Investing January 23, 2020

Pressure Is Building to Consider Climate Change When Investing

Retirement plan fiduciaries, for now, should at least consider the role climate change will have on plan investments and vice versa.
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Art by Brian Stauffer

Recent news reports say an environmental scientist in Australia is suing his pension fund for not adequately disclosing or assessing the effect of climate change on its investments. The participant is only 24 years old and won’t be retiring any time soon. But, the news reports say, he is acting now because he is “concerned about what the world may look like then.”

There is no doubt, whether you believe it is happening or not, climate change is the subject of a strong activist movement.

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A just-published report about a yearlong, cross-disciplinary research effort at McKinsey & Company says climate change is already having substantial physical impacts in regions across the world. And it finds substantial impacts continuing until 2050—the latest date for which the study makes projections—unless measures are taken to reduce global warming.

The study measures the impacts in five systems. For example, for livability and workability, the report says, “Hazards like heat stress could affect the ability of human beings to work outdoors or, in extreme cases, could put human lives at risk. Increased temperatures could also shift disease vectors and thus affect human health.” It makes similar observations about food systems, physical assets, infrastructure services and natural capital.

What does this have to do with retirement plans? As the McKinsey report says, “Financial institutions could consider the risk in their portfolios.” There is a portfolio risk in investing in companies that are allegedly hurting the climate, and there are opportunities in investing in companies that are working to mitigate the effects of climate change.

George Michael Gerstein, fiduciary governance group co-chair at Stradley Ronon Stevens & Young LLP in Washington, D.C., says there are more studies coming out by asset managers and insurers that are identifying material risks to performance based on climate change. “It’s not a reaction to some moral uproar; they are really analyses based on risk and return,” he says. And he anticipates there will be increasing acknowledgement that climate change can influence investment performance.

Google “risk to investment performance from climate change” and a number of reports will pop up. One study led by Mercer and supported by International Finance Corporation (IFC), in partnership with Germany’s Federal Ministry for Economic Cooperation and Development and the UK Department for International Development (DFID), says effects on returns from climate change are inevitable. The report—“Investing in a Time of Climate Change”—assesses investment exposure to climate risk, estimates the impact on investment returns through 2050 and offers insights on how investors can improve the resilience of their portfolios. The study concludes, “However, if we manage to cap the temperature increase to two degrees Celsius, financial returns for long-term diversified investors will not be jeopardized because of investment opportunities created by the world’s transition to a low-carbon economy.”

A report from Ernst & Young says, “The risks posed by ‘stranded assets’—assets that unexpectedly lose value as a result of climate change—are rapidly climbing the investment industry’s agenda.”

Suing over climate change

The Australian environmental scientist’s lawsuit is not the only one related to climate change. Dr. Maximilian Horster, managing director and head of climate solutions at Institutional Shareholder Services (ISS) ESG in Germany says climate litigation has been around for many years and individuals have been suing companies for harming the climate. Horster gives the example of a Peruvian farmer suing Germany’s largest power producer for causing glaciers to melt, which threatens to flood his town and his home. According to Time magazine, the farmer says that because research by the Carbon Disclosure Project and the Climate Accountability Institute says the power producer is responsible for 0.5% of global greenhouse-gas emissions, it should pay for 0.5% of the cost of flood defenses for his town.

But, according to Horster, there is a new trend of entities considering offenses against asset owners. “It’s kind of preparation for large cases happening,” he says.

For example, Horster says, the Swiss Federal Office for the Environment decided just last week that if pension plans are found in breach of climate commitments by investing in high carbon assets, it should sue them.

In December, the Dutch Supreme Court in the Netherlands upheld a ruling requiring the government to slash greenhouse gas emissions by at least 25% of 1990 levels by the end of 2020. Horster says the court also just ruled that if companies or the government act against this reduction target, they are in breach of law and will be assessed a penalty.

Providing a different take, this month, in a case in the United States, a divided 9th U.S. Circuit Court of Appeals decided federal courts could do nothing to stop the U.S. government from causing climate change. The court said the youth plaintiffs’ case in Juliana v. United States must be made to the Congress, the president or to the electorate at large.

Horster also mentions that ClientEarth, based in the U.S., Australia and Europe, is a group of lawyers that sue companies and investors for harming the environment. And the two-degree investment initiative says if an asset manager claims a fund is addressing climate change and it is found not to be, the asset manager is misleading investors and it will get into trouble.

“The bottom line is there are many initiatives around by which investors face the risk of being sued about climate change,” he says.

A fiduciary duty to address climate change?

So reports say investing in companies that harm the environment affects returns, and courts and activist groups say it helps companies harm the environment. Whether considering investment returns or the effect on the environment, do retirement plan sponsors have a fiduciary duty to consider climate change when choosing investments?

Gerstein notes that in the environmental, social and governance (ESG) investing trend, institutional investors would make decisions based on collateral objectives—e.g. divesting from companies doing business in Sudan or from gun makers. The Department of Labor weighed in, issuing Field Assistance Bulletin (FAB) No. 2018-01. Under 2008 guidance, ESG investing factors could serve as a tiebreaker when considering economically similar investments. Gerstein says, “FAB 2018-01 expressly reaffirmed the notion that a fiduciary under [the Employee Retirement Income Security Act (ERISA)] could take a factor such as climate change into account where he thinks it has a super impact on performance and he doesn’t have to use the tie breaker test. I think that’s where the trend is going.”

As for whether there is a fiduciary obligation for plan sponsors to take specific action to mitigate the risk of climate change, Gerstein says he doesn’t see any obligation to take any affirmative action. But, he adds, “I think there is a fiduciary obligation to at least consider the risk. Fiduciaries don’t have to take action, but at least be aware.”

“It is reasonable to think that these risks are baked into share prices already. There’s an idea that particularly with U.S. securities in a highly efficient market, if there’s a hidden risk, the share prices would already reflect that,” Gerstein says. He adds that early court indications suggest that retirement plan fiduciaries can generally assume that.

However, Gerstein says, some very public officials say the risk is not reflected in share prices. “Should a participant challenge a plan sponsor for failing to take action to mitigate climate change risk, I don’t see that as a successful strategy now—not until there becomes a greater mountain of evidence that climate change is incorporated in share prices. In five years it could be there, in 10 years, yes,” he says. “Because we are in early days of really understanding the link between climate change and investment performance, I believe courts will wait for the data to be more refined.”

Gerstein contends this ties into a broader issue regarding federal securities law. He says one of the obstacles to greater ESG adoption is a lack of good disclosure by issuers in terms of how climate change affects their bottom line and how they are mitigating climate change risk. “How much disclosure do federal securities laws require in public filings and statements,” Gerstein queries. “This has an effect on retirement plan fiduciaries evaluating holdings.”

He adds that whether climate change information should be put in prospectuses provided to participants is one of those issues still working its way through securities laws. There is a desire for disclosure on climate change and ESG more broadly, he says.

And, Gerstein says, there is disparate treatment of disclosures about climate change globally.

Horster says plan sponsors are wanting to understand how climate change influences investments and vice versa. They want to understand what the risk of climate change is to investments or how to invest to help mitigate climate change. He says there are firms that offer services to tell investors if they have risks from climate change and what they are.

Horster notes that in the case filed by the environmental scientist in Australia, he is not suing for his retirement plan to invest differently, he is suing because plan fiduciaries don’t even understand or measure the risk from climate change. This is why the first step is to understand.

Gerstein says, as part of plan investment committee meetings, it would be helpful to be aware of the studies and public statements or actions by very large asset managers globally. “When there are very large, respected investment managers making significant pronouncement on these issues, committees should be aware of and discuss them,” he says.

Just last week, BlackRock announced it will be accelerating efforts to deepen the integration of sustainability into technology, risk management and product choice. In a client letter, the firm said, “Over the past few years, more and more of our clients have focused on the impact of sustainability on their portfolios. This shift has been driven by an increased understanding of how sustainability-related factors can affect economic growth, asset values, and financial markets as a whole.” It said the most significant of these factors today relates to climate change.

This week, MSCI, a provider of decision support tools and services for the global investment community, released its own view on ESG investing, urging all investors globally to more readily integrate ESG throughout their investment processes. The firm also published, “The MSCI Principles of Sustainable Investing,” a framework to illustrate actionable steps investors can take to improve ESG integration.

While the first step is to understand, Horster says the next step is to act on the information—divest or shift asset classes. He points to Climate Action 100+, an investor initiative to ensure the world’s largest corporate greenhouse gas emitters take necessary action on climate change. Retirement plan sponsors can say, “I want to invest in you, but I want to make sure you will be viable in the future by avoiding the risk of climate change,” Horster says.

“Pension plans are very special outfits in the financial industry because they invest money for a future for people. More than any other investors, they should invest in a way that people’s future wealth is worth retiring into,” Horster says. “Not only should they make sure the plan’s investments generate returns necessary for participants to have a secure retirement, but they have a societal role to play in considering what the investments mean for the world participants will retire in.”

Administration January 17, 2020

Mechanics of DB Plan QDROs Differ From Those for DC Plans

There are different paths for getting the right benefits to the right people when a plan participant divorces.
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Art by Ellen Weinstein

There are requirements for a qualified domestic relations order (QDRO) that apply whether the QDRO is for splitting up defined contribution (DC) plan assets or defined benefit (DB) plan assets, notes Lisa Loesel, partner at McDermott, Will & Emery in Chicago.

However, the mechanics of setting up QDROs vary between DC and DB plans.

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A QDRO typically happens when a couple divorces; retirement plan benefits may be given to an ex-spouse or to a child. Loesel says a QDRO has to be issued pursuant to a state domestic relations order (DRO). It has to include the alternate payee and the plan participant’s name, address, and Social Security number. She notes that, for privacy reasons, sometimes this is included in an addendum.

The DRO must also answer these questions in order to be a QDRO:

  • Which plan to which the DRO applies;
  • The amount or formula for the split of assets;
  • When payments will commence; and
  • The number of payments or time period to which the order applies.

Erika Lorenson, senior director, defined benefit foundation leader in Alight Solutions wealth business in Lincolnshire, Illinois, says that similar to QDROs for DC plans, ones for DB plans cannot require any kind of provision that doesn’t otherwise exist in plan. For example, if lump-sum distributions are not available to the plan participant, they are not available to the alternate payee.

Loesel adds that alternate payees are allowed to have access to any form of payment under plan except for a joint and survivor (J&S) annuity. According to the Department of Labor, “The order must not require a plan to pay benefits to an alternate payee in the form of a qualified joint and survivor annuity for the lives of the alternate payee and his or her subsequent spouse.”

Plan sponsors may receive DROs that do not answer all these questions. For example, Loesel says a DRO may say it applies to the X Corporation Retirement Plan, but the company has more than one plan. She says the best practice is for a divorce attorney to complete the DRO and to ask the plan sponsor for a model QDRO to fill out.

According to Diana Jacobson, senior director, defined contribution foundation leader in Alight Solutions wealth business, a plan having a model order available to parties will help plan sponsors. “Even if the parties don’t use it in totality, they may use elements of it. It helps the parties know what needs to be provided,” she says. “A model could also assist parties in reducing legal fees and getting the QDRO done faster.”

Jacobson adds that the process can be complicated and there are organizations that specialize in QDRO review and approval. Alight is one, but there are others. “A vast majority of our clients engage a specialist for review,” she says. Lorenson says a specialist may include Employee Retirement Income Security Act (ERISA) counsel or a recordkeeper.

If there is no model, Loesel says, the next best option is for attorneys to submit a draft order before asking a court to qualify the DRO, and ask the plan administrator if there are any questions or deficiencies. “But, sometimes this doesn’t happen. Sometimes the DRO is already entered and approved by the court,” she notes. “If it doesn’t make sense, sometimes plan sponsors make difficult interpretations and document them to the participant and alternate payee. Otherwise, plan sponsors can ask the alternate payee to go back to the court and get clarification.”

When a plan sponsors receives a QDRO, the assets of the participants account must be put on hold from any distributions until the assets are split.

Differences with DB plan QDROs

Lorenson says the two biggest differences between processing a QDRO in a DB plan and processing one in a DC plan are the point in time at which the account can be split and the degree of independence the alternate payee has post-split.

In a DC plan, whatever portion the QDRO states the alternate payee gets goes into a separate plan account for that alternate payee. The alternate payee’s account is recordkept just as any other participant’s account.

Lorenson explains that a QDRO might define the split as a resulting percentage of the period of time the participant and payee were married divided by the participant’s total service with the employer. If the participant is still employed and accruing service, the benefit that goes to the alternate payee can’t be figured out until the participant’s benefit ends or he separates from service. While there is no account for the alternate payee, the payee should be flagged for entitlement to a benefit. The plan sponsor will have to keep up with this.

Loesel says the earliest an alternate payee may be allowed to commence distribution of benefits is the earliest retirement age under the plan. If the participant doesn’t commence benefits at early retirement, there should be provisions in the plan about calculating the payee’s benefit. However, Loesel says she thinks it would be better if the QDRO mandated how benefits should be calculated in this case.

According to Lorenson, a QDRO may say payment to the alternate payee can begin when the participant starts receiving benefits. If the participant takes early retirement, he will get a smaller payment, but over a longer period of time, and so will the alternate payee. She adds that the QDRO should specify whether the alternate payee gets a share of any subsidies for early retirement. “Recordkeepers and plan sponsors have to pay attention to this,” she says.

The QDRO should be clear about whether it is a stream of payment QDRO or separate interest QDRO, says Loesel. A stream of payment QDRO exists when a participant is already in pay status. The annuity stream will be split based on the QDROs provisions for the remainder of the participant’s life. “This is far and away the simplest DB plan QDRO, but also the least common,” Loesel says.

The separate interest QDRO splits the accrued DB benefit into two separate portions.

The QDRO should explain what happens when each party passes away—if the participant predeceases the payee and vice versa, what happens before the commencement of benefits and what happens after? “The QDRO should be crystal clear about whether the participant gets his full benefit back if the alternate payee dies prior to the commencement of benefits,” Loesel says. The alternate payee, except in a cash balance plan, has no way to designate a beneficiary. Does the benefit just vaporize? There is no good guidance on this.”

If the participant dies first and he has a new spouse, the spouse gets his benefit. However, there is no specific guidance about what happens if the participant dies first and is unmarried, according to Loesel. “The school of thought is that the alternate payee should be treated as a surviving spouse, in which case he would get the 50% survivor annuity portion,” she says. “However, ideally, the QDRO will walk through each scenario.”

This highlights how little independence the payee of a DB plan QDRO has post-split. As Jacobson points out, “By comparison, post-split in a DC plan there are no ties between the participant and the alternate payee. The alternate payee can do as any individual participant can.”

Loesel notes that it depends on the DB plan sponsor’s internal processes whether it turns to an actuary for benefit calculations when a QDRO is received. Sometimes the actuary will weigh in on whether the QDRO is in good order and asked to be contacted when the participant and/or alternate payee is ready to get benefits. However, she notes, sometimes the actuary gets involved to send the alternate payee a benefit estimate and send the participant a revised benefit estimate. “There is no legal requirement to get an actuary involved,” Loesel says.

Considering special DB plan circumstances

It’s not unlikely that a QDRO be sent to a DB plan that is frozen or closed. According to Lorenson, if the participant is still accruing benefits, plan sponsors may need to wait until the participant is no longer accruing benefits or commences payments to determine the benefit split for the alternate payee.

If a QDRO is sent to a plan in which the participant is no longer accruing benefits, the split for the alternate payee depends on the QDRO terms. If the benefit depends on vesting terms, it’s possible there will still be a wait to determine the split for the alternate payee.

Many DB plan sponsors are considering offering lump-sum windows to eliminate some of their plan liability risk. Both Loesel and Lorenson say in this case, plan sponsors may decide whether or not to include alternate payees in the offering.

Loesel stresses that the first thing DB plan sponsors should do if they receive a DRO is read through it to make sure it makes sense and the plan sponsor understands its intent. If it is clear, it can be qualified. If it is not clear, plan sponsors can either ask for clarification, or if terribly unclear, tell the parties to go back to court to have a new DRO created.

Lorenson highlights how much value there is in having model QDRO language available to participants, alternate payees and their counsel. “It helps get them started and limits the back and forth that may be needed to get a DRO to be a QDRO,” she says.

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