With so many flavors of sustainable investing in the investable universe, the question is no longer if a plan sponsor should consider environmental, social, and governance (ESG) investing into their participant’s fund lineup, but instead how it should be integrated.
And there is undoubtably a strategy that fits every investor. The sustainable investing sector has come a long way, making leaps and bounds since ESG investing began in the 1960s, but there is still much room for growth in the industry. Once believed to be an antiquated, return-lagging investing technique, this is no longer the case. In fact, many ESG-friendly funds perform in line with or even outperform the broader market.
However, these investing options are not one-size-fits-all; each plan sponsor needs to tailor their selection to the participant’s preferences. Here are some factors to consider if your organization is just getting started with ESG investing.
Aligning investing and personal values
The first step in your ESG journey is is to decide what’s most important to your organization as you incorporate it into your retirement plan.
Start by thinking about who is advocating for ESG investments – is it your employees and plan participants? Is the impetus coming from the board, certain shareholders, or corporate management? Perhaps it’s a combination of all the above, which is why it’s imperative to take a broad survey of all stakeholders to determine their position on this topic before you embark on an ESG strategy that participants aren’t going to invest in.
As you seek input, get specific on the sorts of ESG issues that are most important to respondents. Are there industries they want to avoid? Maybe they’d like their investments deployed to specific interests such as sustainable energy or social justice. Ultimately, you want to be very clear on the trade-offs that your participants are willing to take. The sustainable investing industry can, at times, be accompanied by a risk premium, which shouldn’t come as a surprise as you’re excluding certain sectors, effectively reducing the diversification factor that comes with a broad market index.
However, a tad bit more risk is well worth it if your participants are more interested in aligning their investing values with their personal values and making it easier for them to lay their heads on their pillows at night.
Setting clear guidelines for yourself and your organization will allow you to find investment managers that share your perspective and make investments in line with your objectives. Once you’ve established investing guidelines, you determine which plan structure will best accomplish these goals.
Needs, constraints, and regulations
It’s important to draw a distinction between defined benefit (DB) and defined contribution (DC) plans because each have their advantages and disadvantages when it comes to ESG investing.
Given their structure, DB plans can consider a broader range of investments, as private and alternative investments are much more common and easier to implement. DB plans also require less employee input, which means you can make changes quickly. If an investment isn’t working out the way you expected it to, you can quickly and easily replace it. The downside to ESG investing in the DB plan comes from taking on additional investment risk while you’re simultaneous attempting to match assets to liabilities for your participants.
A DC plan on the other hand comes with more flexibility because the plan participants control their asset allocation. While you and others in the organization may adore the ESG investments, other participants decide whether to fund it. You can provide the necessary education, but investing in these funds is at the discretion of your members. So, if your employees are advocating for an ESG investment, the DC plan would seem to be the logical place to deliver it.
There are downsides to DC investing: The U.S. Department of Labor (DoL), which regulates retirement plans, has been subject to political forces and their guidance around ESG investing has changed with each administration. Who says it won’t change again come 2024 or 2028, so you’ll need to weigh your needs, constraints, and the regulations when embarking on an ESG investment strategy.
Identifying the material elements of ESG
You’ll also need to identify the right investment approach for your plan. And there are options.
An exclusionary approach is well-suited for investors who want to avoid certain industries. Some of the more common exclusions are so-called sin stocks: gambling, tobacco, alcohol, firearms, and prisons. More recently some environmental advocates have excluded energy and material companies. Keep one thing in mind when choosing an exclusionary approach – risk and returns are often secondary considerations.
Impact investing pursues opportunities that are going to explicitly target societal impacts as opposed to a risk-return objective. In many ways, impact investing is the inverse of exclusionary investing.
The most common approach found in the sustainable investing industry today includes ESG integration. All good fundamental investors integrate some ESG risks into their traditional, mainstream investments and consider the risks from government regulations or changing consumer preferences. The best fundamental analysis cannot be properly projected without acknowledging ESG elements in their model, which means it’s very likely that the active strategies you have in your plan today are already integrating some ESG risks in their portfolio. So speak with your consultant or asset managers to find out which elements of ESG they deem material and are factoring into their decision making – there’s no need to rely on funds that have an ESG or sustainable label attached.
Measuring success
In a traditional retirement plan context, monitoring consists of reviewing performance, digging into portfolio exposures, and identifying any organizational issues with your investment managers. Because ESG is relatively new and because investment managers are much more engaged with their investments than ever before, monitoring these managers is much more involved and time-consuming.
From a performance perspective, you can and should continue to benchmark your ESG investments against traditional market benchmarks and peer groups. Those benchmarks represent the opportunity set and give you a good sense for the risk-return trade-offs you are making.
And finally, it’s beneficial to collaborate with your peers and consultants. Share your experiences, trade ideas. For example, if you’re not getting the kind of disclosure you expect from your investment managers, talk to other investors. Perhaps together you can get more transparency. This is a new component to investing, so take advantage of other firms’ experiences.
Leading the charge
There’s still much room for growth in the industry, and it takes us, the investors, to lead that charge.
At the end of the day, you are investing on behalf of your employees – their interests must be the top priority that outweighs any other consideration.