EVENTS

Date:	Monday, June 7, 2004
Time:	9:45 AM -- 5:00 PM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

June 2004

"Socially Responsible" Investing and Pension Funds: Welcome Reform or Fiduciary Nightmare?

"Socially responsible" investing (SRI), which incorporates non-financial social and ethical criteria, has attracted significant publicity in recent years and sparked interest among some institutional investors, public pension funds, and Social Security reform advocates, particularly in the wake of recent corporate scandals. SRI adherents claim that one of every ten dollars in United States markets is invested using SRI principles. Although those claims are widely disputed, there is no question that public and some private pension programs are being asked to consider if and when they should include social and ideological screens when making investments. Social investing is not an exclusively American phenomenon. It is popular in Britain and Europe, and governments from Malaysia to Sweden to Canada have utilized pension funds to support stock markets or to make loans or create incentives with explicit social goals. At a June 7 AEI conference, experts examined whether this trend is welcomed or constitutes a threat to fiduciary independence and responsibilities.

 

Jon Entine
AEI

A growing number of government-employee pension systems, including California's Public Employees Retirement System (CalPERS) and State Teachers Retirement System (CalSTRS), which together hold more than $300 billion in assets, use social criteria to guide their investment policies. Minnesota, Connecticut, and the State and City of New York, among other localities, have supported initiatives and shareholder resolutions on gay rights, toxic clean-ups, and climate change. Public funds have been used to make moral statements by dumping tobacco stocks and holdings of companies embroiled in scandals. Governments have used pension funds to support "economically targeted investments" to create local jobs, subsidize low-income housing and bail out firms deemed critical to fragile economies. In one case, legislators authorized the sale of shares of Walt Disney to protest alleged sex and violence in films made by a Disney subsidiary.

The size and growth of the social investment phenomenon are open to debate. The Social Investment Forum (SIF), a trade group for the industry, claims that "nearly one out of eight dollars under professional management in the United States"--more than $2 trillion dollars or about 12 percent of assets under management--are invested using social criteria. However, the percentage invested in socially screened mutual funds has not increased perceptibly in recent years. Less than $200 billion in total is invested in "socially responsible" mutual funds, which is smaller than the size of a number of individual fund companies. The member funds in the SIF hold less than 0.2 percent of the $7 trillion mutual fund market. Notwithstanding its tiny financial footprint, the media profile of social investing is significant and increasing. Numerous private and public pension funds, which hold more than $7 trillion in assets, are debating whether to include social investment criteria.

Social liberals are the most aggressive supporters of SRI and form the core of the leadership of the SIF. Traditionally, the SRI industry focused on litmus issues such as tobacco, defense spending, nuclear energy, genetically modified organisms, climate change, environmental policies, animal rights, diversity, and overseas sweatshops. More recently, SRI advocates have focused on corporate governance, contending that social principles can promote corporate reform by identifying companies that act more ethically. Pension funds have also periodically incorporated or considered country-specific criteria, targeting apartheid South Africa, Northern Ireland, and Israel.

The SRI concept remains controversial. Empirical research is ambiguous about whether or how much social investing--buying or boycotting of a company's products and shares or aggressively promoting minority shareholder resolutions--affects stock valuations or achieves the social goals of advocates. There are also concerns that socially screened investments may be financially imprudent and may violate the fiduciary responsibilities of pension funds.

According to Alisa Gravitz, head of Co-Op America and the vice chair of the SIF, "Social investing is a powerful concept--investors can invest for their own futures and a better world at the same time." Social investing was conceived as a client-centered investment philosophy based on the precept that ethical corporate behavior is in the eyes of the beholder--a procedural approach that required that an investor believed his or her choices were "socially responsible." Consequently, there still exist widely varying standards of corporate social responsibility and ethics based on often sharply divergent religious and political views.

In response to the spate of corporate ethics scandals that snagged companies rated highly based on liberal social criteria and mission statements, SRI advocates are now more aggressively supporting a substantive approach. This involves screening based on actual evidence that investment choices yield measurable social and economic benefits. Pension and mutual funds base their investment decisions on the research and ratings developed by organizations such as Kinder, Lydenberg, Domini (KLD) of Boston and corporate governance rating services like Institutional Shareholder Services.

Alicia H. Munnell
Boston College
Social Investing: Pension Plans Should Just Say "No"

Professor Munnell addressed the effectiveness of social investment screens for public pension funds. She and co-author Professor Sundén believe that current social investing approaches are not effective and, even if they were, neither public nor private plans should engage in this type of investing. Negative screens designed to rid portfolios of "sin" stocks do not screen out all the firms that support the activities of these companies. As long as the marginal investor is willing to buy the stock, social investing screens do nothing to change the stock price or the cost of capital to "sin" companies. Investors forfeit returns by reducing the number of possible investments. Private plans are tax subsidized and regulated by ERISA and have a fiduciary duty to maximize return for any given level of risk. Social investing may be fine for wealthy individuals who want to feel good about themselves and can absorb the loss in return to their non-pension savings, but it should not play a role in the investment of either public or private pension assets.

S. Prakash Sethi
Baruch College, CUNY
Socially Responsible Investing: It's a Must Because There is No Better Alternative

Under prevailing conditions of imperfect markets and concentration of capital and technology, an exclusive or even primary emphasis on return on capital would inflict enormous harm on the maintenance of free enterprise system, however imperfect. At the macro level, it would make the current system even more irresponsible with the apparent failure of corporate governance and the resultant enormous increase in agency costs as reflected in top management compensation. For the long term, the unfairness of the allocation of returns to various factors of production would undermine not only market-based capitalism, but also the foundations of democracy and rule of law. Furthermore, by ignoring the environmental and human consequences of economic actions, it would be tantamount to giving the corporations carte blanche to pillage the commons and thus do irreparable harm to the well-being of current and future generations. In that context, social investing is essential, even considering the fiduciary concerns raised by its critics.

Robert J. Palacios
World Bank
Managing Public Pension Reserves: Lessons from International Experience

Dr. Palacios discussed the prevalence of public pension funds, governance, and investment policy and performance in five countries--Canada, New Zealand, Japan, Sweden, and Ireland--and the lessons that other countries can take away for their experiences. 

Jarol B. Manheim
George Washington University
Corporative Dissonance: The Strategic Use of CSR Investing

Professor Manheim contended that a corporation is a social institution whose purpose is to balance reinforcing and contradictory interests with diverse goals, only some of which are economic. This notion of "corporative dissonance" is a variant of the so-called stakeholder theory advanced by liberal scholars Edward Freeman and Margaret Blair, which has been employed by advocates of social investing to argue for the importance of ethical behavior in business. This paper analyzes the systematic exploitation of "corporative dissonance" by social investors to achieve social goals. It examines how the social investment community and its allies manipulate power structure relationships, systemic changes in shareholders' rights, and proxy battles over corporate policy, as well as the intended and unintended consequences of these efforts.

Peter D. Kinder
KLD Research and Analytics
Pensions & the Companies They Own: Emerging Fiduciary Duties in a Changing Social Environment Dictate New Approaches

In its January 2003 proxy voting regulations, the Securities & Exchange Commission altered the traditional application of "fiduciary duty." Investment companies and investment advisers must apply a "governing" standard--long advocated by social investors--in evaluating proxy resolutions and, perhaps, ownership itself. This rule will become the general rule for all fiduciaries, whether subject to the SEC's jurisdiction or not. A governing standard--how the company is actually run, in whose interests, and to what effect on the environment and society--has the potential to force fiduciaries to wrestle with questions that extend well beyond what is now termed "corporate governance." They go, for instance, to the extent and nature of externalized costs. The new fiduciary standards inevitably raise issues about the effectiveness of current forms of oversight. For example, can the board fulfill the roles the corporate model assigns to it? They also raise questions about the nature and obligations of share ownership. By adopting implicitly social investment's position on shareholders' obligations as owners, the commission has opened issues that have not been addressed since the last wave of corporate reform in the first decade and a half of the 1900s.

Charles E. Rounds Jr.
Suffolk University Law School
When the State Gets into the Investment Business, Social Investing is Inevitable and There is Little that the Law Can Do About It

Professor Rounds asked why, when the "state" gets into the business of administering other people's money, legal safeguards designed to limit the its agents from engaging in social investing are not worth the paper they are printed on. Social investing is a precarious investment philosophy that reflects the personal financial, social and/or political predilections of the investor-all of which are often independent of fiduciary responsibilities. With respect to Social Security tax receipts, if one is concerned that there be legal accountability for those who socially invest, then to entrust the United States with the responsibility for investing in corporate equities and bonds is not the way to go. Those who advocate that the federal government get into the investment business appreciate neither the limits of the law nor the fallibility of human nature. If meaningful fiduciary accountability for social investing is desirable, then Social Security privatization is the only option that brings with it legal safeguards that have teeth. FICA payments must be segregated and the legal title to them transferred to private fiduciaries. Without these reforms, social investing, with all its unintended and perhaps reckless fiduciary and social consequences, is an inevitable by-product of the government getting into the investment business.

Sarah Fuhrmann
v-Fluence Interactive Public Relations
Corporate Philanthropy in Unfriendly Times: The Consequences of Social Investing Advocacy

Corporate social responsibility and socially responsible investing comprise a multi-billion-dollar industry in which some well-funded anti-corporate advocacy groups have established a strong foothold. Many of these groups tactically identify target companies they can portray as being "irresponsible" in order to generate resources and promote policies that end up undercutting efforts by companies to be more socially responsive. In the absence of set corporate social responsibility/social investing standards, companies are subject to the whims of groups that shift their criteria. The linchpin for this ideological agenda is the Internet, which proponents use to organize shareholder resolutions, e-mail action alerts, letter-writing campaigns, and more. Given these conditions, there is an enormous risk that even companies committed to improving stakeholder relations will end up as targets. The consequence of this anti-corporate ideology is that many well-meaning companies are reluctant to work with social investing activists, and may in the future disengage from some philanthropic investments.

George Gay
First Affirmative Financial Network
Retirement Investment, Fiduciary Obligations, and Socially Responsible Investing

Within the retirement investment industry, the question of the permissibility and fiduciary responsibility of SRI must be addressed with increasing frequency. Whether it is brought about by the recent corporate scandals, by a desire not to profit from alcohol and tobacco, or by a growing concern for environmental sustainability, more plan participants express a desire for a coherent system of selecting investments based on criteria beyond conventional analysis, with a focus on societal goals beyond investment returns. But in what circumstances, and to what extent, might such an investment strategy be permissible? May those charged with making decisions about retirement investments reasonably choose SRI? Our position is that consideration of the fiduciary obligations of the trustees of retirement plans shows that SRI investment strategies are not in and of themselves impermissible. On the contrary, we argue that the farther we move from self-directed defined contribution plans toward institutionally invested, defined benefit plans, the narrower the range of allowable investment options becomes; and yet SRI investment strategies are always an acceptable option.

Timothy Smith
Social Investment Forum
Social Investing: Challenging Institutional Investors to Meet Their Fiduciary Responsibilities

Mr. Smith discussed social investing in theory and practice, including what motivates religious investors, activist state or city pension funds, labor unions, and foundations, and how each understands their fiduciary responsibilities. He provides an overview of the industry, including its investment strategies and its international growth prospects. The paper discusses current trends in social investing in corporate governance and key social issues such as global warming. He suggests the interest in social investing and its growth reflects not only a fundamental shift in social values but also a more nuanced understanding of fiduciary responsibility and how it contributes to competitive performance.

AEI Research Assistant Ryan Stowers prepared this summary.