a mandate to do so by 2026. In a preliminary analysis, consultants for the Maine Public Employees Retirement System (MainePERS) estimated that the policy would affect roughly $1.4 billion in fund assets and could result in $565 million in immediate losses. System officials noted that plan administrators would face a short five-year deadline to navigate “both disposing of significant existing investments as well as making fundamental changes to MainePERS’ investment approach.”

Vermont lawmakers considered similar legislation this year, requiring the state’s retirement funds to divest from fossil fuels by 2030. Analysis by the Vermont Pension Investment Commission estimated that the bill could reduce expectations for long-term investment earnings, which could in turn lower funding levels for the state’s municipal employees plan and increase required contributions to its teachers’ and employees’ retirement plans by roughly $55 million a year. Although the bill sponsors sought to mitigate these potential costs by amending the proposed divestment time frame for private equity holdings, commission leaders continued to raise concerns, and the bill was ultimately tabled.

Lawmakers in Indiana, meanwhile, introduced legislation in 2023 that required plan officials to consider “only financial factors” and prohibited investment of state pension assets with the goal of influencing social, political, or environmental policy. The state Office of Fiscal and Management Analysis estimated that adopting the measure as introduced could lead to as much as $6.7 billion in reduced investment earnings over the next decade because of the portfolio restructuring that would have been required. After considerable debate, lawmakers amended the bill to limit the scope and application of its anti-ESG requirements. Still, analysis of the final statute notes that plan administrators may face increased workloads and transaction costs when changing investment managers who violate the statute’s ESG provisions.

A similar 2023 proposal in Kansas called for plan investment managers to divest holdings in companies engaged in ESG-based market actions within 360 days of the plan providing notice to companies of such activities. Pension officials estimated that doing so could result in immediate losses of $1.14 billion from early divestments; $3.6 billion in reduced earnings over the next decade linked to expected portfolio restructurings; and $2.4 billion in increased unfunded liabilities. Although lawmakers ultimately enacted legislation with significantly curtailed anti-ESG requirements, state estimates show that the final statute could still result in additional and ongoing administrative costs to the pension fund.

Risk assessment and monitoring: A more measured approach to considering ESG

Instead of mandating immediate changes to plan investment portfolios in line with policymakers’ positions on broader social impact considerations, some states are taking a more measured approach by using ESG factors to monitor emerging risks and inform potential long-term strategies. For example, plans and investment boards in Minnesota, Washington, and Texas produce routine reports that document how they are evaluating risks and developing strategies to screen and integrate changing economic sentiments—such as declining demand for fossil fuels or tobacco products—into investment decisions. Other states, such as Massachusetts, have established special advisory committees to study ESG issues and approaches and provide recommendations to retirement plan trustees on these matters.

States are also using stress testing and scenario analysis of emerging risks: Colorado lawmakers adopted a requirement for the state’s retirement system to include assessments of climate-related risks and related investment strategies in annual investment reports. A similar requirement enacted in Maryland builds on the state’s efforts to assess, identify, and mitigate climate-related financial risks.

In addition, retirement funds in New York and other states are directly engaging with companies they invest in or using proxy voting to encourage more sustainable investment practices by the companies they invest in and mitigate climate transition risks. For example, the sustainable investment approach used by California’s Public Employees’ Retirement System (CalPERS) favors engagement over immediate divestment. CalPERS’ statement of principles asserts that “investors that divest lose their ability as shareowners to positively influence the company’s strategy and governance.” Even so, legislation passed by the California Senate in May would require CalPERS and the State Teachers Retirement System to divest from fossil fuel companies, which would affect almost $15 billion in assets.

As approaches to ESG continue to grow and evolve, challenges range from the considerable disagreement on the specific factors that constitute such considerations to the lack of comparable and reliable data on ESG criteria and metrics, which can make it challenging to assess investments based on these factors.

Still, there is widespread agreement among experts that environmental factors in particular will pose systemic risks to the broader financial system and, in turn, to the more than $5 trillion in assets invested by public pension funds.

With this in mind, state policymakers and pension officials will need to discuss and make judgments on whether and how these methods should be used in investment decision-making. Investment managers and pension trustees, for example, will need to understand emerging risks such as the short- and long-term financial implications of global efforts to respond to the effects of a changing climate—climate-related transition risks. Understanding the range of approaches for incorporating and evaluating ESG—as well as the potential impact of legislative parameters governing investment policies—will be critical as plan trustees consider investment strategies and manage risks over the long term.

Stephanie Connolly is a principal associate and Fatima Yousofi is a senior officer with The Pew Charitable Trusts’ state fiscal policy team.