Art by Dalbert B. Vilarino

On April 23, 2018, the U.S. Department of Labor (DOL) published a Field Assistance Bulletin providing guidance to fiduciaries of private-sector employee benefit plans as they consider implementing environmental, social and governance (ESG) investing for assets covered by the Employee Retirement Income Security Act (ERISA).

According to the DOL, the “sub-regulatory action” was not meant to substantially change the status quo with respect to ESG investing under ERISA, but instead merely to clarify how the new administration views existing regulations in this area. In particular, the Field Assistance Bulletin addressed Obama-era DOL 2015 guidance on economically targeted investments and related 2016 DOL guidance on shareholder engagement.

Even though the DOL was careful to note that it had not changed the underlying regulations with its bulletin, retirement industry stakeholders were left to reassess their own stances on the risks and rewards of utilizing ESG investments for plan assets. According to attorneys with Stradley Ronon, this period of introspection has largely concluded, and ESG “continues to proliferate at breakneck speed across asset classes.”

In written commentary shared with PLANADVISER, Stradley Ronon attorneys said they are helping both registered and private-fund clients incorporate various ESG strategies. They are also advising fiduciaries on the implications of using ESG under ERISA, “such as how integration, shareholder engagement and divestment can be conducted in a manner consistent with ERISA.”

“We simply don’t see ESG going away anytime soon,” they explained. “Environmental, social and/or governance issues are a fact of life. Cybersecurity and climate change are two examples.”

According to the attorneys, one factor slowing growth in this domain is widespread confusion over what ESG actually means. In particular, clients want to know how “ESG investing” differs from “impact investing,” “socially responsible investing,” “economically targeted investing,” and “sustainable investing.” They also spend a lot of time explaining that the days are gone when ESG investing consisted primarily of either screening out or divesting from certain issuers/sectors because they do not meet some moral or other noneconomic test.

“Today’s ESG is much more driven by data linking one or more ESG factors and investment performance—an ESG factor can now be a material risk,” the attorneys wrote. “On an even more fundamental level, there is not unanimity on what constitutes an E, S or G factor. ESG is an umbrella term capturing as many as 40 different topics.”

George Michael Gerstein, co-chair of the fiduciary governance practice at Stradley Ronon, suggested the DOL “might prefer integration as an ESG approach over strategies that make investment decisions for moral reasons or to otherwise promote a public policy.”

Gerstein defined “ESG integration” as more sophisticated efforts by managers to incorporate ESG-related data or information into the wider process they use when making an investment decision within a given fund or portfolio. The main purpose of such integration is to enhance portfolio return or reduce portfolio risk, rather than to advance an environmental or social cause.

“The DOL stresses the importance of documenting why the fiduciary believes the respective ESG factor will have a material effect on performance, without having to make a series of wishful assumptions to reach that conclusion,” Gerstein said. “We suggest that fiduciaries will want to build a record in support of the view that a particular factor bears a relationship with investment performance, and carefully consider how much weight to put on that specific factor.”

The Stradley Ronon attorneys pointed out that the DOL’s most recent guidance on the ESG topic also “zeroed-in on shareholder engagement in respect of ESG issues that have a connection to the value of the plan’s investment in the company, where the plan may be paying significant expenses for the engagement or development of proxy resolutions.”

If anything, the attorneys concluded, this shareholder engagement aspect of the most recent DOL bulletin has the most significant ramifications—though it has received less attention from sponsors and advisers.

“If plans are viewed as paying indirectly for engagement through the management fee, which view we think the DOL takes, then proxy voting and other forms of shareholder engagement need to be monitored for both costs and benefits, particularly as the time spent on the engagement increases,” the attorneys recommended. “In our view, ESG will continue to evolve and proliferate, while also garnering the attention of both the DOL and SEC on a number of levels. ESG is, in essence, entirely fluid and will continue to present business opportunities and compliance challenges. We will likely have more to say on this in the coming weeks.”

Hands-Off Approach Likely from SEC?

Despite calls for additional guidance to ease fiduciary concerns, regulatory experts do not broadly anticipate further action under the current administration.

The Trump DOL, indeed, has already “clarified” its stance on ESG investing under ERISA. And when it comes to the prospect of the Securities and Exchange Commission (SEC) building some sort of unified ESG reporting framework for stock issuers, that’s also seen as unlikely.

In fact, in one of his final public speeches of 2018, SEC Chair Jay Clayton directly addressed this topic. From his perspective, Clayton said, the main hurdle to a wider embrace of ESG or SRI investing by fiduciaries has to do with the availability, quality and comparability of data being provided by publicly traded companies. Yet he does not necessarily see this as a challenge for SEC to address.

“Disclosure is at the heart of our country’s and the SEC’s approach to both capital formation and secondary liquidity,” he said. “As stewards of this powerful, far-reaching, dynamic and ever-evolving system, a key responsibility of the SEC is to ensure that the mix of information companies provide to investors facilitates well-informed decision making. The concepts of materiality, comparability, flexibility, efficiency and responsibility (i.e., liability) are the linchpins of our approach.”

Turning to ESG, which he called “a broad term,” Clayton said the investment industry is increasingly seeing disclosure of ESG information by issuers—and requests for ESG information by investors.

“I am also aware of efforts by third parties to develop disclosure frameworks relating to ESG topics as well as calls by some market participants for issuers to follow third-party disclosure frameworks relating to ESG topics,” he said.

Clayton said his belief is that while third-party standards relating to ESG topics may allow for comparability across companies, this should not mean that issuers should be required to follow these frameworks in order to comply with SEC rules.

“Each company, and each sector, has its own circumstances, which may or may not fit within a standard framework,” Clayton said. “That does not mean the standards do not have value. They do, in some cases, in much the same way that appropriately presented non-GAAP financial measures and key performance indicators add value to the mix of information.”

Clayton went on to say that as third-party standards have evolved and been discussed by market participants, he has seen investor-company dialogue around “certain issues and in certain sectors improve.”

“That said, I think it is important to remember two principles: first, in complying with our disclosure rules, companies should focus on providing material disclosure that a reasonable investor needs to make informed investment and voting decisions based on each company’s particular facts and circumstances; and second, investors—and here I’m thinking about asset managers who are required to vote in the best interest of their clients—should also focus on each company’s particular facts and circumstances,” Clayton said.

“It is important to note that although we do regulate disclosure and oversee registered investment advisers, we do not regulate the merits of any particular investment strategy,” he concluded. “The success of a particular investment strategy depends upon a multitude of factors, which may or may not include the extent to which the asset manager incorporates ESG factors. From my perspective, what is important is that investors have full and fair disclosure of the material facts about the investment strategy their fiduciary is following so that they are in a position to make informed investment choices.”

Will Emerging Advisers Help Drive Demand?

Social impact and ESG investing is growing in importance among the new generation of financial advisers in the U.S., according to a recent Incapital survey.

The survey looked at advisers with between three and nine years of industry experience, finding that very nearly all (99%) of those who use individual bonds discuss social impact goals with their clients. This is almost 25% more than advisers with over 10 years of tenure, according to the survey.

“This generation has had more access to information on social impact investing than any before them, so it is no surprise that Millennials and the generation of advisers that serve them are like-minded in their support of results-driven causes,” observed Louise Herrle, managing director and head of Incapital’s platform for distributing social impact investments. “They understand that they can achieve their clients’ financial goals with investments that reflect their personal values.”

A majority of surveyed advisers continued to use equity assets to achieve social impact or ESG goals, with fewer using fixed-income options. On the equity side, 44% of advisers said they use actively managed equity mutual funds for ESG/SRI exposures, 35% use individual stocks, and 31% use equity exchange-traded funds. At the same time, 30% use fixed-income actively managed mutual funds, 29% use bonds, and 22% use fixed-income exchange-traded funds.

More than half (58%) of those advisers with three to nine years of tenure agreed there are too many equity ESG options and not enough fixed-income ESG options to show their more conservative investors. Only 34% of advisers with over 10 years of tenure agreed, however.

“Advisers are looking for options that best match their clients’ risk tolerance,” Herrle said. “Equity ESG funds may have too much risk for some conservative clients. Advisers are finding that social impact bonds—which do carry credit risk but also the benefits of income predictability, return of principal at maturity and declining interest rate risk as the maturity date approaches—can be utilized as part of a conservative income portfolio strategy.”