A Push to Normalize ESG in Retirement Plans

This framework doesn’t leave much room, if any, for sponsor’s to actually bring ESG into their plan, even in the DC context, where it is conceivable a plan participant would actively choose an ESG investment specifically for its environmental, social or governance characteristics. The chances a sponsor will have the time (or interest or resources) to run this kind of analysis, and then have enough confidence in the analysis to base a documented fiduciary decision on it, are pretty slim.

A sister bulletin also issued during Campbell’s tenure, filed as “Bulletin 08-02,” deals with questions concerning when it is appropriate for retirement plan participants and sponsors to operate as “shareholder activists”—using plan assets to influence the way companies or industries are managed. These questions get into a similar analysis, Campbell says.

“It’s very simple really,” he concludes. “As things stand today, in order to spend money to try to change the way companies are operating or to address environmental factors, the fiduciary needs to be sure this will have a clear economic benefit for the plan.”

Looking Ahead Responsibly

With so many difficult regulatory issues confronting employer-sponsored retirement plans, David Richardson, managing director and head of institutional business development at ESG specialist Impax Asset Management, says he is not surprised that few plan sponsors and service providers have stood up to challenge the DOL’s unfavorable view of environmentally minded investing in retirement plans.

He explains that Impax was first launched in 1998, “to help endowments and other large asset holders structure their portfolios to capture opportunities in addressing issues like climate change and resource scarcity, as these investment themes become more important to overall portfolios.”

“We were around during the creation of what I like to call ESG 1.0, which was really just a way to screen defense-related investments or other ‘sin stocks’ out of clients’ portfolios,” Richardson explains. “Since then, we have watched as this thinking has become much more sophisticated. I would say we have, as an industry, evolved well beyond ESG 2.0 and are pushing into the territory of ESG 3.0.”

He explains ESG 2.0 as the movement that followed up sin-stock screening. As large institutional investors started to think more deeply about environmental, social and governance risks, they started asking what other categories of companies or investments could or should be screened out from portfolios, and in what ways.

“We have seen screens develop in response to water scarcity concerns or carbon emissions, as a few examples,” Richardson notes. “As part of this evolution, there has been a steadily expanding cadre of asset managers who subscribe to the belief that ESG factors are not just moral issues. They include critical factors that speak to the overall risk-return outlook of any portfolio.”

Richardson says this thinking is leading to a new approach and mindset around ESG—one that is not based on negative screening of stocks but on the positive attributes ESG thinking can bring to a portfolio from a purely economic perspective. This positivity is the hallmark of ESG 3.0, he says.

“Today we are at a point where we are ready to apply powerful technology and ESG principals together to cut portfolio risk and boost returns in an economically meaningful way,” Richardson says. “One aspect of this thinking is just the recognition that, regardless of your view on climate change, making investments in companies that are doing better than their peers on energy efficiency, use of renewable energy, resource recovery, waste mitigation and water efficiency offers the prospect of superior portfolio growth.”

Richardson says the important element to ESG 3.0 for plan sponsors and other fiduciaries to consider—the reason why the conversation is becoming more and more relevant even under the restrictive DOL guidance—is this positivity.

“We’re no longer talking about limiting a portfolio’s return outlook because we don’t want to put money into certain categories of stocks that happen to have negative social or environmental associations,” Richardson explains. “Instead, we’re talking about using ESG to optimize any portfolio from the risk-return perspective, not just an environmentally minded portfolio. We are treating climate change and resource scarcity as a pervasive global macroeconomic risk, not an uncertainty.”

ESG in the Short Term

Richardson clarifies ESG 3.0 by explaining it as “an attempt to go under the surface and examine the actual steps businesses across economies and markets are taking to reduce their carbon footprint and prepare for greater resource challenges in the short-, medium- and long-term future.”

He says there is a wealth of reliable research that shows this type of thinking is materially good for returns. While his firm focuses mainly on portfolios that do have a top line environmental theme, the thinking can be applied much more broadly.

“Just as a basic example, consider a diversified commodities portfolio that takes this type of thinking into account,” Richardson continues. “This is not going to be a green portfolio by any stretch of the imagination, but it can certainly be advantaged by realizing that some mining companies or resource transporters have a better environmental safety record and are more skilled at efficiently using resources and minimizing waste or accidents compared with others.”

These types of facts are easily gleaned from data published quarterly by publicly traded companies, Richardson adds, which is why the rapid advancement of data technology is also opening new doors for ESG in retirement plans.

“Imagine if you could open up a database that represented your entire pension portfolio and could break down exactly what parts of your asset allocation program are exposed to which ESG risks,” Richardson continues. “It goes back to this principal of resource optimization, and how investing in the most efficient companies with the best governance will bring the best results, whatever the sector.”