Considerations Before Adding ESG Specific Funds to Your Defined Contribution Plan
April 17, 2022
“ESG” stands for “Environmental, Social and Governance.” Those are three areas of ethical standards to which this approach seeks to apply investment decisions.
- Environmental investment can mean favoring companies seen as having a positive impact on the environment or at least avoiding those with an especially negative impact.
So this could mean investing in a company whose products use eco-friendly technologies, such as electric vehicles, or it could mean refusing to invest in companies whose operations create an overly large amount of pollution. - Social investing can mean looking for companies which actively promote policies such as inclusion and social justice, or avoiding companies with negative track records in those areas.
For example, this could mean seeking out companies whose board memberships are built around certain diversity standards. It could also mean avoiding companies with an ongoing history of discrimination complaints. - Governance investing refers to how a company is run. The guiding principle is that boards and executives should be accountable to the company’s investors, employees, and the community at large.
Investing according to governance standards might include favoring companies where the majority of directors on the board are independent of day-to-day company operations and avoiding companies where that is not the case.
There are two types of ESG funds
- Impact funds, which actively invest in businesses that the manager considers socially beneficial (such as solar power, racial injustice, and workplace safety and diversity) and,
- Exclusionary funds, which simply avoid companies whose business activities the manager considers to have a negative impact on society (guns, tobacco, petroleum, and boards of directors dominated by white men).
Growth of the ESG market: statistics from Morningstar’s Sustainable Funds U.S. Landscape Report, February 10, 2021:
- In order for a fund to be considered ESG, ESG concerns must be central to its investment process and the fund’s intent should be apparent from a simple reading of its prospectus. In particular, the Principal Investment Strategies section of the fund’s prospectus should contain enough detail to leave no doubt that ESG concerns figure prominently in the fund’s investment process.
- The number of sustainable open-end and exchange-traded funds available to U.S. investors increased to 392 in 2020, up 30% from 2019. The group has experienced a nearly fourfold increase over the past 10 years, with significant growth beginning in 2015.
- In 2020, 71 sustainable funds were launched, easily topping the previous high-water mark of 44 set in 2017. At least 30 funds have been launched each year from 2016 to 2020.
- Sustainable funds attracted a record $51.1 billion in net flows in 2020, more than twice the previous record set in 2019. Sustainable fund flows accounted for nearly one fourth of overall flows into funds in the U.S.
Legislation: NAPA, Regulatory Compliance October 30, 2020
Shortly after taking office, President Biden signed an executive order calling for a review of environmental actions taken by the Trump administration, including the DOL’s guidance addressing “Financial Factors in Selecting Plan Investments,” which became effective Jan. 12, 2021. The final rule pulled back from some of the more stringent requirements outlined in the proposal, but arguably was still implicitly directed at ESG investing.
The Labor Department’s position is that “the lack of a precise or generally accepted definition of “ESG”, either collectively or separately as “E, S, and G” made ESG terminology not appropriate as a regulatory standard.” Therefore, the final rule – which will be effective 60 days after publication in the Federal Register – refers to “pecuniary factors and non-pecuniary factors” in defining the relevant fiduciary investment duties.1
Considerations from a Company Standpoint
- What is the company’s goals/objectives with regard to the plan and its investments?
- Attract and retain talent?
- To help employees become retirement ready?
- What are the company’s ethical priorities?
Pros:
- ESG funds give investors the ability to align their investments with their personal values.
- Morningstar’s behavioral research team found that 72% of the U.S. adult population expressed at least
moderate interest in sustainable investing.
Cons:
- There is no clear-cut definition of what constitutes ESG. ESG investing is a personal choice and means something different to every participant.
- It isn’t one-size-fits-all.
- People have different opinions about what is ethical – not to mention the fact that these issues are
constantly evolving. - There is a concern that investing in unprofitable, unsustainable activities diverts limited financial resources to unsustainable business models.
- The ESG label has also been used to provide cover for managers who invest poorly, charge high fees, or both.
