IN FOCUS6-8 min read

ESG in DC: Prove it

It has been over a year since the Department of Labor proposed changes to rules related to the consideration and use of ESG factors within retirement plans, highlighting that they may have a material effect on financial risks and returns.

11-29-2022
legislation
Read full reportESG in DC: Prove it
4 pages

Authors

Lazaro Tiant
Sustainable Investment Analyst

It has been over a year since the Department of Labor (DOL) proposed changes to rules related to the consideration and use of ESG factors within retirement plans, highlighting that they may have a material effect on financial risks and returns. Issues such as cyber and data security, human rights within a global supply chain and the physical risks of a changing environment impact companies and sectors widely. Although it is not mandated, it is prudent for investors to understand the financial implications of these types of factors over short, medium and long-term horizons. Additionally, policy changes for a more sustainable economy, such as the evolving energy transition, continue to draw attention to potential investment opportunities.

On November 22, 2022, the DOL published its final rule. While it is largely consistent with what was proposed, there is a new provision clarifying the permissibility for participant preferences to come into consideration when constructing a menu of prudent investment options (our retirement survey indicates that 87% of participants do indeed want investments aligned with their values).

Now that this highly anticipated step forward has been finalized, the question is no longer, “Are plan sponsors allowed to consider ESG factors and provide sustainable investment options?” but rather “How do sponsors go about assessing and implementing ESG-integrated and/or Sustainable investment options?” This is to be expected; choosing any investment option as part of a retirement plan lineup is never a simple task.

A yearlong wait has given us time to reflect on the question of implementation. The rule makes it clear that ERISA’s core principles include duties of loyalty, prudence and governance, but also alleviates concerns that the use of Sustainable investment and ESG integrated products is inherently incompatible with these core principles, which require plan fiduciaries to focus on material economic factors and avoid sacrificing investment returns or taking on additional investment risk to secure a collateral benefit to plan participants. When it comes to this question of implementation, demonstrating that a sustainable investment option is in line with these core principles is the path forward. This is the key challenge for plan sponsors and asset managers: establishing the value of these investment options.

ESG-in-DC-considerations

Earlier this year, we published Ten things to consider when implementing ESG in your DC plan in an effort to help our partners as they embrace what may become the new ESG landscape in the retirement business. Revisiting this list, we believe that there are several milestones that are essential for plan sponsors to keep in mind:

1. Do the research, decide on an approach and review the potential investment options

ESG is often misunderstood as a single catch-all phrase, so it is important that plan sponsors first understand ESG-integration and the different approaches to Sustainable investing. There is a difference between rigorously considering ESG risks and opportunities and seeking (and more importantly measuring) outcomes that are defined as sustainable. It is also possible to capture a well-integrated ESG process as well as exposure to sustainability themes across many asset classes and segments such as equities, fixed income, developed and emerging markets, global opportunities and even alternatives.

A variety of potential approaches exist across the spectrum of ESG and Sustainable investing:

An ESG-integrated approach involves rigorous analysis to understand the ESG trends and factors that affect investments. The primary goal is to achieve better returns by identifying and managing critical investment risks effectively. Excluding companies is typically not the goal of this approach. Engaging with issuers can instead revolve around the management of issues across the ESG spectrum to ensure earnings growth, cash flow durability and a resilient business model.

We expect asset managers to understand how factors such as interest rate and currency risks impact a portfolio. Knowing the extent to which there are ESG risks is no different. Having a full picture, with performance driving the decision-making, is the objective.

For those that wish to go beyond merely taking ESG factors into consideration, Sustainable investments seek outcomes as a goal of the investment process, while remaining focused on investment returns. If an ESG-integrated approach is about anticipating financial risks and opportunities affecting a company today, a sustainable approach seeks to identify businesses that will thrive in the long run. Exclusions based on economic analysis may apply here, depending on the investment philosophy and definition of sustainability.

At Schroders, we often define a sustainable approach as one that considers externalities and the impacts that companies have on society and the environment, such that we are able to anticipate these impacts before they become financial costs. We leverage our research framework SustainEx to measure and report on externalities at the company, sovereign and portfolio levels. This is about understanding risk to companies and shareholders.

For example, energy and utility companies provide power, a critical benefit to society. At the same time, these industries are facing global pressures, as well as policy-driven incentives, to evolve their businesses to include more renewable capabilities, lessening negative impacts on the environment while maintaining societal benefits alongside financial growth. Our approach to sustainable investing captures the balance of these benefits and costs that companies provide to or impose on society and measures the extent to which a portfolio has an overall positive (absolute or relative) benefit versus its benchmark. This helps our clients understand the sustainability profile of their investments.

It’s important to point out that excluding certain companies or a portion of an industry is not for everyone; however, it’s just as essential to understand the context of why an exclusion may be applied. This is why we link sustainable outcomes with externalities. For example, tobacco companies are often candidates for exclusion from sustainable investment products. Through the lens of externalities, and with the aid of academic research, we are able to quantify the negative social costs related to smoking. While not currently priced into the financials of tobacco companies, we anticipate that this industry may face ever-increasing regulation and business-model risks over the long term. While an ESG-integrated approach might consider being compensated for these risks in the short and medium term, a sustainable approach does not just avoid the current negative impacts to society, but also takes a longer-term perspective that this business and industry may experience changes that make it less attractive from an investment standpoint.

All things considered, when seeking Sustainable or ESG-labeled investments which target outcomes, the ability to define, measure and report on these potential investments is a key component of what the DOL expects of plan sponsors and managers.

SI-spectrum

In our view, Thematic investing with a sustainability angle is about pursuing investment themes that align with and target the United Nation’s Sustainable Development Goals (SDGs). These themes can include climate change, good health and well-being, responsible consumption or sustainable infrastructure, to name a few.

Thematic investing is a way to capture direct exposure to trends that are gaining global momentum, such as the energy transition and other areas of innovation and disruption. Thematic investments may be narrow and exposed to structural and cyclical risks, such as slow policy momentum, rising rates, and supply chain disruptions; therefore, time horizon is an essential consideration, particularly for multi-decade trends.

At Schroders, we define Impact investing (in line with the IFC[1]) as investments made in companies or organizations with the intent to contribute measurable positive social or environmental impact, alongside a financial return. This includes leveraging our own expertise and adopting industry-standard principles to define an impact intent, contribution and most importantly measurement.

While Thematic and Impact approaches to investing have become more common in recent years, we will need to keep our eye on whether plans sponsors seek to include these types of strategies in plan lineups in the near term. Plan fiduciaries will need to carefully analyze individual funds or strategies before including them in a DC lineup.

2. Educate plan participants on the new options

If a sponsor has decided on a Sustainable investment approach and is about to implement it, communication to plan participants is essential. Education is the best tool in this instance, as the topic of sustainability within investments is likely not well understood by many end investors. Education can take different forms:

  • Product level: What is the fund’s sustainable objective (if any)? What will ongoing reporting look like? If there is no sustainable outcome, will engagement and voting information be reported? Are there company-level examples demonstrating what sustainability or an integrated approach looks like in practice?
  • Broader education: We believe that there is currently a unique opportunity to educate employees and plan participants on sustainability in a broader sense. What are the macro policies driving system-level changes? What are the emerging themes that have become investment opportunities? What are the different approaches to ESG investing and where does a plan option land on the spectrum?

If sponsors are to provide Sustainable investment options, helping participants make informed decisions on the choices offered and how they can fit into their overall retirement investment portfolio is a significant value-add. To help our partners solve for this, we have created a School of Sustainability program to guide plan sponsors and participants on the nuances of sustainability and its relation to investments.

3. Monitor, measure and report the results

Whatever choices have been selected and implemented, it then becomes a part of the sponsor’s fiduciary duty to monitor, measure and report the results both to plan participants and the plan investment committee, not only to consider the approach to sustainability, but also primary comparators such as performance expectations and fees. Plan sponsors will also have to work with their managers to set reporting standards, highlighting a clear link to the investment thesis, including with respect to how any voting of proxies (whether in pooled funds or otherwise) aligns with the investment manager’s stated approach. For example:

  • ESG-integrated: Since sustainable outcomes are not the goal, a documented understanding of the approach to considering sustainability risks and opportunities will be important. This may include ongoing reporting of portfolio company engagements and votes that are sustainability related.
  • Sustainable: Ongoing reporting demonstrating alignment to the defined sustainable outcome measurement of the investment product.
  • Thematic: Ongoing reporting aligning to the relevant Sustainable Development Goals and/or other firm-specific measurement demonstrating thematic alignment.
  • Impact: Ongoing reporting capturing progress of the key indicators of intended impact over time.

What next?

While the DOL’s ruling that the use of ESG factors may be considered as prudent for investors is a big step, sustainable investing will need to continue to evolve if there is to be expectation of wide adoption. By this we mean improvements in the transparency provided (by companies, investment managers, etc.) to sponsors, consultants and intermediaries on the respective definitions of sustainability and the evidence to demonstrate that a fund does in fact seriously incorporate sustainability factors. If there are also outcomes in mind, this means highlighting the process intended to help achieve sustainable objectives, as well as showing that ESG considerations are also economic drivers of financial performance.

Other potential regulation to look out for includes the SEC’s proposals on ESG disclosures for registered investment funds and the so-called “names” rule. If adopted, these rules will further help retirement plans consider mutual fund options as part of their lineup, as they will require managers to identify whether a fund is “integrated” “sustainable” or “impact” and require that fund names which utilize ESG terminology be consistently reflective of the investment strategy. These rules will also mandate that reporting of fund progress aligns with stated ESG objectives. This may lead to an easier process for plan sponsors of identifying potential options based on their stated investment and sustainability approach, with regulators also telling investment managers to “prove it” when it comes to ESG.


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The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.

Authors

Lazaro Tiant
Sustainable Investment Analyst

Topics

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