Introduction to ESG in Retirement Plans
By Dustin Roberts, MBA, QKA, AIF®
Investors are increasingly interested in factors beyond those most traditionally cited in investment risk and return assessment. The industry labels these in various ways, the two most common being socially responsible investment (SRI) and environmental, social, and governance (ESG) investing. The range of potential topics is enormous, from labor standards to board composition to carbon emissions, among many others. The possible ways to meaningfully measure and weigh respective values or areas of focus are equally vast.
ESG investing has been a popular topic in recent years as companies pursue more initiatives to align with employee and customer values. The regulatory climate has become more complex and contentious. While the landscape is evolving, there are signs of buy-in from companies, investment managers, and regulatory bodies that these factors will be important to long-term success.
Fiduciaries are guided by a duty of loyalty, acting solely in the interest of plan participants, and a duty of prudence, monitoring plan investment options with an expert level of care and skill. It is important to consider how these core principles can be applied. Defining the subject, exploring available information, and navigating diverse perspectives about factors involved are some of challenges inherent to the topic.
ESG investing involves consideration of a set of factors in the investment decision-making process alongside more traditional financial factors. The additional analysis weighs business practices, policies, and competitive positions that could impact financial risks and opportunities for a company, or for a mutual fund investing in those companies. Like traditional investing, financial returns are the primary objective for ESG investing, pursued with broader motivations.
By comparison, SRI refers to an approach of actively excluding or screening out specific practices, industries, or themes deemed undesirable. The approach is less nuanced, as identifying what one should not do is often simpler. Impact investing, another term often used in this discussion, implies investing where the intended non-financial impact takes priority over the financial return.
Investment managers largely report incorporating ESG factors in their analysis to build actively managed mutual fund portfolios. Many are signatories of the United Nations Principles for Responsible Investing (PRI), a public commitment to responsible investment that does include some reporting requirements but does not stipulate specific investment practices. Importantly, this is not limited to funds explicitly focused or branded as such but could apply to any actively managed fund.
Managers select underlying securities by first identifying an investment theme, then analyze financial fundamentals and data points to find material risks and opportunities. Similarly, managers using factors that fall into ESG categories are analyzing these data points to determine where risks and opportunities exist within the applicable segment. The goal is to construct a portfolio of securities with more risk-efficient returns coupled with a more favorable, sustainable, long-term impact.
The information available to assess ESG factors is also progressing. The difficulty is less about the quantity of data and more about the quality, consistency, and relative importance of different metrics. For investment managers, data can come directly from individual companies or from third-party ratings providers. The latter use research to score individual companies and to score mutual funds based on those underlying holdings.
Two of the largest examples of these ratings providers, based on number of investments covered, are Morningstar Sustainability Rating and MSCI ESG Rating. Both measure company exposure to material ESG risks and how well those risks are being managed, but they do not use the same methodology. Like individuals, ratings providers apply different relative importance to the many factors underlying the total score. As a result, a company or a mutual fund can score differently across different ratings. Seeking a competitive advantage, research firms and investment managers alike apply their expertise to determine which factors are relevant and how to weigh them relative to each other. For retirement plan fiduciaries, ratings can provide an additional metric about investment managers, while due diligence of a manager’s investment process can illuminate how it integrates ESG factors.
The Securities and Exchange Commission (SEC) has proposed regulations to enhance and standardize related disclosures for investors. Funds that consider ESG factors would need to report additional information, depending on the role those factors play in the investment process. For example, to protect investors from exaggerated marketing claims, “ESG-focused” funds require more disclosure than funds that are not being marketed as such. Globally, agencies such as the International Financial Reporting Standards Foundation (IFRS) are also pursuing sustainability and climate disclosure standards.
The Department of Labor’s (DOL) most recent statement on the topic, in late 2022, reiterated prior guidance that fiduciaries should not subordinate the economic best interests of plan participants to unrelated objectives, but should base decisions on factors relevant to an investment’s risk and return analysis. Importantly, it clarifies that these factors could include an investment’s “economic effects of climate change and other ESG factors.” If competing investments equally serve the plan’s economic interests, then collateral factors could be considered to select one. The DOL also specifies that fiduciaries may also consider participant preferences when creating an investment menu for participant-directed accounts, as accommodating investor preferences can lead to greater participation, savings rates, and retirement security.
Plan sponsors seeking to meet participant interest sometimes consider adding a mutual fund that is focused on ESG or SRI characteristics. While this might be right for some plans, it is important not to rely on fund names to determine focus or validity. It is equally important to note that retirement plan fiduciaries oversee plan assets, not employer funds, and are tasked with providing investment options in the best interests of all plan participants. Therefore, a specific ESG strategy at a plan level is often difficult.
One solution could be to utilize a self-directed brokerage option, allowing participants access to a broader array of investment options that may better fit their specific interests, where appropriate. Another is to incorporate ESG information into employee education, as many are unaware that some factors already play a role in many actively managed funds. In all cases, best practice is to establish investment strategies based on stated plan objectives and to document the decision-making process.