Environmental, Social and Governance (as in Corporate Governance). This is only the newest acronym in a very acronym heavy industry. In the context of retirement plans, this is referring to factors that are being deployed within specific investments, such as mutual funds, in order to restrict those investments from putting money towards certain areas that are deemed to be negatively contributing to society in some way. As with anything new, clear lines as to what constitutes the criteria to be broadly categorized in this way are about as clear as mud. So, without a clear definition, but WITH a clear demand, what is the best way to incorporate these (or not) into retirement plans? As with anything retirement, this is actually a complicated subject.
The industry has been debating this topic for quite some time, I can recall being offered the Calvert Socially Responsible Fund WAY back in the mid 1990's in my own very first 401(k) plan. However, only recently (mid 2020 DOL Proposes New Rules Regulating ESG Investments) has the Department of Labor (DOL) opined on this topic, and in typical DOL form, they were fairly vague in the language they used and caused everyone to google search what the definition of the word pecuniary means, lol.
In short, the simplest way I can interpret what was said is that the DOL said that social attitudes should not factor into ERISA-driven decision making, but rather only consider the statistical metrics and follow the fundamental fiduciary rules when choosing funds for a plan. Namely, the Exclusive Purpose Rule (always acting solely in best interest of participants and their beneficiaries) and Duties of Loyalty, Prudence, Due Care, etc. Candidly, I agree that these principals should be applied. However, it's a bit more complex and I will tackle what I mean in a moment. Quick note; these proposed rules came out in mid-2020 under the Trump administration, and in March of 2021, the Biden administration announced (Biden DOL Announces Non-enforcement Policy on ESG) non-enforcement until the rule could be studied, and presumably changed to be more socially friendly. None of this is surprising given current partisan politics.
Here's why this is complicated in my opinion.
It's Supposed to be about the Participants!
For the sake of this part, lets assume that ESG factors are neutral when it comes to benefiting investment returns OR being detrimental to them. If this is the case, then the stance of only looking at the normal evaluation metrics based on asset class should be the driving factor and much of what the DOL said is moot. However, a natural conclusion is that applying any restriction to a money manager would have the impact of reducing return opportunity which can only be viewed as detrimental, and so the DOL opinion has some controversy to it.
The one area that I keep thinking about is the participant and their perspective on this, of which, I've seen almost nothing written about. More pointedly, I'm thinking about how individuals who are concerned about ESG tend to invest. In my 25+ years of experience, it's been my observation that individuals fall into one of three camps regarding ESG;
1.) Those where it's not important
2.) Those who are blissfully ignorant of the issue altogether AND
3.) Those where it is extremely important and a moral issue.
For this third group, the moral aspect of it leads them to think about investing in the same way they think about other decisions, like where to eat and where to buy groceries or clothes. Where they get these things, and what those companies ideals are is important to them. And for these people, the decision on investing ESG or not is a binary one, and tends to be All-OR-None. Because of this, plan fiduciaries, in applying the principal of doing what's in the best interest of the participant should first consider which of the three groups their employees fit into. If it's solely the first two, then ESG is a non-issue. However if a modest or even a large amount of participants fall into the third category, there are additional considerations that need factoring in.
What I'm positing is that if having ESG will cause category 3 participants, to go from not participating in to fully saving in their 401(k) plan, then regardless of pecuniary factors, it is better to have the ESG investments in the plan then to not include them. In other words, it's generally better for participants to save and invest in the plan then to not save at all, even if the investments are potentially slightly worse then they could be.
If this is a true conclusion, the question becomes how does an investment manager or committee go about choosing ESG funds for a plan in light of the current rules. Here are my two ideas;
1.) Create a Second line-up that mirrors the first but for ESG. This is going to be a challenge for a variety of reasons, here are a few;
- Recordkeeper constraints, either on fund availability or quantity of funds system can handle
- Quality of ESG menu OR availability of ESG funds in specific asset classes
- QDIA issue or Target Date fund issue....same issue, are there viable options?
- Enrollment and other Communication materials.....how does playing field become level?
- ......there are more
2.) Incorporate an ESG fund selection process as part of the Investment Policy, identifying that the ESG investment in the plan will be a single investment, that would otherwise qualify as a QDIA. It would be diversified, incorporating stock and bond investments. Perhaps it is part of a TDF series OR not. Think Asset Allocation fund OR a specifically designed Asset Allocation Model comprised of multiple ESG funds, that are separate and distinct from the core menu, but screened by the Investment Manager for quality.
In conclusion, this topic is likely to continue to be an open discussion point until clearly defined rules are decided and finalized. Until then, I like Option 2 above. It provides a viable, well thought out, higher quality ESG alternative to offer in the plan, with minimal confusion and high consideration to the All-Or-None characteristic of ESG investors while not losing the need for investment diversification.
As always, would love to hear what people think about the above ideas. Feel free to comment or reach out to me directly.
- Jason Grantz, QPA, QKC, QKA, AIFA
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