By Mitch Shames CEO, Harrison Fiduciary

How Plan Fiduciaries Can Navigate the Waters

ESG strategies in the United States have seen significant growth in the past couple of years and it’s estimated that they now account for over $17 trillion. It’s not surprising as investors, particularly the younger generations, are making a connection between global climate change and recent wildfires, drought and flooding. More and more, we are seeing investors who are highly motivated by the idea that their savings can be put toward solving some of society’s greatest challenges. And they are putting their money where their mouths are.

Interestingly, ESG investments in American’s retirement plans have seen no such uptick and the latest estimates tell us that less then 3% of 401(k) plans offer ESG options. In spite of significant interest, plan sponsors and retirement plan fiduciaries have hesitated to adopt ESG factors because of a lack of clarity as to whether these factors are appropriate for Employee Retirement Income Security Act (ERISA)-qualified retirement plans. But that may be about to change.

In the fall of 2021, the Department of Labor (DOL) issued a proposed rule that would amend its investment duties regulation related to the use of ESG factors in selecting investments appropriate for ERISA-qualified plans. While the rule hasn’t yet gone into effect, in its current form, it would explicitly pave the way for the consideration of ESG factors. Given the new layer of regulatory support, it’s reasonable to expect a whole new category of ESG funds and strategies to emerge in the universe of investment options.

Notwithstanding this widespread demand and excitement, we would urge all fiduciaries of qualified retirement plans to proceed with caution. When fiduciaries consider adopting an investment strategy that includes ESG factors, they should first consult the plan’s own fiduciary policies and procedures. Very often, implementing new strategies or adding new fund options requires committee approvals and may require amending other documents, such as an investment policy statement (IPS).

After addressing these procedural requirements, plan fiduciaries should establish a prudent, analytic framework for evaluating ESG managers and investment options. Internally, our firm has made great progress in our work of creating a process-driven analytic model to specifically analyze ESG investment options and managers for inclusion in retirement plans. As we dig into the research, the complexities are multiplying. ESG is a very broad label and with little to no industry standards of practice, managers employ different ESG data sources, factors and techniques in deciding what can qualify as an ESG fund or strategy. Analyzing funds and strategies is not necessarily an apples-to-apples comparison. Best practices, however, suggest that fiduciaries adopt an analytic framework before jumping in and examining specific managers or funds. 

As the conversation on ESG investing in retirement plans heats up, there are other issues to sort out as well. In particular, we see concerns around the benchmarking of ESG portfolios. Benchmarking is an important tool used by fiduciaries to assess the investment performance of a strategy or a manager. How do you analyze the performance of an investment strategy, or compare the performance of a strategy against others in its category without comparing them relative to a benchmark? 

As mentioned above, within the broad headings of Environmental, Social and Governance, managers employ numerous factors and multiple methodologies for applying them. In the context of ESG strategies, the plan fiduciary’s selection of a benchmark is critically important.

In fact, selecting an appropriate benchmark could prove to be more valuable than endorsing any specific ESG factors or data sources. We are suggesting this hypothesis upon the examination of other investment strategies. Consider this: when fiduciaries review active growth managers, they will likely seek to identify the growth factors that the manager employs, and they will likely seek to validate the investment processes that the manager uses. However, at the end of the day, performance will be evaluated against a benchmark. Performance versus a benchmark remains a key evaluation tool. We predict that, over time, chances are high that the same dynamic will likely prevail when it comes to evaluating ESG strategies.

So, where does the investment industry stand with respect to ESG benchmarks? Our initial research shows there is an increasing number of ESG benchmarks that reflect various characteristics. Some of them are broad, some are narrow. We welcome this wide array of benchmarks and the analysis and commentary which will naturally evolve. Ultimately, the academic and industry debate on benchmarks will benefit plan participants. At the moment, however, our review and research tell us that no one benchmark has risen to the level of an industry standard.

When looking to determine the appropriateness of a published benchmark, there are several areas that we look to address:

• What is the source of the ESG data used to rate the benchmark constituents, and what is the criteria for choosing that source?

• What ESG factors are used in compiling the benchmark, and what is the construction methodology for the benchmark?

• What are the rules for including the benchmark constituents?

• How are individual companies weighted?

• Is the benchmark recognized as a broad and investable index? 

The selection of a benchmark is not a static event. Some may remember the early days of international investing, when the MSCI EAFE Index quickly became an industry standard. Over time however, the debate shifted to cap-weighted indexes, equal-weighted indexes and indexes reflecting many different industry tilts. Similarly today, benchmark selection remains a dynamic topic of review. 

These questions do not yet have answers, but like all the other challenges we’ve seen over the years, the answers are coming. We continue to engage with credible sources throughout the industry and we urge plan fiduciaries who may be considering adopting ESG strategies to do the same. 

We thrive on the robust dialogue that new options like these ignite. These are exciting times and the excitement in the marketplace is building. Our fiduciary DNA, however, urges prudent decision making.