Responsible investing may include socially responsible investing (SRI), as well as environmental, social and governance investing (ESG). “SRI and ESG are both types of responsible investing,” Earle Allen, vice president of Cammack Retirement Group, tells PLANSPONSOR. “SRI uses a process of negative screening to eliminate companies from potential investment based on the products or services they deliver or the actions they take. ESG investing tries to identify companies that follow green procedures as a complement to products and services it provides.”
Investment experts note that considerations for ESG investments can involve anything from an investment’s carbon footprint to its sensitivity to potential resources of energy shortages (see “Looking Ahead Responsibly”). They also note that responsible investing is not a passing trend and that plan sponsors need to think about how to integrate such options into their investment selection process (see “Paper Examines Responsible Investing”).
The New York-based Allen, who wrote a paper about responsible investing, notes that one limitation of such investments, specifically SRI ones, is that the negative screening process can result in a significantly restricted pool of potential companies from which to choose. Plan sponsors may also be concerned that responsible investments in general may not perform as well as other non-responsible investments, he says. “This may cause a fiduciary problem for them. So, if the participant demand is not there, plan sponsors are typically reluctant to undertake that potential risk for limited benefit.”
To address these concerns, Allen says, “Plan sponsors should first identify participant interest in having responsible. Assuming the demand is there, plan sponsors need to analyze the available options. There are responsible investments that are competitive in terms of performance, which is key to avoiding potential fiduciary problems from the Department of Labor. Once implemented, plan sponsors must remain vigilant in their ongoing review to make sure the selected options remain competitive, or replace them if they are not.”
To maintain diversification among responsible investments, Allen explains, “Careful analysis by plan sponsors is critical. Competitive standards can be met with responsible investments in many asset categories, such that a diversified array can be crafted. However, the more responsible investments offered, the more potential risk for underperformance and need to search for replacements. This is why plan sponsors frequently just offer a balanced fund that enables the participant to diversify his or her account all in one responsible investment.”
As a way to address the potential for lower returns, Allen says plan sponsors could include responsible investments in the lowest group of a tiered array and expressly indicate that those funds are not carefully reviewed. However, he cautions, there is no guarantee that such a plan would pass scrutiny by the Department of Labor. “It has yet to be tested,” Allen says. “We strongly encourage plan sponsors to speak with legal counsel before implementing such a plan.”
To gauge participant demand for offering responsible investments, Allen recommends, plan sponsors check with their human resources or finance departments to see if any comments have been received from participants regarding a desire to invest in responsible options. They could also issue a survey to receive feedback from employees about their interest.
Before choosing which responsible investment options to offer in their retirement plans, Allen says, “The plan sponsor should start by deciding if they want the investments to be guided by a particular mission, such as no alcohol, or firearms, or lab animal testing, etc. and use a negative screening process, or if it is more interested in ESG type investing. If there is no specific social agenda, the plan sponsor will have more options from which to choose, and thus presumably a better chance for finding competitive options.”
Beyond the social criteria, Allen says, the plan sponsor should use the same investment criteria it uses for any other fund related to performance, fees or process. From this screening process, they will find funds that meet both the social and performance criteria to be eligible for inclusion in the plan.
A copy of Allen’s paper can be found here.
« (b)lines Ask the Experts – Preparing for an IRS Audit