DC participants seen as next advocates of ESG mantra

Environmental, social and governance investing is getting a closer look from defined contribution stakeholders as a potential way to increase participant engagement and participation, provide diversification, achieve higher long-term returns and manage risks.

Driving this closer look is a feeling among more investors, particularly younger ones, that they would like their investments to encourage companies to behave in sustainable and responsible ways, said Jon Hale, Chicago-based director of sustainable investing research at Morningstar Inc. in Chicago.

Also driving the interest in ESG today, Mr. Hale said, is the idea that "incorporating ESG criteria into the investment process is an enhancement ... that can result in better performance."

Unlike the older idea of socially responsible investing, which took a purely values-based approach, an "investment-related" theme is driving the field today, Mr. Hale said.

Alex Bernhardt, Seattle-based head of responsible investment, U.S., at Mercer, added "the advent of the chief sustainability officer and corporate focus on sustainability that's been paid over the past few years ... has percolated into benefits management and retirement plans."

Among the potential benefits of aligning a company's DC plan with its sustainability strategy is increased employee engagement and participation, Mr. Bernhardt said.

Mercer recently released a list of recommended focus areas for plan executives in 2018. One was a recommendation to assess and consider ESG factors in manager ​ evaluations and consider adding ESG-focused funds to plan lineups.

Currently, only a small percentage of DC plans offer ESG-focused funds in their main lineups. According to Vanguard Group Inc., just 8% of the plans for which it is a record keeper offered a socially responsible domestic equity option in 2016.

Options are available outside of equities, although most of the pickup tends to be in equities, said Sabrina Bailey, Chicago-based global head of retirement solutions at Northern Trust Asset Management.

Lori Lucas, Chicago-based executive vice president and defined contribution practice leader at Callan LLC, pointed to the DC industry's focus on simplifying investment menus as a headwind for the addition of ESG-focused funds. In general, DC plan executives are reluctant to expand their investment menus out of concern that the more funds they offer, the more confused people will become, Ms. Lucas explained. "More demonstration that ESG screens lead to better performance" could make it easier for plan executives to view ESG funds as core investment options, she said.​

Other barriers sources cited were plans' limited governance budgets and the short track records of some of the options.

Ms. Lucas emphasized that even if an ESG option is not offered as part of the main lineup, participants may still be able to access ESG options through a brokerage window.

While only a small number of plans now offer dedicated ESG options on their main lineups, more DC plan executives are asking for education on the topic, said Jason Shapiro, New York-based investment consultant and a member of the defined contribution steering committee at Willis Towers Watson PLC.

Among other things, plan executives are seeking more information about the Department of Labor's stance on ESG investing, Mr. Shapiro said.

Seven years after releasing guidance that discouraged plan executives from allowing ESG considerations, the DOL released new guidance in 2015 that said plan executives could use ESG factors as "tiebreakers" between investment options that are otherwise equal. The DOL added that when ESG factors have a direct relationship to the economic and financial value of a plan's investment, "these factors are more than just tiebreakers."

Plan executives are considering other ways to incorporate ESG factors outside of adding dedicated ESG options, sources said.

There is "a spectrum of approaches" DC plans can take to implement ESG, said Drew Schechtman, New York-based head of ESG strategy at Voya Investment Management LLC. "I think a starting point, which many (prospective) clients are asking for, is how are ESG factors integrated into (the firm's) investment process," such as how is the firm voting proxies and engaging with companies, Mr. Schechtman said. For many clients, this might be enough, while others might seek out dedicated ESG strategies, he said.

Demonstrating its commitment to incorporating ESG factors into its investment decisions, Voya Investment Management signed on to the United Nations-supported Principles for Responsible Investment in January. More than 1,800 investors worldwide are PRI signatories.

One way plan executives can request information on whether managers are incorporating ESG factors is through requests for proposals. Mr. Schechtman estimated that last year, the number of RFPs Voya received requesting information on how ESG is incorporated into its investment process was in the "high teens or low 20s" across all asset owner types. He did not have information on how many were DC plans.

According to a recent Callan survey of a variety of asset owners, just three of the 17 corporate DC respondents said they incorporated ESG factors into their investment decisions in 2017. Ms. Lucas said that aside from adding a dedicated ESG fund, plan executives might exclude a fund that they feel is inconsistent with their values.

Among those looking to add ESG-focused funds, there has been an appeal for a combination of negative screening strategies — the process of excluding sectors or companies that do not align with investors' values — and best-in-class strategies that target companies with strong ESG performance, said Mamadou-Abou Sarr, Chicago-based global head of sustainable investing at Northern Trust Asset Management.

While the DC world may still be in the "early innings" of ESG, Mr. Schechtman said that he believes plan executives will move toward having an understanding of ESG factors across their lineups as well as offering focused ESG funds. Once plan executives learn about ESG investing, they "don't forget about it; (they) just figure out how to do it," he said.

One 401(k) plan sponsor with an eye toward ESG investing is Bloomberg LP. In 2015, the financial data provider added the Parnassus Core Equity Fund, an ESG-focused large-cap equity fund, to the lineup of its $2.5 billion U.S. 401(k) plan.

Around the same time, plan executives updated the plan's investment policy to integrate ESG considerations into its 401(k) plan management and monitoring decisions, which included making an effort to identify at least one fund that considers ESG factors in every fund search, said Cathy Bolz, global head of benefits at Bloomberg in New York.

In October, Bloomberg became the first U.S. corporate retirement plan sponsor to sign on to the Principles for Responsible Investment.

In a statement at the time, Dom Maida, global head of global data and chairman of Bloomberg's investment committee said: "Bloomberg is committed to providing data and insights on ESG issues for its clients. This content is available on the Bloomberg terminal. Research shows firms that manage these issues well, often provide better long-term returns. Our employees are long-term investors, and giving them the choice to take ESG criteria into consideration in their retirement planning strategy was a logical next step."

Ms. Bolz said Bloomberg decided to integrate ESG into its 401(k) plan because the company determined "it was in the best interest of the plan and participants to provide them with this type of diversity in (their) fund lineup."

In the past three years, there has been a "tremendous" increase in the number of ESG fund options, Morningstar's Mr. Hale said. According to Morningstar data, there were 235 open-end funds or exchange-traded funds in the U.S. that do sustainable investing or ESG-related investing as of Dec. 31. Of that, 102 were launched in the past three years.

However, with the majority of new contributions in DC plans flowing into target-date strategies, it's difficult for ESG options to gain a foothold, Mr. Hale said. Even ESG target-date series might struggle to gain a foothold because some plan executives would probably be reluctant to replace an existing target-date series with a sustainable one, he said. In that case, plan executives might have to be convinced to offer a sustainable series alongside the existing one, Mr. Hale said.

Natixis Investment Managers launched the first off-the-shelf ESG target-date mutual fund series in February 2017. So far, between $30 million and $35 million total is invested in the strategy, said Ed Farrington, Boston-based executive vice president, retirement securities.

The early adopters are skewing toward firms that focus on sustainability as some part of their business practice or have workforces that skew toward millennials, Mr. Farrington said.

"Knowing that millennials tend to look for a connection between investment choice and (their) value set," one investor signed on with the hopes of better engaging its millennial population, Mr. Farrington said.He declined to name the investor.