ESG As a Fiduciary Consideration

Industry professionals highlight the importance of implementing environmental, social and governance strategies, and explain how the investments connect to a plan sponsor’s fiduciary duty.

Interest in environmental, social and governance (ESG) investing has peaked in recent months.

This may be due to drops in daily carbon dioxide emissions connected to the COVID-19 pandemic, which some experts believe swayed more investors and plan sponsors to consider sustainable investing. Or it could be because the conversation took on a new relevance when the Department of Labor (DOL) issued a proposal that seems to impose stricter limits on ESG investing and, more specifically, increase fiduciary considerations when it comes to sustainable investing.

Many retirement industry experts and other professionals shared their strong disapproval of the proposal, arguing that ESG considerations are financial considerations. The DOL received more than 1,500 comments during its 30-day comment period—1,100 of which criticized the proposed rule.

In an interview with PLANSPONSOR, Vikram Gandhi, a Harvard Business School professor who developed the school’s first course on impact investing, made the case for pension plans interested in ESG investing. For these plans, he says, the fiduciary obligation is to preserve and increase capital given a certain level or risk, especially if employers are considering the long term. “If you have a long-term time horizon, then you should be thinking of ESG [investments] as part of the investment process, because otherwise you’re not fulfilling your fiduciary obligation,” he argues.

And, as ESG investing continues to become more popular with younger investors, Gandhi says its significance spans beyond just “feel-good” investments. “The DOL’s proposal is coming from a mindset that implementing ESG is doing good, as opposed to incorporating ESG means it’s a better investment decision,” he says.

Larry Swedroe, principal and director of research at Buckingham Strategic Wealth, says ESG investing has evolved from what was considered “socially responsible” investing in the past. While socially responsible investing was motivated by social and political values, ESG strategies have since moved to encompass a broader category of sustainable investments, along with a focus on governance and the environment, he says.

Drew Schechtman, vice president and head of ESG strategy at Voya, says ESG factors are a core part of the investment process, so much so that these strategies are more likely to outperform or perform in line with a benchmark than other strategies. U.S. ESG funds outperformed conventional funds last year, according to a report by Morningstar. Another report by the data provider showed that ESG had outperformed other funds consistently over the past 10 years.

“The DOL doesn’t acknowledge that evaluating ESG can be a part of fiduciary responsibility, and this limits the ability for plan sponsors to actually provide investment options that may outperform,” Schechtman says.

Like other investments, adding ESG strategies requires robust processes, documentation and testing to fulfill fiduciary responsibilities. Schechtman says he believes the DOL’s proposal places an undue burden on these investments by adding a higher hurdle for sponsors to clear to vet ESG investing and, thus, adding a layer of complexity for employers to navigate. Many, instead, will choose to forego implementing such a strategy rather than unravel the confusion, Gandhi adds. “Employers are running a business. Managing the pension plan is not their core activity,” he says. “It’s normally managed by the human resources [HR] department or they’ve delegated it to another fund manager. Theres this general view of not taking risk and not messing with it.”

Yet this idea can be detrimental to a plan sponsor’s fiduciary status. Swedroe argues that by only focusing on risk-adjusted returns, the DOL’s proposal does not acknowledge higher risk scores, risk management and compliance standards that ESG factors tend to bring. “They also have less risk of fraud, corruption, litigation and all these things that create tail risk,” he says. Research has shown that companies that are “browner,” such as those that only invest in oil and coal funds, have greater tail risk than “green” funds, Swedroe says.

Instead, more companies are incorporating ESG practices to add a competitive edge, Swedroe notes. “Private equity will go up, the cost of capital will down for equities and interest rates on bonds will be lower even for the same credit rating,” he says. “The good news about all of this is you’re seeing pressure on companies to do the ‘right thing,’ because, if they don’t, they’ll end up with low sustainability scores, have a higher cost to capital relative to their investors and they won’t be able to compete effectively. They’ll be at a disadvantage.”

Depending on how the presidential election goes in November, a different set of eyes may be looking at the proposal going forward. According to an article on Groom Law Group’s website, if President Donald Trump does not win a second term, it’s possible the DOL will want to finalize a rule this year, as undoing a final ruling is more difficult than making changes to an interim rule.