GAO Issues Report: Federal Workers' Portfolios Should Be Evaluated for Possible Financial Risks Related to Climate Change

WASHINGTON, June 26 -- The Government Accountability Office has issued a report (GAO-21-327) entitled "Retirement Savings: Federal Workers' Portfolios Should Be Evaluated For Possible Financial Risks Related to Climate Change".

The report was sent to Sen. Maggie Hassan, D-New Hampshire, chairman of the Senate Homeland Security and Governmental Affairs subcommittee on Emerging Threats and Spending Oversight, and Sen. Jeff Merkley, D-Oregon, on June 24, 2021. Here are excerpts of summaries associated with the report.

What GAO Found: "Retirement plans' investments, including those of the Thrift Savings Plan (TSP) for federal employees, could be exposed to financial risks from climate change, according to GAO's literature review and interviews with stakeholders knowledgeable about climate change and financial markets. Stakeholders said climate-related events, from natural disasters to changes in government policy, are expected to impact much of the economy and thereby investment returns (see figure https://www.gao.gov/products/gao-21-327). Retirement plans can assess their exposure to these risks by analyzing the potential financial performance of holdings in their portfolios under projected climate change scenarios.

GAO reviewed retirement plans in the United Kingdom, Japan, and Sweden that had taken steps to incorporate climate change risks into their plan management. Officials from these plans described using engagement--such as outreach to corporate boards--to encourage companies in which they invest to address their financial risks from climate change. Officials had taken other steps as well, such as incorporating climate change as a financial risk into their policies and practices. Officials communicate information on climate-related investment risks through public disclosures and reports.

The agency that oversees TSP, the Federal Retirement Thrift Investment Board (FRTIB), has not taken steps to assess the risks to TSP's investments from climate change as part of its process for evaluating investment options. Officials told us that they use a passive investment strategy and do not focus on risks to a specific industry or company. FRTIB is required by statute to invest TSP's funds passively, however, it has previously identified and addressed investment risks. For example, in the 1990s, FRTIB reviewed its investment policies and recommended adding an international equities fund and a small- and medium-capitalization stock fund, both passively managed, to incorporate classes of assets that it determined were missing from TSP's investment mix. Stakeholders in the financial sector, including an advisory panel to a federal financial regulator, have stated that it is important to consider the investment risks from climate change. Evaluating such risks is also consistent with GAO's Disaster Resilience Framework. Taking action to understand the financial risks that climate change poses to the TSP would enhance FRTIB's risk management and help it protect the retirement savings of federal workers."

Why GAO Did This Study: "Climate change is expected to have widespread economic impacts and pose risks to investments held by retirement plans, including the federal government's TSP. As of November 2020, TSP had 6 million active and retired federal employee participants and nearly $700 billion in assets. GAO was asked to examine how the agency that oversees TSP has addressed its exposure to such risks.

This report examines (1) what is known about retirement plans' exposure to climate change-related investment risks, (2) what comparable retirement plans in other countries have done to address risks from climate change and how they communicate this information to the public, and (3) what steps FRTIB has taken to address investment risks from climate change.

GAO reviewed relevant literature and interviewed representatives from investment consulting firms and other stakeholders knowledgeable about climate change and its possible financial impacts. GAO reviewed documents and interviewed officials from selected retirement plans for public- and private-sector employees in the United Kingdom, Japan, and Sweden identified as examples of plans that are addressing climate risks. GAO also reviewed TSP documents, and interviewed FRTIB officials."

What GAO Recommends: "GAO recommends that FRTIB evaluate TSP's investment offerings in light of risks related to climate change. FRTIB did not indicate whether it agreed or disagreed with the recommendation and stated that it subscribes to a strict indexing discipline and efficient market theory."

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May 25, 2021

To: The Honorable Margaret Hassan, Chair, Subcommittee on Emerging Threats and Spending Oversight, Committee on Homeland Security and Governmental Affairs, United States Senate

The Honorable Jeffrey Merkley, United States Senate

Climate change, including rising temperatures and sea levels, is expected to have widespread economic impacts, increasingly disrupting and damaging critical infrastructure and property, labor productivity, and the general welfare in communities. In 2018, the United States Global Change Research Program's (USGCRP) Fourth National Climate Assessment stated that under a business as usual scenario, climate change is expected to cause growing losses to U.S. infrastructure and property and impede the rate of economic growth over the 21st century./1 Domestic and global economies are vulnerable to climate change's risks to financial investments, including those held by retirement plans.

Retirement plans manage investments over long time horizons and the economic effects of climate change could negatively affect their returns and thereby the financial health of retirees.

The Thrift Savings Plan (TSP) serves 6 million active and retired participants, which includes federal employees and members of the uniformed services, and is the largest public retirement plan in the United States and the largest defined contribution plan in the world./2 A number of large retirement plans abroad have adopted investment strategies that take into account investment risks from climate change. However, less is known about the extent to which TSP and most U.S. retirement plans are exposed to investment risks from climate change, and the extent to which TSP has assessed its exposure and implemented strategies to help address any risks.

You asked us to review how the federal agency charged with overseeing TSP--the Federal Retirement Thrift Investment Board (FRTIB)--is considering investment risks posed by climate change. In this report, we examine (1) what is known about retirement plans' exposure to investment risks associated with climate change, (2) what have comparable retirement plans in other countries done to address risks from climate change and how do they communicate this information to the public, and (3) what steps, if any, has FRTIB taken to address investment risks from climate change.

To examine how climate change could expose retirement plans to investment risks, we reviewed relevant literature published by experts knowledgeable about climate change and its impacts on the global economy. These included reports that assessed the impact of climate change on a specific retirement plan, such as the New York State Common Retirement Fund, or a specific segment of the economy, such as the companies represented by Standard & Poor's 500 (S&P500). We interviewed representatives from public retirement plans, investment consulting firms, and other stakeholders knowledgeable about climate change and its economic impact to gain their views on the nature, scope, and magnitude of the investment risks related to climate change.

To examine the actions of retirement plans in other countries, we selected three retirement plans that have each taken action to assess and address investment risks from climate change. Specifically, we selected the United Kingdom's National Employment Savings Trust (NEST), Japan's Government Pension Investment Fund (GPIF), and Sweden's AP7 to examine how they incorporate climate risks in their investment strategies and communications./3 These plans share certain key characteristics with TSP, such as using a long-term passive investment strategy./4 For each plan, we reviewed publicly available climate-related disclosures, plan documents, and any climate risk assessments. We also conducted semi-structured interviews with plan representatives to learn about their experiences with incorporating climate risk into their portfolio, what options they considered, how they monitor risk and returns, and how this information is publicly communicated. We note that while a particular strategy may have been successful in one or more of the countries included in our review--which may have significantly different cultures, histories, and legal systems--it does not necessarily indicate that it would be successful in the United States.

To determine what steps FRTIB has taken to address the impact of climate change on TSP, we reviewed TSP's five core funds and the federal law that authorizes and provides for the structure of each of the funds. We also reviewed FRTIB documents such as annual reports, its proxy voting policies for fund managers, minutes from Board meetings, and reports written by an investment consultant. We interviewed FRTIB officials, representatives of TSP's primary asset manager (BlackRock), and an investment consultant hired to review TSP's investment offerings.

We conducted this performance audit from October 2019 to May 2021 in accordance with generally accepted government auditing standards.

Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.

See footnotes here: https://www.gao.gov/assets/gao-21-327.pdf

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Conclusions

Investment risks associated with climate change are expected to impact the global economy and cause unprecedented disruption to the financial markets, and investors, including retirement plans, are considering how their portfolios may be exposed to these risks. Passive investment strategies, like those used by TSP, are generally seen as providing the important benefits of broad diversification and low costs, leading to greater risk-adjusted returns when compared to active investment strategies. However, even passive investment strategies are exposed to financial risks from climate change as the impacts are expected to be widespread across all economic sectors. Climate and financial experts urge passive investors and others to consider the unique and systemic risks posed by climate change. As noted by the Market Risk Advisory Committee of the U.S. Commodity Futures Trading Commission, these risks may not be adequately reflected in current market values, which increases the likelihood of systemic shocks. Similarly, the Federal Reserve has reported that this mispricing of assets poses a risk of downward price shocks and could thereby make climate change a risk to stability of the financial system. In addition, the Market Risk Advisory Committee of the U.S. Commodity Futures Trading Commission reported that climate change over time will likely touch virtually every sector and region of the country. Moreover, selected retirement plans in other countries are assessing the impacts of climate change on their portfolios and have leveraged their knowledge to develop strategies for addressing these risks as part of their passive investment approach.

In managing the TSP, the FRTIB has not explicitly assessed the potential financial impact of climate change on the $700 billion in assets it manages for 6 million active and retired federal workers. FRTIB is subject to requirements different than those for the plans we reviewed in other countries, which affect what actions it may take. However, FRTIB has a process to understand risks and has previously undertaken efforts to address risks. Including consideration of climate change as part of this process would provide FRTIB more complete information about potential risks relevant to its passive investment approach. Taking action to understand the financial risks that climate change poses to the TSP is a useful first step that would help FRTIB be better positioned to consider, as part of its ongoing oversight activities, if any changes are needed to help ensure that the retirement savings of federal workers are protected.

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Recommendations for Executive Action

The Executive Director of the Federal Retirement Thrift Investment Board, to better inform the Board's ongoing oversight activities, should evaluate TSP's investment offerings in light of risks related to climate change.

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Agency Comments and Our Evaluation

We provided a draft of this report to FRTIB for review and comment. In written comments, reproduced in appendix II, FRTIB did not indicate whether it agreed or disagreed with our recommendation. FRTIB noted that it subscribes to a strict indexing discipline and that the efficient market theory concludes that the market is pricing all risks into its valuation on an on-going basis. FRTIB stated that its next investment consultant review is planned for fiscal year 2022 and that it would review any recommended changes to its fund offerings at that time. FRTIB further stated that it would examine any recommendations made by the U.S. Securities Exchange Commission and the Federal Stability Oversight Commission on climate change-related risks and determine whether and how to apply those lessons to the TSP. FRTIB also stated that it disagreed with a statement in our draft report that it did not currently have any knowledge of the potential financial impact of climate change on TSP assets. We removed this characterization from the report.

GAO recognizes that FRTIB has an established process for evaluating TSP's investment options and utilizes an investment consultant to conduct a review. While the most recent investment consultant review in 2017 did not include any consideration of climate-related risks, its next review in 2022 is an opportunity for FRTIB to conduct a focused evaluation of these risks and clarify what additional steps, if any, are needed. Given the systemic and unprecedented risk that climate change is expected to have on global financial markets, GAO continues to believe that it is important for FRTIB to evaluate TSP's investment offerings for these risks. While FTRIB stated that its upcoming mutual fund window would provide TSP participants with an opportunity to invest beyond the five core funds, the mutual fund window does not address the potential climate change-related risks to TSP's core investment funds. Examining climate change-related risks facing TSP's $700 billion in assets under management would provide FRTIB with a greater understanding of its potential exposure to these risks and enable it to decide if any further actions are necessary to protect the retirement savings of over 6 million federal workers.

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The text of the GAO report is available at https://www.gao.gov/products/gao-21-327

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