It would seem obvious that defined contribution plan sponsors who are tasked with helping their employees create long-term retirement security would champion ESG investing — the wider environmental, social and governance factors that impact long-term corporate performance — as a core approach on their investment menu. After all, plan participants have become more vocal in demanding ESG-related options on DC plans. But adoption has not been as rapid as one might think. How are DC plans responding and ramping up their education around ESG considerations? A panel of industry experts — John Streur, president and CEO of Calvert Research and Management; Emily Chew, global head of ESG research and integration at Manulife Investment Management; and Edward Farrington, executive vice president of Natixis Investment Managers — all longtime practitioners of ESG investing, demystify the confusion around ESG perspectives for DC plans, decipher the fiduciary concerns and offer ways for plan sponsors to move forward to embrace ESG investing.
ESG in DC: despite headwinds, more plans embracing responsible investing
Pensions & Investments: What is the state of ESG in DC plans today?
Ed Farrington: We are seeing increased interest in ESG from plan sponsors, plan participants, consultants and really the entire community around DC plans. Natixis Investment Manager's survey data shows two-thirds of institutional investors believe that ESG will become the industry standard within the next five years. We also know that participants want access to more responsible or sustainable investment options. For example, two-thirds of millennials state they would invest in their plan for the first time or increase their contribution rate if they had access to more responsible investments. By the year 2025, millennials will be 75% of the American workforce, making this an incredibly important trend. So we’re seeing more and more DC plans across the spectrum — small, medium, large and mega — asking questions about ESG and looking to the consultant community to find out the best ways and the best strategies to go down this road.
Emily Chew: I think the state of ESG in DC remains quite uneven. There’s a lot more research and education going on than there’s action at the plan sponsor level. Obviously, a lot more conversations are happening, and plan sponsors are seeing inquiries from participants going from a slow trickle to a steady stream of constant queries. Some plan sponsors are more active than others in educating themselves and determining the right time for them to start incorporating ESG solutions.
The megatrend that’s picked up steam in the last five years has been ESG integration for institutional fund solution providers. So at the underlying fund level, even if there isn’t explicit labeling or disclosure of ESG, there’s a lot more activity by portfolio managers around ESG integration into the investment process. That’s not necessarily obvious, as many of these funds might not be labeled as sustainable or ESG funds.
John Streur: I think we’ve entered a period of adoption and addition. In other words, DC plans have really begun to add ESG or responsible investment options to the plan menu, a trend that has accelerated over the last five years. It’s coming from either specific demand or requests from the plan participants or [from] the plan trustee’s understanding that the plan participants probably want this option. So it’s very much driven by either actual or perceived plan participant demand for investment strategies that address environmental and social issues in the process.
P&I: What broader trends are driving ESG investing by DC plans?
Chew: A few trends are driving sustainability or ESG in investments more generally. The first is the availability of data and the technology to gather, harvest and make that data available to investment decision makers. In 2011, 20% of S&P 500 companies reported sustainability metrics; today, that’s over 80% of companies, which is illustrative of the sea change in the rate of disclosure we’re seeing today.
The second trend is evidence that ESG behaviors that pertain to strategic decision-making at the corporate level potentially support long-term stronger performance, less volatility and more adaptability to wider sustainability megatrends. As companies get better at sustainability planning, we are seeing evidence that ESG will not detract from returns in your investment portfolio. At a minimum, it’s a neutral impact on returns and, at best, in some market cycles, it could even be associated with alpha generation. This is early data, but it is a fundamental shift in the perception among mainstream financial players that ESG is a cost and you will lose value. That is really an outmoded view now.
Finally, at the cultural, environmental and socioeconomic level, the world is changing. People are much more aware of a changing environment, whether it’s climate or pollution issues, around them. That just creates a groundswell in our culture around the alignment of sustainability with economic growth and human prosperity.
Streur: If you take a broader view, there’s so much going on in the real world that we don’t always connect to the stock market. From what’s going on in their day-to-day lives, people are saying, “We need to address these environmental and these societal issues,” and companies that can do that well are viewed as better companies. People are really just connecting the dots, and it seems very obvious they are driving awareness and adoption into the investing space.
Most workplaces are attempting to improve their environmental impact and trying to improve how they deal with their people and their communities. Most organizations have a sustainability report, and some have initiated major sustainability efforts. So that, in turn, gets people to say, “If this is important to our company, shouldn’t we be investing in other companies doing these things? If this is important to our company, shouldn’t we have these as options within our DC plan?” It’s a virtuous cycle, and not by just millennials. The oldest millennial is now 38 years old, which is probably older than most people think when they say millennial, right? I’m 59, by the way, but I have millennial children. People understand that the factors critical to sustainable investment or responsible investing make good business sense and this is of interest across age groups, across genders and across demographics.
P&I: What makes ESG and sustainable investing a good fit for DC plans?
Streur: The considerations for a DC plan sponsor are to provide excellent investment options to their participants, options that the participants will be comfortable with and that will be able to meet their retirement savings goals for the long term. Those considerations can be very well met through ESG options today. In fact, ESG can really meet those considerations in an extraordinary way because people are very enthusiastic and comfortable with these portfolios.
But today, ESG means different things to different mutual fund companies. ESG or responsible investing doesn’t carry with it a set of standards that implies one is similar to another. We’re just not there yet. The investment consultant is playing an absolutely critical role at this stage of the game in providing that due diligence to plan sponsors. The investment consultant is spending enormous amounts of time and energy understanding ESG company to company to company, asset manager to asset manager. That educational process is ongoing, and plan sponsors should be taking advantage of the investment consultant here. Ultimately, linking together environmental outcomes, social outcomes, corporate performance, investment portfolios and investment options for everybody, that’s what’s so interesting and so important to improving value creation and improving these outcomes.
Chew: Sustainability and ESG are megatrends for the finance industry that are not going away. These are cultural and socioeconomic megatrends, not just in a niche segment of finance. What we’re really tackling here in the ESG space is creating a finance system that is fit for purpose in the modern world. The modern world has a lot of constraints and challenges around climate change, income inequality and other issues, but there’s also a ton of opportunities. So the way we think about it as a provider of fund solutions is this is about being fit for purpose in the modern world. And if DC plan sponsors think about it in those terms, it becomes less about why and more about why not.
Farrington: By their very nature, by their design, defined contribution plans are long-term investment vehicles. I even mean that for someone who is 60 years of age because life expectancies being what they are, you’re still talking about having a 20- to 30-year time horizon. If you’re a young investor new to the workforce or if you’re in the middle of your career, you have a 30-, 40-, 50-year time horizon. It’s our belief that ESG criteria are incredibly well aligned for long-term investors. We see evidence that ESG helps move investment managers away from short-termism and into longer-term considerations. We’re seeing many different studies that verify this, that managers that use ESG criteria are outperforming over longer cycles. That’s no surprise. These are long-term considerations that help identify companies who are thinking about the long term, and therefore they are perfectly aligned for defined contribution plans.
P&I: While understanding of ESG investing continues to grow, why is the pace of adoption still cautious in the DC world?
Farrington: The most prominent headwind is the regulatory side. The April 2018 bulletin from the Department of Labor caused a fair amount of confusion and actually caused certain plans to pause in their adoption of ESG. But when you actually read that bulletin, it boils down to a simple concept: If you add ESG managers to your plan, they have to go under the exact same considerations as other managers. What the DOL is saying is that you can’t make any concessions for ESG. It has to be purely for the financial benefit of your participants. The good news is that we can make that case.
The second headwind is that this is an educational conversation right now. Many people in the U.S. still confuse ESG with traditional socially responsible investing or impact investing. A socially responsible investor says, “There are certain things I don’t want to own.” It might be alcohol, tobacco or firearms, and they use a social lens to exclude these types of companies. That typically reduces your investment universe and it can ask you to make a trade-off between performance and your social beliefs. On the other end of the spectrum, impact investing says, “I want to make an investment, and its impact on society will be on a par with my financial return.” ESG is neither of those things. ESG is purely a framework that is a more complete due diligence process. It seeks to identify themes, to identify management teams that have a long-term view and that understand risk — short-, medium-, and long-term; therefore, it’s perfectly aligned with fiduciary duty. What we’re currently doing is educating plan sponsors on that very fact.
Streur: In a very real sense, we’re at the beginning of this process and, therefore, have challenges associated with any process that’s at its beginning. For example, while Calvert has responsible investing funds across global equity and bonds, active and passive, with long track records, we don’t have 10 competitors that look like Calvert. While lots of fund companies have created products in the past couple of years, they don’t yet have the track record to create a competitive peer group and that can meet the traditional manager search work that institutions are used to doing. That condition will change over time, but at this stage, the lack of large numbers of competitive funds makes responsible investing different from standard investing in terms of the peer groups and fund universes that you can put together for your search.
At Calvert, we’ve been in this space and we have enough assets under management so that we can handle large assignments, and we aren’t the only firm. But there aren’t very many competitors that can say that, and that is still to develop.
Chew: As noted earlier, there’s this incumbent perception that sustainable behavior is a cost to the company and, therefore, must lead to worse portfolio returns. There’s institutional inertia around this perception and it’s still held by many decision makers, board members and [chief investment officers], and we have quite some way to go before they shift to understanding that sustainability is impacting companies at the cellular level.
There’s a related perception that ESG considerations don’t meet the fiduciary duty of plan sponsors in offering options that will generate the best risk-adjusted returns. If you have doubts in your mind about the return potential from ESG factors, you’re going to immediately equate that as being in conflict with your duty as a fiduciary. There hasn’t been a clear enough statement from regulators about expectations around fiduciary duty and how sustainability factors are well within the range of fiduciary duty. While the United Nations PRI — Principles for Responsible Investment — has done really great work to help demystify that space, regulators are sending mixed signals in that regard.
P&I: So how should plan sponsors think about the alignment of their fiduciary duties with ESG integration?
Streur: The DOL has made it clear that they’re less comfortable with an ESG fund being the [qualified default investment alternative] than they are with an ESG fund just being another option. To be candid, we’ve got the products, but I think the typical DC plan will add a responsible investment fund or an ESG fund as another option as opposed to a QDIA. I do think that virtually any reading of the DOL guidance that came out in 2018 would lead you to that conclusion. It’s always been the case that anybody who’s working in the [Employee Retirement Income Security Act] environment is thinking very carefully about making sure that their investment process follows the outline necessary to discharge their duties as a fiduciary. No question about that. I don’t want to try to give legal advice here, but we believe that many DC plans are comfortable in understanding the DOL guidance as allowing the use of ESG funds as an additional option in the plan, but not as the only option in the plan.
Farrington: Do ESG funds align with a plan sponsor’s fiduciary duties? That’s a resounding yes. ESG criteria are financial and long term and, therefore, well aligned with the plan sponsor’s fiduciary duty. I’ll take it a step further. I believe we are entering a phase where plan sponsors who don’t consider these criteria will be held to account as to why not. When we know these are financially material considerations, why are we not asking those questions when we’re thinking about the options we provide our plan participants? That’s where we’re heading with this, and we want to be at the forefront.
P&I: How can you introduce ESG or sustainability investing to DC plans?
Streur: We work hard to make clear that our selection process is built around a framework that emphasizes producing long-term value. In other words, competitive performance is our No. 1 objective. Another key objective is to find the companies that are doing the best job addressing their financially material environmental exposures and social exposures. This is extremely important because there’s still a part of the market that thinks about exclusionary investing or socially responsible investing that excludes, say, tobacco or alcohol companies. But that’s just an outcome of the selection process where we’re saying, “How does this company deal with its financially material environmental exposures and social exposures?” We really spend time making sure that the plan sponsor and consultant understand our work that links environmental and social exposure management to financial returns and investment results.
The second major piece that Calvert emphasizes is the need to engage with the companies we’ve invested in through direct engagement, proxy voting and the shareholder resolution process. Again, always linking to financial materiality is a big part of what it means to be a responsible investor. Whether it’s defined benefit, defined contribution, endowment or foundation, or high-net-worth investor, once they really grasp this, they understand that this is simply about outperformance.
Farrington: Many institutional investors and asset managers are incorporating some ESG criteria in the investment process. In fact, rating agencies will rate any investment strategy for ESG criteria, though some don’t explicitly state that they are ESG and score quite high. On the other hand, there are investment managers who are bold and transparent in explicitly stating that they hold themselves to ESG criteria in the investment process because certain investors and plan participants will want to know that criteria are being used in investment decisions. They’re increasingly seeing that the criteria of the E, the S and the G are showing up in the stock price. Certainly, managers who are explicit about ESG criteria are showing that they understand it best. The overall shift ― whether stated or not ― to ESG criteria is because [they are] financial criteria. ESG is not collateral, and it is not simply feel-good. ESG is about outcomes and making better decisions when deploying capital.
What we typically see today, and it’s a good first step, is DC plan sponsors will typically add an equity option — global equity or U.S. equity — that has ESG criteria underpinning it. One of the easy ways to implement ESG, if you do accept that this is good long-term investment criteria, is a target-date range that gets people a fully diversified portfolio with ESG criteria, including green bonds, international equities, U.S. equities and so on. We offer the Natixis Sustainable Future Funds, with the rigor of a well-diversified glidepath and world-class fund managers managing the underlying segments of the product. Clients also like the collateral benefits, which include the ability to help engage your workforce.
Chew: With the evolution of ESG integration into the investment process at fund management firms, plan sponsors can and should be asking a lot more questions as part of their due diligence about how these firms think about ESG integration [and] provide evidence of their practice of it, such as examples of how it has informed or enhanced their investment decision-making process at the fund level. DC plan sponsors should basically demand a high level of service around ESG due diligence from their existing institutional fund providers.
If a plan sponsor wanted to get started on this ESG integration piece, it would be one to two years of rolling out a due diligence questionnaire for information discovery. Then, over time, they could introduce that as an influential factor in the decision-making process around which funds stay or come onto the platform. In today’s environment, there is no excuse for an institutional fund manager to not service their clients well when it comes to ESG integration or ESG considerations. It is about information that can lead to better investment outcomes. But doing it well remains challenging because the data remains patchy or inconsistent, and so fund managers with capabilities in this space for strong integration do have an edge.
P&I: Could you elaborate on the types of ESG-focused funds available for DC plans?
Streur: We see DC plans seeking and adding responsible investment-specific funds. You could call them ESG-specific funds or responsible investing, which is our preferred term, as opposed to saying, “We want to make sure that our traditional fund is integrating.” We see the investment management industry is trying to create ESG-specific funds to meet growing demand, partly from DC plans.
Calvert has responsibly managed funds, so we have not had to create anything new. We use a holistic approach that integrates fundamental research, ESG analysis and company engagement in everything we offer. We have a balanced fund and three global asset allocation funds: conservative, moderate and growth. These are the types of structures that could be used as a qualified default investment alternative. It’s really up to the plan sponsor to determine whether or not they would make an ESG fund or a sustainable fund the QDIA.
Farrington: The Natixis Sustainable Future Funds are a full target-date offering of 10 different vintages. We were explicit that the managers of those funds take ESG criteria into account when making decisions as to what managers to add to the glidepath. Since inception, [we have] one of the top-performing target-date ranges against not just ESG, but against the entire target-date universe. So we’re performing well, but the consultant community typically looks for at least a three-year track record when it comes to deploying a target-date range. So if they can’t get past that three-year number, we’re ensuring that they understand how the product is designed — performance, risk management, alignment with long-term interests, the ability to engage employees — such that when that date comes, on February 28, 2020, that they’re very educated and ready to consider it as an option in their plan.
Chew: If DC plan sponsors want to consider introducing an ESG-focused fund or ESG-labeled fund, it could be any variety of a sustainable global equities fund, a U.S. green bond fund or something like a sustainable impact equity fund, but the main differentiator is that these are fund products that go over and above the ESG consideration/ESG integration element that should go into all investing. Here you have certain commitments around the sustainability, performance and profile of the underlying assets that the fund provider commits to and discloses against. In a sense, there’s a greater intentionality around the types of outcomes the fund provider understands and the participant who invests in the fund accepts that they are getting.
P&I: For ESG in a DC lineup, is there interest in other asset classes besides equities?
Chew: In the past year, there’s been a lot of activity in fixed income; the idea that ESG is good risk management is actually a natural piece of corporate bond investing, which is all about downside risk protection and protecting stable cash flows. This year, in collaboration with our credit analysts, Manulife Investment Management has extended that analytical framework to the sovereign bond space, which is a critical component to have the capability to properly integrate ESG considerations into this asset class. We have our own proprietary model looking at historical trends around sustainability at the country level and real-time events that affect sustainability performance and assesses sovereign bonds over the short term and long term. That’s pretty new, but you’ll see a lot more of that in the years to come.
Farrington: One of the reasons Natixis has been able to do the target-date series is because over the past 10 years, there’s more and more data being published on ESG concerns. It’s due to a host of reasons: different regulations, agreements between governments, the desire by corporations to attract capital and so on; so you can begin to rate any security, whether a stock or a bond. We now have this proliferation of data, so we can see ESG investment strategies available in stocks, bonds and real estate. There’s enough raw material in all of those asset classes to construct investment strategies that don’t ask the investor to make concessions. Our Sustainable Future Funds have international equities, emerging markets, small- and mid-size equities and green bonds. So this is no longer about just picking stocks from feel-good companies; this is about investment criteria across the spectrum of capital. ■
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