Catherine Reilly is an investment and retirement professional who is passionate about sustainable investing and expanding access to high quality retirement solutions for employers and employees. She has extensive global experience designing retirement saving and spending solutions.
Environmental, social, and governance (ESG)-based investing is currently one of the fastest growing areas in asset management, with annual growth rates registering double digits. At the start of 2018, more than $30 trillion was invested according to sustainability criteria globally, and Europe, with about 50% of all assets managed according to sustainable criteria, was the world leader in dollar terms, followed by the US with about 26% of all assets.
The rising interest in ESG investing is not simply driven by altruistic motives. Rather, long-term investors such as defined benefit (DB) pension funds and insurance companies are increasingly concerned about the impact that climate change will have on the value of their investments and their ability to meet their long-term commitments. Climate Action 100+ is an alliance of 373 of the world’s largest institutional investors, representing assets of over $35 trillion, committed to engage with the world’s largest corporate greenhouse emitters to increase transparency and improve performance. Signatories include many large public pension plans and other institutions, including CalPERS, CalSTRS, and the Harvard University Endowment Fund, that have incorporated ESG criteria into their investment processes.
In the United States, defined contribution (DC) plans are now the predominant vehicle for retirement saving for private sector workers. Unlike traditional DB pension plans, DC plan providers have no long-term liabilities: instead, the plans offer an investment menu and participants bear the responsibility for saving and investing their retirement monies.
To date, only 9% of all DC plans and 19% of large plans offer a “socially responsible” domestic equity option that participants can elect. Nevertheless, the take-up of these funds has been quite slow. This is not surprising, since most DC contributions flow into default investment options, usually a passive target date fund, preselected by the plan sponsor.
Yet DC plan participants themselves have long-term financing needs for retirement, and are increasingly concerned about whether their nest eggs are sustainable.
Why were DC plans left behind?
For ESG investing to become more widely adopted, this principle would need to be integrated into the default investment option offered by DC plans. Yet the Department of Labor’s (DOL) most recent guidance requires plan sponsors wishing to incorporate an ESG option into the default investment to justify this move on economic terms. It also cautions that fiduciaries must not too readily treat ESG factors as economically relevant.
Naturally, this raises the bar for plan sponsors looking to incorporate ESG options, so it is unsurprising that the rate of adoption has so far been lackluster. In its analysis of the DOL opinion letter, the American Bar Association concluded that “[u]nless and until there are more precise and reliable means to measure ESG factors … it seems unlikely that there will be widespread endorsement of these investments.”
ESG can be confusing
Plan sponsors’ reluctance to adopt ESG investment principles may partly be due to confusion over exactly what this terminology means. ESG is sometimes equated with “socially motivated” investing, where returns are secondary to “collateral benefits.” Retirement plan fiduciaries must make prudent economic decisions that are suitable for large groups of workers, many of whom may have different preferences. Furthermore, the conclusions of different ESG scoring methodologies can vary considerably.
Mounting evidence that ESG can enhance performance
It is clear that in order for any investment option to be deemed suitable as a default investment option in DC plans, it must be justifiable on economic grounds. The good news is that ESG integration has the potential to enhance investment returns and reduce risk, though there remains a vigorous discussion about exactly how this happens. The methodology for measuring and reporting ESG impacts is also rapidly becoming more rigorous.
For example, the MSCI ESG-themed indices have consistently outperformed their non-ESG counterparts over the past decade. Research shows that firms that rank well on material sustainability topics significantly outperform poorly rated firms. Not only does good performance on ESG-related topics tend to be associated with stronger returns, it also reduces downside risk associated with climate-related events such as the California wildfires or stranded assets following stricter regulations.
ESG measurement: Increased rigor and standardization
A major challenge to those proposing sustainable investing is the difficulty of differentiating between genuine impact and “greenwashing” (making deceptive claims that an organization or investment strategy is environmentally friendly). To address this conundrum, the European Union (EU) is now requiring more rigorous sustainability reporting from investors. It recently introduced rules requiring investors and advisors to disclose how they integrate ESG into their investment processes, along with ESG-related risks associated with their investments.
Furthermore, the EU has developed a technical taxonomy evaluating the environmental impact of a range of different activities (e.g. car production). Investors who market sustainable funds to European investors are then required to use this as a reference point when explaining their own investment approach. The EU pensions regulator has also added a required assessment of climate-related risk to its bi-annual stress tests of European pension funds. Unlike their European counterparts, American regulators have so far not established ESG-related reporting requirements for companies or investors.
In turn, investors have begun to require companies to improve and standardize the way they measure and describe sustainability. Two of the world’s largest asset managers have recently thrown their weight behind reporting metrics proposed by the Sustainability Accounting Standards Board (SASB) and announced that they will vote against management at companies that do not disclose risks adequately. This alone will not be enough to achieve harmonization and there will continue to be a variety of reporting methodologies, such as the International Integrated Reporting Council (IIRC) or the Global Reporting Initiative (GRI); the latter provides guidance across a wider set of stakeholders than the investor-focused SASB or IIRC. Nevertheless, a heightened focus on transparency and metrics is likely to make greenwashing increasingly difficult.
Rising appetite for ESG in DC plans
With the global push towards sustainability reporting, ESG factors increasingly constitute relevant economic information for fiduciaries. There seems to be little justification for treating ESG funds differently to other funds that differ from market capitalization weighted benchmarks, such as active or style funds. Participant demand for more ESG-friendly investment options is also likely to grow as Millennials become a larger group of DC plan savers. Older workers may also begin to demand more transparency regarding their retirement accounts. As a result, plan sponsors will need to broaden the factors they consider relevant as fiduciaries, and some will challenge conventional guidance in order to attract and retain a more sustainability-conscious workforce. The DOL may then need to modify its due diligence requirements for incorporating ESG strategies into the DC plan menu, including as the default investment.
Views of our Guest Bloggers are theirs alone, and not of the Pension Research Council, the Wharton School, or the University of Pennsylvania.