If we believe that the 191 governments that are currently parties to the Paris Agreement on climate change will successfully follow through on their promises, the logical conclusion is that companies must either voluntarily decarbonize or be forced to do so. We should expect a pile-on of companies scrambling to get their carbon action plans, and related ESG (environmental, social and governance) reporting, in order. This is indeed happening.
While this massive corporate transformation takes place, there is a similar pile-on in the investment world. Investors, particularly new generations of young professionals, are putting their money into ESG funds, hoping to invest in alignment with values such as racial justice and stopping global warming, while also garnering top-tier fund performance. The most vocal, activist individual investors are calling for more than ESG; they want their investments to be divested from fossil fuels, whether that means boycotting oil company stocks or going further, for example divesting from banks whose loan portfolios include oil companies.
The Securities and Exchange Commission (SEC) has heard the call, issuing a statement on March 15 requesting public comment on climate disclosure. “There is really no historical precedent for the magnitude of the shift in investor focus that we’ve witnessed over the last decade toward the analysis and use of climate and other ESG risks and impacts in investment decision-making,” said acting SEC chair Allison Herren Lee in a speech to the Center for American Progress the same day.
While the rush to align with the Paris Agreement dominates the environmental narrative (the “E” in ESG), diversity, equity and inclusion has risen to the forefront in the U.S. on the social, or “S,” front. DEI is a human rights issue for business, along with such concerns as forced labor in supply chains. Governance is a theme dear to investors because good governance tends to mean some protection from the kinds of scandals that can cause a share price to plummet.
In the last two years, ESG funds have begun attracting a lot of attention with net flows more than doubling in 2020 over 2019, and growing tenfold since 2018. Morningstar said assets in U.S. sustainable funds reached $236.4 billion—up more than 70 percent from 2019. But that was only 24 percent of overall flows into funds in 2020, and ESG assets remain a fraction of the overall investing landscape. They are particularly rare in the world of retirement savings, even though ESG and the long-term approach of 401(k) managers would seem to be a natural fit. It is very rare to find ESG target date funds—funds designed around the working lifespan of the future retiree. The Plan Sponsor Council of America, announcing its most recent survey of retirement plans, which reflected 2019 data, said “while ESG/SRI investments have been a hot topic of late, fewer than three percent of plan sponsor respondents included that option on their plan investment menu.” Why the slow uptake?
After all, adding an environmental, social and governance lens to financial analysis helps investors factor important elements into investment decisions. ESG adds a layer of risk analysis that offers greater depth to traditional financial analysis and includes a long-term view. If companies need to decarbonize by 2050, are they laying the foundations now to be able to achieve such a goal? Proponents of ESG say it modernizes asset management, helping financial performance. “ESG is a data revolution more than a values revolution,” says Jeffrey Gitterman of Gitterman Wealth Management. He uses the metaphor of the GPS emerging to upgrade paper map navigation. Collecting data on corporate environmental, social and governance risks and opportunities adds a new dimension to an investor’s knowledge about a company.
401(k) fiduciaries tread very carefully in terms of their duty to retirement plan beneficiaries, offering choices vetted for solid performance over years with low fund management fees. The Department of Labor’s guidance on plan fiduciary responsibility focuses on prudence, acting solely in the interest of plan participants and their beneficiaries, diversifying plan investments and keeping plan expenses low.
In fact, most legal complaints made against employer-sponsored 401(k) plans focus on the plan management fees, and fiduciaries, steered by hired professional advisors, are heavily focused on reviewing fees to make sure they are kept low. Fiduciaries also tend to select, among equity funds, ones that have a broad basket of equities across industries in order to protect against an industry or group of industries underperforming. So, 401(k) plans are correctly managed with special caution.
ESG proponents like Gitterman suggest that caution should mean increased use of the ESG lens, for better management of risk. But an old narrative persists that ESG is about values and isn’t financially based, meaning there could be a tradeoff; if you adopt ESG, you’ll have to give up financial performance.
But, on the contrary, Morningstar data shows increasing correlation between ESG and financial performance.
“After holding their own in the fourth quarter, sustainable equity funds finished 2020 with a clear performance advantage relative to traditional equity funds,” wrote Jon Hale, head of sustainability research for the Americas at Morningstar, in January. “Sustainable funds are those that emphasize the use of environmental, social and governance criteria to generate financial return and broader societal impact. For most of the year, the kinds of stocks that sustainable equity funds prefer—those of companies with better ESG profiles and that are aligned with the transition to a low-carbon economy—outperformed.”
When the Department of Labor proposed a new rule last year suggesting that ESG should not be included in retirement plan decisions, an avalanche of public commentary was filed insisting that this approach was based on outdated ideas. “ESG investing can be less risky,” wrote Jon Lukomnik of Sinclair Capital in a comment. “Indeed, we would suggest that…any fiduciary who does not consider ESG is violating his/her duty of care.”
On March 10, the Biden Department of Labor issued an enforcement policy statement saying that until it publishes new guidance, it will not enforce last year’s rule—effectively killing the rule. And now SEC officials John Coates and Allison Herren Lee, the acting chair, are quickly putting ESG front and center.
In the meantime, caution prevails as 401(k) plan fiduciaries and their professional advisors favor a conservative approach. But at some companies with a large proportion of millennial employees, ESG funds have been introduced into retirement savings plans; Google, for example, offers a TIAA-CREF “social choice equity” fund. Vanguard, Fidelity and BlackRock, among others, all offer ESG funds, and Natixis and BlackRock even have ESG target date funds. PRM Consulting Group, an HR consultancy, hired Michael Rhim to introduce ESG options in 401(k) and 403(b) plans. Last year, the Intentional Endowment Network, an organization representing foundations and universities, created a retirement initiative to introduce retirement plan ESG options and recently brought on board Rhim to create a toolkit to accelerate ESG adoption among their members. And the World Business Council for Sustainable Development (WBCSD), together with Mercer and other partners, developed a project called “Aligning Retirement Assets” with two toolkits that have been rolled out to interested companies.
“Employees invest in their retirement for the long term with the expectation that when they retire, they will have saved a significant amount of money that will allow them to live well in their retirement,” wrote William Sisson, executive director of WBCSD for North America. “This is precisely why ESG funds are a smart retirement strategy as they too are based on the long term.” WBCSD published a report called Vision 2050, describing what a sustainable world could look like with nine billion people. “Today’s employees need the choice to invest in funds that take these factors into account,” Sisson says.
The views and opinions expressed in this article represent the author’s personal views and opinions and do not represent the view, opinions or official policy or position of any organizations or persons the author may be associated with in a professional or personal capacity.