Despite three attempts in the last four years by the Department of Labor to clarify if, when and how environmental, social and governance (ESG) factors can be used in the investment due-diligence process for retirement plans, advisers are still confused.
According to the Callan Institute's 2017 ESG Survey, institutional investors cited "my fund must consider ESG factors as part of our fiduciary responsibility" as the most common reason for incorporating ESG. In direct contradiction, apparent fiduciary concerns topped the list of reasons for not using ESG factors.
DOL guidance on ESG investing in recent years has focused primarily on setting a tone. A field bulletin released in April didn't make substantive change to standing policy on ESG investing, but warned that "fiduciaries must not too readily treat ESG factors as economically relevant to the particular investment choices at issue when making a decision."
Obama-era DOL guidance offered in 2015 expressed the opposite concern. It said the DOL "may be dissuading fiduciaries from … pursuing investment strategies that consider [ESG] factors, even where they are used solely to evaluate the economic benefits of investments and identify economically superior investments."
Rather than attempting to intuit possible deeper meanings behind the shifting tones that come from each administration, retirement advisers should concentrate on established facts.
Can ERISA fiduciaries safely apply ESG factors in their investment decision-making? Absolutely. Guidance provided by the DOL under both the Obama and Trump administrations make it clear that any factors, ESG included, that qualify as legitimate economic considerations "should be considered by a prudent fiduciary along with other relevant economic factors to evaluate the risk and return profiles of alternative investments."
Fiduciaries should apply ESG factors in their decision-making process when they reasonably believe inclusion would contribute to making better investment-related decisions. Specifically, the factors used should reasonably be expected to contribute positively to the economic well-being of plan participants and beneficiaries based upon risk, return and time-horizon considerations.
How should ESG factors be applied? DOL Interpretive Bulletin 2015-01 said it best: "The fiduciary standards applicable to Economically Targeted Investments [DOL's umbrella term that includes ESG investing] are no different than the standards applicable to plan investments generally."
Essentially, this means that the fiduciary must: (1) act solely in the interest of plan participants and beneficiaries (2) with the care, skill, prudence and diligence of a prudent expert, (3) incur only reasonable plan expenses, and (4) act in accordance with plan documents. A closer look at these four overarching responsibilities answers other important questions for fiduciaries.
(Watch: Trends in ESG investing)
To act "solely" in the interest of plan participants and beneficiaries, in the context of ESG, means the only acceptable motivation is to produce economic benefits for plan participants. Standing DOL policy is that "collateral benefits" to others or society at large can be used as tie-breakers; however, some legal experts suggest that to include ancillary benefits in the analysis is at odds with the true meaning of "sole" interest.
ESG investing is also consistent with the "prudent expert" obligation. The Forum for Sustainable and Responsible Investment has assembled an impressive compendium of studies demonstrating that ESG investing generally promotes positive outcomes. CFA Institute surveys also show that most portfolio managers and research analysts apply ESG factors in their analysis and decision-making.
Some ESG applications may require special care. The DOL's concern, outlined in Field Assistance Bulletin 2018-01, is that a fiduciary may assert a policy preference in choosing a default investment option that a participant does not personally select. However, the warning doesn't mean the rules are different for qualified default funds — if ESG factors are used with the reasonable expectation that doing so would achieve superior outcomes, the fiduciary should use them, regardless of what type of investment vehicle is involved.
How do costs come in to play? It is always imprudent for a fiduciary to waste money. According to the DOL, in FAB 2018-01, "plan fiduciaries may not increase expenses, sacrifice investment returns, or reduce the security of plan benefits in order to promote collateral goals." Costs incurred must be worth the benefits received.
An investment policy statement is permitted to address ESG investing, but is not required to do so. As a plan-governing document, the IPS should be crafted in conformity with fiduciary principles and implemented the same way.
ESG investing isn't about setting a tone. It's about making a positive difference for investors. Resulting benefits to society, while uncounted in the fiduciary decision-making process, ultimately flow back to enrich all.
Blaine F. Aikin is executive chairman of fi360 Inc.