The Markets March 13, 2019

Factors Hindering Adoption of ESG Investments in DC Plans

According to a Cerulli report, fee sensitivity, concerns about performance and regulatory confusion are headwinds to environmental, social and governance (ESG) investment adoption in defined contribution (DC) plans.

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The topic of environmental, social, and governance (ESG) investing has permeated the asset management industry in recent years, spanning distribution channels and client types. But while Cerulli Associates says it would not describe the defined contribution (DC) retirement plan market as a hotbed of ESG activity, an uptick in ESG-focused conversations is noticeable.

According to the Cerulli Edge, U.S. Retirement Edition for 1Q 2019, more than half (56%) of the 1,000 active 401(k) plan participants it surveyed agree with the statement, “I prefer to invest in companies that are environmentally and socially responsible.” However, when Cerulli asked plan sponsors to identify their top-three most important attributes considered when selecting 401(k) plan investments, “environmental and social responsibility” ranked last with 16% of responses.

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Cerulli found fee sensitivity and the notion that ESG investing entails a trade-off in performance are two broadly applicable headwinds to ESG adoption. Another challenge specific to the DC market is the regulatory environment.

Long-term investment performance and cost of investments were the top-ranked attributes considered when selecting 401(k) plan investments, gathering 45% and 38% of responses, respectively. “Data shows that plan sponsors care about ESG factors, but they place a greater emphasis on performance and price,” the Cerulli reports says.

Cerulli cites Callan research that shows ESG investment adoption in DC plans is low, and says, given that Callan’s clients comprise mostly large and mega plans, “which are typically forerunners in market trends,” ESG adoption in the overall DC market may be even lower.

Cerulli also notes that guidance from the Department of Labor (DOL) has caused confusion and perhaps stymied the adoption of ESG investments in DC plans. In 2015 and 2016, the DOL issued field assistance bulletins related to the evaluation of ESG factors in ERISA-covered retirement plans. Within this guidance, the DOL stated that fiduciaries may use ESG factors as a “tie-breaker” when choosing between two investment options that are otherwise equal with respect to return and risk. This guidance was largely viewed as supportive of increased ESG adoption in the DC market.

In 2018, the DOL issued further ESG-related guidance intended to clarify prior years’ bulletins. The 2018 guidance takes a contrasting tone and explicitly scrutinizes the use of ESG-themed investments as a plan’s qualified default investment alternative (QDIA).

Cerulli says this guidance raises an important point related to ESG investing in a DC plan context: ESG investments must be prudent options for all plan participants, not a select group or sub-segment. “Cerulli contends the best path for ESG-oriented funds to gather assets in the DC market is in a QDIA role, but the DOL guidance and idiosyncratic nature of ESG investing create significant hurdles,” the report says.

Cerulli adds that several asset managers note the challenge of effectively benchmarking ESG funds, and suggests that if asset managers grapple with the complexities of ESG benchmarking, one can assume that less sophisticated stakeholders (i.e., end investors, plan sponsors, and, to an extent, advisers) have less knowledge in this area. “This example underscores the importance of educational efforts in spurring greater ESG adoption in not only the DC market, but also the entire asset management industry,” Cerulli suggests.

More information about this topic can be found in The Cerulli Edge―U.S. Retirement Edition, 1Q 2019 issue, which may be ordered from here.
Compliance March 13, 2019

IBM Asks Supreme Court to Review Stock Drop Decision

A 2nd U.S. Circuit Court of Appeals decision reversed the company’s District Court win in a lawsuit alleging imprudence in managing company stock investments in one of its retirement plans.

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IBM has asked the U.S. Supreme Court to weigh in on a 2nd U.S. Circuit Court of Appeals decision which reversed the company’s District Court win in a lawsuit alleging imprudence in managing company stock investments in one of its retirement plans.

Specifically, the Retirement Plans Committee of IBM and other defendants ask the court to answer “Whether Fifth Third’s ‘more harm than good’ pleading standard can be satisfied by generalized allegations that the harm of an inevitable disclosure of an alleged fraud generally increases over time.”

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The Employee Retirement Income Security Act (ERISA) lawsuit argues defendants continued to invest retirement plan assets in IBM common stock despite the defendants’ knowledge of undisclosed troubles relating to IBM’s microelectronics business. In doing so, plaintiffs allege, the plan defendants violated their fiduciary duty of prudence to the plaintiffs under ERISA. Offering alternative actions IBM could have taken—per new pleading standards set forth in the Supreme Court’s decision in Fifth Third v. Dudenhoeffer—the plaintiffs suggested that “once defendants learned that IBM’s stock price was artificially inflated, defendants should have either disclosed the truth about microelectronics’ value or issued new investment guidelines that would temporarily freeze further investments in IBM stock.”

The U.S. District Court for the Southern District of New York determined that the plaintiffs did not plausibly plead a violation of ERISA’s duty of prudence, because a prudent fiduciary could have concluded that earlier corrective disclosure would have done more harm than good—a similar finding to many stock drop decisions handed down after Dudenhoeffer.

Considering the plaintiffs’ assertion that the standard expressed by the District Court is actually stricter than the one set out in Dudenhoeffer and that the District Court and others have applied this stricter standard in a manner that makes it functionally impossible to plead a duty‐of‐prudence violation, the 2nd Circuit noted that the Supreme Court first set out a test that asked whether “a prudent fiduciary in the same circumstances would not have viewed an alternative action as more likely to harm the fund than to help it.” This formulation, the appellate court says, suggests that lower courts must ask “what an average prudent fiduciary might have thought.”

The appellate court pointed out that “only a short while later in the same decision, the [Supreme Court] required judges to assess whether a prudent fiduciary ‘could not have concluded’ that the action would do more harm than good by dropping the stock price.” According to the 2nd Circuit, “This latter formulation appears to ask, not whether the average prudent fiduciary would have thought the alternative action would do more harm than good, but rather whether any prudent fiduciary could have considered the action to be more harmful than helpful.”

The appellate court said it is “not clear which of these tests determine whether a plaintiff has plausibly alleged that the actions a defendant took were imprudent in light of available alternatives.”

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