Though there are likely broader corporate environmental, social and governance (ESG) initiatives, there has been relatively limited adoption of ESG investing among U.S. based corporate retirement plans (ERISA qualified defined benefit and defined contribution plans). There are circumstances, such as the dramatic shift in Department of Labor guidance between the Trump and Biden administrations, which could have understandably contributed to the reticence of ERISA plans sponsors to implement ESG investing strategies. However, ESG investing is growing in prevalence among some U.S. public retirement plans, retirement plans based in Europe and among investment managers. In fact, most ERISA plans using active management probably already have some level of ESG integration included in their plan regardless of whether an ESG policy or approach was actively adopted by the plan sponsor.
This article draws on Russell Investments’ experience working with some of the world’s largest and best-known institutional investors, dedicated manager research resources and ongoing ESG research to draw out some observations on the adoption of ESG by ERISA qualified plans, delve into what may be influencing those decisions and provide guidance on how to move forward on ESG .
Unpacking the approaches to ESG investing
There are various approaches to implementing ESG investing: exclusion, inclusion and integration. Historically, asset owners may have equated ESG investing with values-based investing and the objective was to exclude so-called sin stocks in industries such as tobacco or firearms or, more recently, fossil fuels. It may have also meant investing in ESG friendly industries such as solar power (inclusion). ESG integration does not mean outright exclusion or inclusion of stocks based on ESG considerations, but rather takes a holistic analytical approach which considers how ESG factors, among a mosaic of other factors, can impact security prices and therefore investment risk/return outcomes.
ESG integration is not about restricting securities, targeting climate related metrics, or even intentionally investing in securities with better environment, social or governance practices. But rather, ESG integration is about understanding how E, S and G impact a firm and will impact the future direction of a security’s price.1Investing on behalf of corporate retirement plans has continuously evolved since the passage of ERISA in 1974. ESG factors are perhaps the latest lens that is expected to be additive to an investment manager’s existing investment philosophy and process.
Embedded in ESG integration is the concept of materiality—the consideration of the ESG factors that are uniquely expected to directly impact the financial performance of a specific company. A simple example of materiality could be fuel-efficiency. Fuel-efficiency could be material to the performance of an airline stock but is probably not material to the performance of a bank stock. Fully implemented, the approach could seek to focus on stocks of companies which score high on material ESG factors but low on immaterial ESG factors. The point is to separate the impactful ESG drivers of future financial performance from those with less consequence as a means of predicting favorable future performance.
Shifting Department of Labor stance on ESG
Since ERISA plans are subject to Department of Labor (DOL) regulation, shifting DOL guidance over the last few decades may have made plan sponsors reticent to implement any ESG related investment considerations. Most recently, the DOL issued differing rules within months of each other in 2020 and then in 2021. In October of 2020, the DOL issued the “Financial Factors in Selecting Plan Investments” which raised the bar for ESG consideration. Notably, the final rule included a pecuniary factor requirement which put a finer point on the ERISA duty of loyalty requirement.
In 2021, the DOL reversed course and announced that the 2020 rule would not be enforced and issued another proposed rule titled “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights.” In a particularly notable shift, this proposed rule included a statement that prudent investment “may often require” consideration of ESG factors.2
The intersection of long-term investing and climate change risk has received attention from the Biden Administration and in May 2021 an Executive Order was issued on Climate Related Financial Risks, which instructed the DOL (among other things) to identify agency actions that can be taken under ERISA “to protect the life savings and pensions of United States workers and families from the threats of climate-related financial risk.”
So far, ESG investing adoption among ERISA retirement plans has been limited, but there is interest
Russell Investments’ U.S.-based consulting clients include over $300 billion in ERISA retirement plan assets across 28 defined benefit and defined contribution plans. In early 2022, a survey of these plans was conducted to garner insights into the progress made by ERISA plans in considering and implementing ESG in their investment processes. Here are some observations:
- Fewer than 1/3 of plans reported that they have either implemented or are planning to implement some level of ESG considerations into their investment process/ investment due diligence.
- Over half of respondents reported having conducted ESG education over the last two years.
- Half of plan sponsors reported changing DOL guidance as a consideration.
- About 1/3 of plans noted a lack of evidence of ESG performance as impacting their willingness to consider ESG.
- Inclusion of ESG options in defined contribution plan menus is limited with only two plans currently offering an ESG option to participants. However, plans may include a self-directed brokerage window through which plan participants can directly access ESG-related investments.
Investment managers are integrating ESG factors into their investment processes
Investment managers are moving forward on ESG, increasingly becoming signatories of the United Nations supported Principles for Responsible Investing and including ESG factors in their investment processes, despite changing DOL regulations and limited direct adoption by corporate retirement plan fiduciaries. Our 2021 Annual ESG Manager Survey quantifies the adoption of ESG by investment managers globally. The survey includes responses from 369 investment management firms, with about half of the manager respondents headquartered in the U.S. Here are some key findings of the survey:
- 80% of investment managers surveyed are signatories to the United Nations supported Principles of Responsible Investment (PRI).
- 82% of U.S.-based investment managers report using explicit ESG factor assessments in their investment process. Governance remains the ESG factor which impacts investment decisions the most. However, the usage of environmental factors is increasing.
- 60% of investment managers report climate change or the environment in general as the single biggest concern expressed by their clients.
Backlash: Is climate change risk an investment risk?
Strong views on ESG investing have been expressed by public officials. Since many of the decisions of public plans are public knowledge and represent a lot of assets, their views and actions receive considerable media attention. Though sound bites do not make sound investment policy, it is interesting to consider some of the skepticism expressed balanced with some of the actions taken. Following are just a few examples which have made headlines in the institutional investment world.
In September 2021, Texas enacted a state law which prohibits state pension plans from investing with firms that “boycott” energy companies. Recently, the Texas State Comptroller began requesting information from more than 140 financial firms to assess whether they restrict or “boycott” businesses with fossil fuel companies under Texas law.3 Early this year, West Virginia Treasurer Riley Moore announced that the state’s treasury investment board (this is separate from the West Virginia Investment Management Board) would no longer use BlackRock to manage its operating funds, citing concerns over the firm’s “anti-fossil-fuel- stance.”4 BlackRock CEO Larry Fink has been an outspoken proponent of ESG investing, yet has also stated that divestment (i.e. boycott) is not the right approach and that BlackRock is not pursuing an oil and gas divestment policy as an organization.5 Further, BlackRock’s significant indexed AUM makes true divestment an impossibility.
In practice, the Investment Policy Statement of the Teachers Retirement System of Texas includes the following text which takes a practical approach to ESG: “Environmental, social, and governance (ESG) factors influence the performance of TRS’s investments. In making investment decisions, the Investment Division will consider ESG factors that are material to long-term returns and levels of risk. Materiality of specific ESG factors vary across strategies, companies, sectors, geographies and asset classes.” The Investment Policy Statement also requires that investment staff report at least annually to the Board on “ESG efforts, methods and results.”6
By early 2022, the New York State Teachers’ Retirement System, the New York State Common Retirement Fund and the New York City Employees’ Retirement System all had implemented fossil fuel divestment and engagement strategies. Together, these three pools of assets represent over $600 billion. New York Teachers’ Retirement System CIO Thomas K. Lee referenced the consideration of how ESG factors relate to the system’s long-term investments and fiduciary responsibility, as well as evaluating the long-term economic risks in the fossil fuel industry and the long-term risks they pose to the system’s investment in such companies.7
Greenwashing: ESG marketing spin or investing reality?
Greenwashing is a misalignment between what marketing materials describe and the actual investment process that are implemented. In other words, greenwashing characterizes the situation where a manager overstates the incorporation of ESG into their investment approach. As more and more managers look to demonstrate ESG capabilities, perhaps for commercial reasons, identifying greenwashing will become an increasingly important issue. The current lack of consistency in reporting standards creates room for greenwashing to occur. The European Union is ahead of the U.S. in the development of standard disclosure requirements with the Sustainable Finance Disclosure Regulation. However, the issue is now coming into focus in the U.S. as the SEC recently proposed rules to standardize climate related disclosures.
Where do ERISA plans go from here?
Clearly, there is a lot to consider in making decisions regarding ESG investing, and the landscape is still evolving and remains somewhat controversial. Here are some of the areas which plan sponsors could consider in their ESG investing decision making:
- Document the decision-making process. Whatever the decision on ESG, the process undertaken and the rationale supporting that decision should be well documented.
- Include ERISA counsel in making ESG-related investing decisions.
- Understand how your consultant/OCIO provider is thinking about ESG investing, and if and how they are including ESG considerations in their manager research process.
- Recognize that if active managers are used in a plan, they could be incorporating environmental and social as well as governance factors into their investment processes (governance factors have long been included by investment managers). Plan sponsors should understand their approaches and decide if they are appropriate.
- For active and passive managers, the firm’s approach to ESG considerations in proxy voting decisions should also be understood
- Be informed and advised about evolving regulations. Again, this is a place to include the legal advice of counsel.
- Provide general and objective ESG investing education to the staff and committee.
- Be clear about the ESG approaches: exclusion (i.e., boycott) and inclusion versus integration
- Climate change and diversity, equity and inclusion seem to be emerging as key topics to watch
- Be aware of the risk of greenwashing. Like any other part of an investment manager’s process, the actual use of ESG should be probed.
Russell Investments is committed to working with our clients to evaluate and develop the ESG investing approach which is most suited to their specific circumstances. We have been a signatory of the UN supported Principles of Responsible Investing since 2009, and have included ESG considerations in its manager research since 2014.
¹ Best Practices for Responsible Investing: Portfolio Management, Research, Ownership and Collaboration
2 DOL proposes new ESG and proxy voting regulation – would significantly change rules adopted by the Trump DOL at the end of 2020,Mike Barry,O3 Plan Advisory Services, October 14, 2021
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