The political football has been tossed back into the hands of workplace retirement investors who want to take their values into account in managing their portfolios. At the end of 2020, the US Department of Labor, responsible under ERISA for regulating 401Ks, changed the rules for sustainable investing, moving the goal posts for fiduciaries by restricting the ability to consider ESG factors and blocking the exercising of shareholder rights. Under the new administration, the rules for ERISA accounts changed again, opening the field to including funds considering climate change and other ESG concerns in their plan line-ups.
But the political hot potato continues to pull ESG investing in different directions. Officials in some states are attempting to demonize ESG investments and seek to make them illegal to include in state pension funds.
Colloquially called Environmental, Social & Governance or ESG investing, the term has broadened over the recent years to include racial, gender, economic and climate justice. Here is a good primer on ESG investing. The United Nations identified this list of 17 Sustainable Development Goals.
Many of our clients want to invest according to their own values and to take into account risks that often avoid appearing on a company’s balance sheet. ESG allows just that and includes factors such as climate change, pollution, workplace safety, human rights, private prisons, executive compensation and board diversity. Some ESG investors participate in “activist investing” and seek to engage with company management to effect changes in corporate policies. Others put a portion of their portfolios into community investments, such as low-income housing.
For Domini, “I view it as fulfillment of a fiduciary obligation. Assets aren’t being managed to the greatest interest of beneficiaries if, in fact, they can’t breathe or life is too dangerous at the end of their wealth building. So, I see it as a means to an end, and that end is a planet that is livable — and lives worth living. And I see it as a strategy that explicitly acknowledges that investors have a role to play in providing these outcomes to the world.”
Says Robasciotti, “We call our work ‘social justice investing.’”
Under the Trump-era rules, fiduciaries faced burdensome documentation requirements and risked lawsuits for suggesting ESG investments to their clients. The “new rule is a model of clarity,” according to Jon Hale of Morningstar.
First of all, the new rule acknowledges that many marketplace investors (i.e. non-ERISA) have enhanced the performance of their investments with “non-pecuniary” ESG considerations, which were nearly forbidden under the former order.
In fact, assets in so-called ESG funds rose 38 percent, to $2.7 trillion, from March 2021 to March 2022, according to Morningstar Direct.
The new rule also removes the prohibition against ESG considerations in QDIAs, or Qualified Default Investment Alternatives, in defined-contribution plans. This is a huge pot of funds because QDIAs are the default vehicles used when an employee contributes money to the plan but hasn’t selected an investment.
And yet another rule change involving “tiebreakers” allows fiduciaries to consider collateral benefit. A DOL rule in place since the 1990s recognized that if an investment offers some sort of benefit above and beyond risk-adjusted returns, that “collateral benefit” could not be given precedence over investment performance. “However, ‘all things equal’ among similarly situated investments, the collateral benefit could be used as a tiebreaker in selecting investments for retirement plans,” according to Hale.
Tie-breakers under the 2020 rule set an unreasonably high bar. Now, Hale writes, “fiduciaries are simply required to conclude prudently that when competing investments equally serve the financial interests of the plan, the fiduciary may decide based on a collateral benefit. There are no special documentation requirements other than ERISA’s long-standing statutory duty to prudently document plan affairs.”
Many plan participants want sustainable funds in their lineup. And many investors and their fiduciaries want to exercise their rights as shareholders. With the new rule, it is not a violation of duty if fiduciaries take participants’ preferences into account in constructing a menu of investment options for defined-contribution plans.
It’s also important to note that the Biden-era rule does not mandate retirement plan fiduciaries to consider climate change or other ESG issues. According to Hale, “It simply removes the barriers to doing so and says fiduciaries should treat ESG as they would any other relevant factor, based on the fiduciary standards of prudence and loyalty.”
The rule change affects ERISA (Employee Retirement Income Security Act of 1974) funds, that have a statutory purpose to prepare participants financially for retirement. And while the rule pertains strictly to ERISA funds, the implications for investments are much larger.
Beginning with deep ethical and religious roots, ESG investing has grown over the course of five decades from a cottage industry to a very serious undertaking. Morningstar has published a remarkable history of the progression.
As of 2022, professionally managed ESG assets in the U.S. alone reached $7.6 trillion, according to the 2022 US/SIF Trends Report on US Sustainable, Responsible and Impact Investing.
The E in ESG has dominated the conversation for many years, especially concerns around climate change and companies’ carbon footprints. But there is also renewed a focus on the S – social issues – such as employee safety and racial diversity in the workplace. All with an eye toward how a company’s reputation and bottom line may eventually be affected.
Asset managers and their analysts have been working diligently since the early days to tie ESG considerations to risk factors that companies face to their bottom lines and to financial performance.
ESG metrics are still evolving. Even in an era of financial accounting irregularities, it’s still easier to measure a company’s revenues and profits than its ESG score. There is not yet anything in ESG investing equivalent to the generally accepted accounting principles (GAAP) in financial reporting. There are multiple “ratings agencies” using different criteria and weighting the criteria differently from one another in their assessment of the extent companies in their investment universe are more – or less – highly rated on ESG criteria.
Performance is a tricky thing. I wouldn’t recommend relying on a pitch that ESG investing is going to “outperform” to induce you into adopting an ESG strategy. There are touts all over the place right now about recent ESG performance, particularly in the areas of fossil-fuel-free and alternative energy portfolios. These performance attributes may or may not persist. So, your financial plan should be designed to succeed, regardless.
Here’s the thing about performance. Unless you are invested in exactly the same portfolio as the next guy or gal, your performance is going to be different. Your performance is either going to outperform or underperform (either by a lot or a little) over any given reporting period, depending on the difference in portfolio composition. And it’s impossible to know in advance, by how much or for how long.
You may have more or less in stocks vs. bonds. You may have more or less exposure to US vs. international stocks. You may own a concentrated portfolio of 25 stocks to represent that asset class as opposed to an index fund with 3,000 different stocks. Diversification could be either a benefit or a peril, depending on how smart or lucky you are in selecting those few stocks.
To avoid the risk of underperforming to an extent that you jeopardize achieving your goals, the key is to be as diversified as possible with your ESG portfolio, while still trying to achieve your sustainability objectives. (There are now many solutions that provide both broad market exposure and reasonable approaches to sustainability.) Once you do that, all the other important things, like your saving and spending rates, tax management, discipline, etc. are going to dwarf by orders of magnitude – in achieving your financial goals – whether your small cap ESG fund underperforms or outperforms its benchmark index by a few basis points.
Only you can answer this question for yourself. Leaving aside the question of “outperformance” – perhaps you can’t bear the thought of owning companies that contribute to global warming or profit off of mass incarceration. If you answer yes to this question, our role as an advisor is to help you understand what’s involved, what the trade-offs might be and to help you figure out the most effective way to execute a sustainable investment strategy in the context of your financial plan.
There are now multiple tools to assist you with your sustainable investing. Morningstar has become a real champion of sustainable investing. In 2016 they rolled out its Morningstar Sustainability Rating for mutual funds and ETFs. And just recently added an ESG screener. This is a great, simple guide for adding sustainable strategies to your portfolio; including this worksheet. It is becoming increasingly possible to invest sustainably in broad index like portfolios.
As with any investment strategy, there is no guarantee that your expectations will be realized; financial or otherwise. But steps can be taken on both counts to increase the odds.
Steve Smith, Principal of Right Path Investments is here to guide you with preparations to take your next step. If you're ready to take that step, schedule some time for a one on one with Steve today.