ESG Investing: What Is It, And How Does It Apply To Retirement Plans?
Recently I had a chance to chat about ESG investing with Jonathan Ricketts, who works with Natixis as Vice President – Southeast Region, Retirement Strategies Group. We discussed some of the reasons why we’re seeing ESG investing so often in the news lately, and cleared up a few misconceptions, as well.
We selected this topic for several reasons (besides that it’s making an appearance in the media). In December 2020, we held a Linkedin Live with two firms in the corporate reputation management space, where ESG came up as part of that conversation. Management of these factors and a company’s ESG rating have become relevant in the corporate reputation space for optics as well as building value.
The DOL released guidance in November of 2020 on Financial Factors in Selecting Plan Investments which covered ESG and was quite controversial. However, until the publication of further guidance, DOL will not enforce that final rule or otherwise pursue enforcement actions against any plan fiduciary based on a failure to comply with those final rules. This was good, because the guidance created more questions than answers for retirement plan fiduciaries.
“These rules have created a perception that fiduciaries are at risk if they include any environmental, social and governance factors in the financial evaluation of plan investments, and that they may need to have special justifications for even ordinary exercises of shareholder rights,” said Principal Deputy Assistant Secretary for the Employee Benefits Security Administration Ali Khawar. “We intend to conduct significantly more stakeholder outreach.”
While we wait on that additional guidance, let’s dive into the topic.
What Is ESG Investing?
ESG (Environmental, Social, and Governance) investing is more than just investing in wind farms and organic food companies. It focuses on factors in the three areas:
Environmental - This focuses on how a company performs as a steward of nature. How purposeful are companies with their sustainability initiatives? How efficient are they with their resources? Are there upcoming regulations that may negatively affect their business long-term?
Social - This focuses on how a company manages relationships with employees, suppliers, customers, and the communities where it operates. Do the companies have poor or unsafe work conditions? What’s their corporate culture like? What are they doing in regards to consumer data privacy? This is both inside the company and outside of it, including reputation risk and product recalls.
Governance - This includes responsiveness to shareholders, board accountability, and overall risk management including audits and internal controls. How diverse is leadership and the board of directors? Is executive pay reasonable? Do they use accurate and transparent accounting methods?
From here, these factors become screening mechanisms to assess a company and its behaviors for the purpose of determining whether to invest, if there’s a good opportunity to invest, or to check for additional investment risk.
In terms of investments, there are 3 basic ways to invest in an ESG-focused fashion:
ESG Integration - Purposeful inclusion of these factors along with traditional financial analysis
Positive/Best in Class - Utilization of screens to create a high scoring portfolio for financial analysis
Sustainability Themed Investing - Investing based on global macro ESG themes while utilizing traditional financial analysis
Note that these three are integrating it into their investment process. The point is to consider these factors in creating a portfolio of securities with the intent of maximizing returns for the investor. Keep that in mind as you read the next three paragraphs.
There are also a couple of thematic ways of ESG investing that, according to Jonathan (and us) shouldn’t be in a retirement plan, but can certainly can be done on one’s own. Those include:
For the purpose of making impact - The investment merit is secondary to the impact on a social good
Socially responsible investing or negative screening - No investment thesis; generally based on what you DON’T want to own, i.e. tobacco, pork, etc.
This is where we (although we are not attorneys and do not render legal advice) get worried about crossing the line with serving two masters. Under ERISA, the only master you can serve is investing for the sole purpose of benefiting the plan participants and beneficiaries. Should you have a second purpose, like using your dollars to pressure a foreign government or take a stand against a social issue, we would worry that would bifurcate the purpose of the investment and put the fiduciary at risk of breaching their sole priority. In our view, it’s a no-go to invest with dual purpose other than what’s best for plan participants.
Bottom line: You are investing money for someone else - you need to do so responsibly and with a goal of having your stakeholders benefit financially. Therefore, any ESG investments still have to pass muster with your organization's plan investment policy statement. If they reduce returns or increase risk or put them out of line with their peer group and won’t pass your investment policy statement, like any other investment considered for the plan, they wouldn't pass.
What About ESG Ratings?
Ratings are not the end-all, be-all. There are several different rating services available, and you guessed it, they measure things differently. Amazon’s sustainability commitment might be viewed well by one, and their environmental impact with their gazillion cardboard boxes may be viewed negatively by the other. Same company, different scores from different rating services.
Additionally, if you’re relying solely on today’s score, it may not be forward looking. A company could have had some trouble but is making strides toward fixing it. In that case, it could be advantageous to buy at, presumably, a discount. Likewise, certain aspects may generate a high rating by one of the rating services, but not actually be meaningful in outcome. Ratings can’t be viewed in a vacuum.
Future Predictions
Investors and consumers are changing their behavior patterns to be more socially and environmentally responsible. This is creating business opportunities and greater awareness as to where investments are made.
Is this another investment trend that will be gone tomorrow? According to Jonathan, with 65% of the workforce 35 and under and resources becoming more scarce, ESG investing is likely here to stay. And, if you ask other investment providers, they’ll say that many of these factors have been considered all along in the past without being branded as ESG. For example, if they were considering two companies that met all other financial and investment factors but one was much more environmentally responsible, that was investment that would win out. Conversely, they may screen out another company on the grounds that it was miserable to work there and their sustained performance was in question because of it.
All in all, these types of factors have to be considered when assessing the overall performance and risk of an investment. That will continue to evolve with time. What are plan sponsors saying? It goes very quickly from “don’t you all own solar panels and organic grocery stores?” to “I understand the economic and risk reasons to be more purposeful in using this approach.”
ESG Investing Byproduct
Retirement plans tend to struggle in getting interest and participation, particularly when automatic enrollment is not used by the plan.
One of the interesting behavioral impacts of ESG branded investments is that it has been shown to drive engagement rates, Jonathan shared. He had several stories of offering these types of investments in a plan in helping engage employees and encouraging investment education related to their retirement plan. This boosted the amount of contributions to the plan and increased the participation rate.
Final words
The ESG investing of today is a long way from the days of socially responsible investing that revolved around screening OUT what you did not want to own, and has evolved into criteria to evaluate a broad range of behaviors and risks.
If you’re interested in incorporating ESG investments into your retirement plan, be sure to give us a call to look at the different aspects of incorporating this into your plan, review your investment policy statement guidelines, and start the discussion.