The Future for ESG Investing in Retirement Plans

The DOL says ESG integration cannot propel financial advancement. Experts say the department is wrong; plan sponsors just need education on implementation.

The Department of Labor (DOL)’s proposed rule on environmental, social and governance (ESG) investment practices, published in June, intended to add clarity to years of obscure regulatory guidance. Instead, it’s created a layer of complexity among fiduciaries and has fueled more than 1,000 critical comments.

The proposed regulation restates that plan sponsors in defined contribution (DC) plans may not disregard financial approaches in an effort to pursue ESG-related considerations without violating their fiduciary duties under the Employee Retirement Income Security Act (ERISA). In plain speak, the proposal claims that ESG practices fail to bring about financial gains—even as the coronavirus pandemic keeps generating interest in ESG among employers and participants alike. Months after COVID-19 was declared a pandemic, net inflows into ESG funds reached $21 billion, according to Morningstar. ESG investing has been booming.

In fact, research has shown that large exchange-traded and mutual funds with a focus on ESG criteria have generally outperformed the broader market during the pandemic. An S&P Global Market Intelligence study analyzed 17 exchange-traded and mutual funds with more than $250 million in assets under management (AUM) that selected ESG-related stocks and found that 14 of those posted higher returns than the S&P 500, with outperformers rising between 1.8% to 20.1%.

“The growth of ESG investment has ongoing support of megatrends, including greater transparency via improved access to alternative data and ESG reporting, increased awareness of climate change and the risk it poses on investments, and the coming transfer of wealth to sustainability-minded Millennials,” says James Salo, head of data strategy and operations at Trucost, which is part of S&P Global.

A recent blog post by AllianceBernstein (AB) argues against the DOL’s proposed rule. ESG considerations are financial considerations, the blog contends, and employers are taking such considerations seriously. In an ongoing AB survey, two in three employers say they believe ESG integration, such as applying purpose-driven factors in fundamental investment analysis, is in fact their fiduciary duty.

“In its proposal, the DOL is reiterating that financial factors have to be the sole priority for DC plans to consider what funds to put on their plan menu,” says Jennifer DeLong, head of defined contribution at AB. “For many plan sponsors who have spent a little time thinking about ESG integration, to not do that is counterintuitive to how you would want an investment manager to run a fund. Many plan sponsors believe it is a fiduciary duty to consider those types of factors in the investments or lineup that they’re offering or allowing their participants to choose from.”

Michelle Dunstan, global head of responsible investing at AB, argues that real ESG integration isn’t, and shouldn’t be, decorative. “Think about an industrial company that builds widgets,” Dunstan says. “It has a factory and emits carbon. Ask yourself, is carbon taxed on the jurisdiction in which it’s currently operating? Could that become taxed at some point in the future? If so, include that in cash flows and take that into account when considering investment decisions. Even if it’s not to become taxed, ask yourself whether new potential regulations could require a company to upgrade its equipment and thereby cost money.

“In this example, if a company is going to have to spend $2 billion on upgrading their equipment, that is actually material to a portfolio manager making an investment decision,” Dunstan adds.

Among other concerns posed over the DOL’s proposed rule are concerns relating to qualified default investment alternative (QDIA) practices, and, more specifically, wahether plan sponsors may implement an ESG-themed QDIA. DeLong recommends that plan sponsors refer to a consultant, adviser or ERISA counsel to gain clarity.

According to an AB survey, plan sponsors say one of their biggest obstacles with ESG funds is knowing how to implement them. DeLong says a continued educational effort within the retirement industry is necessary.

Melanie Adams, vice president and head of corporate governance and responsible investment for RBC Global Asset Management (RBC GAM) emphasizes the importance of active stewardship among investment groups. “Meeting with companies in which we’re engaged, asking them questions about their ESG risks and opportunities and voicing concerns that we may have back to the company,” are ideas she lists to engage in ESG.

Until the DOL adds further guidance, DeLong says she believes choosing any investment strategy that integrates ESG factors—whether that be a QDIA, core menu option or self-directed brokerage window—should be sufficient.