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Keeping your eye on the ball: Consideration of non-financial factors in the selection of defined contribution plan investments

Keeping your eye on the ball: Consideration of non-financial factors in the selection of defined contribution plan investments

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One prominent issue recently impacting defined contribution plans has been whether plan fiduciaries are permitted to consider cultural, ethical, and political factors in the selection of plan investment options.

Viewing plan assets through other than a strictly financial lens has long been a practice for government defined benefit (DB) plans.  For instance, some U.S.  states and localities have recently passed laws banning any of their pension funds from investing in companies that boycott Israel.  And New York State’s pension fund, one of the world’s largest pension investors, recently pledged to divest its holdings of fossil fuel stocks by 2025. But this issue hasn’t received the same attention in defined contribution (DC) plans – until now.

While some DC plans have offered what were originally known as “Social Responsibility Funds”, these assets represent a miniscule percentage of total plan balances. (According to a recent Morningstar analysis, only about 4.5% of DC plans had a “sustainable fund” and they average less than 1% of a plan’s assets.)  Today, with more than $5 trillion in total defined contribution plan assets, it is perhaps  inevitable that a broader constituency championing a particular set of political, ethical, and cultural concerns now  views this great concentration of wealth as a tool to help further their objectives.

How should Fiduciaries view requests to offer plan funds that only invest in companies whose practices meet certain Environmental, Social, and Governance standards?  Unfortunately, recent actions by U.S. government entities don’t provide a clear path forward.  First, in May 2020, the Federal Retirement Thrift Investment Board, which administers the Thrift Savings Plan (TSP) serving over 3 million federal government employees, rejected the advice of its investment consultant to broaden the countries covered by its International Index Fund and deferred a final decision to adopt an objective benchmark holding approximately 12% of its total assets in Chinese equities, based solely on China’s representation.  The decision followed a series of public statements from senior Trump Administration officials and members of Congress denouncing the proposed investment due to concerns about the potential influence of Chinese government and military officials in these companies.  As the Board’s stated mission is to act solely in the interest of its participants and beneficiaries, the official justification for deferring the decision was uncertainly due to the COVID-19 pandemic.  But only the most gullible observers could miss the political factors involved.

Then, in October 2020, the U.S. Government appeared to take a different position on permissible factors influencing fiduciary decision making.  The U.S. Department of Labor issued a final rule effective at the beginning of 2021 requiring that plan fiduciaries only consider “pecuniary” or financial factors in its evaluation of plan investments.  (The rule was issued in part, based on the public comments received, after lobbying from the fossil fuel and firearm industries who fear disinvestment from funds invested according to Environmental, Social, and Governance (ESG) principles.)

The final rule doesn’t explicitly ban non-QDIA funds from investing based on ESG or other non-financial principals so long as they can demonstrate the “risk adjusted” returns merits selection. This may require fiduciaries to update their investment policy statements to more fully incorporate risk factors as well as historical returns in in their fund evaluation process.  Clearly this is an emerging area and best practices have to yet to be developed.  And further complicating matters is the possibility that  the Biden administration will seek to repeal or change the rule, although this can’t take place until later in 2021 at the earliest.

This is admittedly a complex issue and with many factors to consider. But my biggest fear is that this topic starts to dominate the focus of plan fiduciaries and distracts from their primary goal, helping participants reach their retirement income goals. Anyone involved in plan committee deliberations over the past several years knows how the fear of litigation has become a dominant concern and we certainly don’t need to add another distraction.

So for plans that choose to continue offering ESG funds in their core lineups, it will be important to develop a set of parameters within their investment policy statements that don’t include consideration of social concerns.  Alternatively, plans could choose not to offer ESG funds (or other specialized funds such as those investing in accordance with religious beliefs) but highlight their availability through a plan’s brokerage window.  Whatever it will take to keep the focus on participant outcomes.

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