Stakeholder chain

The plan sponsors, with the assistance of pension consultants, structure the plans and make decisions about investment options, although, in the case of DC plans, the plan beneficiaries are required to make investment selection decisions and bear the investment performance risk.

The agency problems and misaligned incentives built into this structure remain significant hindrances to the retirement system in general as well as to the ability of plan beneficiaries to exercise their options to integrate ESG into their retirement portfolios. By exploring the role of each of the stakeholders along with the specific incentives and challenges they face in the incorporation of ESG factors, a series of recommendations for action emerge.

ERISA plan stakeholders

Factors	Plan sponsors (PS)/ Fiduciaries	Consultants	Investment managers	Independentadvice providers	Beneficiaries
Role	Fulfill fiduciary duties Manage costs	Assist PS to carry out fiduciary duty DB: meet liabilities DC: structure plan and investments	DB and DC: Provide investment products to meet PS needs DC only: May also provide record keeping and advice to beneficiaries	DB: Not applicable DC: Provide advice on asset allocation and fund selection to beneficiaries that is independent of PS or investment managers	DB and DC: Receive benefits under plans DC only: Make investment decisions based on personal needs and preferences
ESG incentives	Increase plan participation Address participant preferences Manage risk Attract and retain talent Align corporate values	Attract and retain clients Develop expertise in growing investment sectors	Respond to ESG fund or strategy demand from plan sponsors or beneficiaries. Manage risk Reduce volatility Enhance long-term performance	Respond to ESG fund or strategy demand from plan sponsors or beneficiaries	Align personal preferences with retirement assets Differentiate employers with retirement plans aligned with corporate culture
ESGChallenges	Control added costs DC: Perceived as more complex when simplicity is needed DB: Perceived as lesser priority as focused on closing funding gaps Access consistent data for selection and monitoring Navigate ambiguous policy guidance, e.g., DOL Access options for small plans Manage legal risk	Must follow not lead clients May lack ESG awareness and expertise May see ESG incorporation as introducing complexity Need to provide education for clients	DB and DC: Identify and access consistent and/or material ESG factors Address continued performance questions about evidence of impact from ESG factors DC Only: Attract participant investment as ESG funds “compete” for attention	DC: Must be instructed to include ESG preferences in advice software by investment manager or plan sponsor	DB: Develop strategies for helping beneficiaries understand the role of ESG considerations DC: Be confident ESG options are authentic (e.g., greenwashing) Align preferences across asset classes when ESG-specific options are limited
ESG stakeholder Recommendations	Expand corporate values and CSR initiatives to include plan assets and stakeholders Develop investment beliefs Update IPS Survey beneficiaries to identify preferences Standardize manager selection and monitoring reports to include ESG analysis Share best practices through trade groups and initiatives Ensure independent advice providers have ESG expertise	Be proactive and discuss with clients Provide education as needed Codify objectives in IPS Integrate ESG analysis for all managers and all asset classes Include ESG analysis in quarterly reporting Assist clients to survey beneficiaries to identify preferences	DB and DC: Standardize ESG disclosure requirements, e.g. SEC, SASB Sponsor and publicize independent reviews of ESG-related investment performance Build diversified, low cost ESG options with competitive risk/return profiles DC: Work with advice engine and algorithm providers to reflect beneficiaries’ ESG preferences Market ESG investment research directly to beneficiaries to stimulate demand and dispel return concerns	Work with plan sponsors and investment managers to include ESG criteria under beneficiary preferences in advice software	DB and DC: Request ESG investments and incorporation Illustrate ESG demand through industry group surveys DC: Request plan sponsors work with advice engine and algorithm providers to reflect beneficiaries’ ESG preferences
ESG Policy Recommendations	Clarify DOL guidance to be more receptive to ESG Promote standards for defining and promoting ESG options.

 

Plan sponsors: Balancing business objectives and fiduciary duties

While ESG incorporation has grown tremendously over the years, as shown by the US SIF Trends data, plan sponsor surveys report that ERISA plans have lagged in interest and adoption. However, conversations with leading investment consultants indicate that companies are starting to address ESG in their DC plans, driven by a desire to have their company values reflected in the retirement benefits they offer their employees. This is consistent with research signaling that a majority of employees care about their retirement plans being aligned with their company’s social and environmental commitments.

Nevertheless, plan sponsors’ low adoption is reflected in New England Pension Consultants’ 2018 ESG survey of its corporate and healthcare retirement clients, showing that just 12% incorporated ESG factors into their manager selection and monitoring. Of the plans that did incorporate ESG, 70% were DC. Of the DB and DC plans that did not, nearly a third (29%) stated they are interested in exploring ESG incorporation, signaling that plan sponsor interest is increasing.

Investment consultants: leading clients from behind

For ERISA plans, investment consultants have not typically been proactive in discussing with plan sponsors the potential for including funds that consider ESG factors in the investment process. However, as mentioned above, plan sponsors are beginning to push their consultants and question whether their corporate values are reflected in their firm’s retirement plan. Consequently, some corporate plans are considering adding a global sustainability fund and/or including ESG analysis in their quarterly performance reports. In addition, nearly half (47%) of the 77 DC investment consultants responding to PIMCO’s 12th annual Defined Contribution Consulting Support and Trends Survey say they recommend ESG as an additional stand-alone strategy within the core line-up. Even though these 77 consulting firms advise roughly 60% of US DC assets (over US$4.4 trillion), this recommendation does not yet show up in the equivalent percentage of DC plans.

Consultants are recognizing the growing interest in ESG incorporation throughout their client base, and some are conducting client surveys and producing white papers. For the last five years, Callan Institute has polled its client base and found that consideration of ESG options leveled off in 2016 and 2017 at 37% across client types, and slightly dipped among corporates (with both DB and DC plans) from 30% to 25%.29 New England Pension Consultants issued its first ESG survey this year, noting that both DB and DC plan sponsors are in the early stages of incorporating ESG investing. In Top Priorities for DC Plan Sponsors for 2018, Mercer includes “Consider ESG Options” as one of the top 10 priorities for sponsors to consider.

Meanwhile, Marquette Associates’ 2017 white paper, Bracing for impact: How to Prepare for the Next Generation of Defined Contribution Plans, lays out the rationale for ESG incorporation and proposes a checklist for those plan sponsors beginning to consider ESG issues. Given that the millennial generation is the most ethnically diverse demographic in the US and will make up the majority (75%) of the global workforce by 2025, Marquette states “ESG strategies seem like an inevitable trend for this generation.”

Marquette’s suggestion, shown in the checklist below, is for plan sponsors to educate their clients, ensure they know their beneficiaries, and start to incorporate ESG data.

1	Review the fund’s investment policy and current fund line-up Does the policy need to be adjusted Where would an ESG option fit into the current line-up?
2	Educate the decision-makers Seek education from consultants and recordkeepers and address all questions and concerns.
3	Survey plan participants Determine level of interest in ESG options, as well as areas of importance (i.e. climate change or labor relations).
4	Outline criteria for search and selection Define whether you seek ESG integration, a thematic fund (such as water or carbon reduction), or other alternatives.
5	Make selection and add to line-up Discuss options, select best candidate, and initiate transition.
6	Educate plan participants Prepare communications to explain the new line-up and rationale behind it.

Investment managers: Key to ESG product quality and authenticity

While investment managers of both DC and DB ERISA plans clearly play an important role in pension fund management, they generally respond to the product requirements of plan sponsors and their consultants. Investment managers are therefore unlikely to drive future adoption of the intentional use of ESG fund options in retirement plans but are rather the creators of the ESG products, and thus can strongly influence the quality and approaches of ESG products and strategies.

Unfortunately, most investment managers of ERISA plan assets have not, to date, embraced the need for or value of ESG incorporation. Offsetting this is the increased use or discussion of ESG incorporation in standard investment processes. While increased use of ESG factors is a positive development for the investment management industry, these factors are rarely at the heart of the investment process and are frequently ignored if they do not clearly impact immediate financial considerations.

Investment managers in the DC space face added challenges to ESG incorporation because providing ESG-based funds does not ensure their adoption by plans or selection by individual beneficiaries. In addition, pressure to provide low-cost options has made some investment managers reluctant to invest in ESG resources, such as services from data providers or dedicated analysts. That said, the cost of ESG incorporation is falling and data is becoming more readily available, as noted in a recent report on ESG integration in US investing.

As beneficiaries make the ultimate investment decisions, the entire chain of advisors and advice engines must be educated or adapted to reflect beneficiary preferences for ESG factors in the funds available to them. Investment managers must also compete with shrinking “shelf space” as plan sponsors seek to make their DC plans easier to navigate by reducing the number of fund options available to beneficiaries. This trend is directly pitting ESG-oriented funds against other investment options.

 

Independent advice providers: Emerging actors in ESG decision making

ERISA DC plans increasingly rely on independent advice providers to help beneficiaries develop an asset allocation and select funds. This advice is usually delivered through some combination of software (“engines” or “algorithms”) and professional advisors, with the goal of providing unbiased advice that is independent of the investment manager. Independent advice providers, such as Financial Engines, are typically hired by the investment manager or plan record keeper.

These independent advice providers’ work with beneficiaries often begins with an automated questionnaire that solicits responses from plan beneficiaries on their goals, timeframes, and risk preferences. Other beneficiary preferences might, for example, include the willingness or not of the plan beneficiary to include international funds in their asset allocation.

Even if available under a DC plan as an investment option, ESG funds are typically excluded from the independent advice provider’s recommendations, simply due to the lack of an ESG question in the advice software that would influence the final fund selection advice. Independent advice providers therefore represent new stakeholders in the DC world that must be convinced of the rationale for ESG inclusion in ERISA and non-ERISA DC plans.

ERISA plan beneficiaries are the primary and ultimate drivers of the increased use of ESG factors in DB investments and DC fund options. However, they typically lack awareness of their ability to effect change through plan sponsors. In the DB market, this is also complicated by a lack of transparency around the investment strategies employed and even a lack of understanding of the plan’s structure and stakeholders.

Rigorous financial analysis, including all financial and ESG factors, benefits the end investor, in this case the plan beneficiary. It is incumbent upon the plan sponsor to require all of its service providers (e.g., investment consultants and investment managers) to account for their due diligence and investment processes, as well as their results.

In the DC market, plan beneficiaries face additional challenges including:

• Lack of awareness: many beneficiaries are unsure whether their plan even offers an ESG option, and most beneficiaries are not asking for ESG incorporation;
• Fund overload: too many fund options (perhaps squeezing out ESG options) lead to beneficiary paralysis and defusing of interest in ESG funds;
• Fund “greenwashing”: investment manager or fund marketing materials may claim ESG incorporation as a marketing device, while the reality is fund managers pay only lip service to ESG factors; and
• Inadequate advice or algorithm engines: these tools often help beneficiaries in areas such as asset allocation and/or fund selection. Typically they do not ask beneficiaries about their ESG preferences, so beneficiaries cannot incorporate those preferences into their portfolios.

Industry initiatives and collaborations: Opportunities to accelerate ESG adoption

ESG adoption will be significantly accelerated by intentional and focused collaboration between plan sponsors and service providers (e.g., investment consultants, investment managers, ESG data providers, and independent advice providers). Current initiatives seek to provide thought leadership, best practice and support for plan sponsors. For example, the World Business Council for Sustainable Development launched its “Aligning Retirement Assets” project in June 2018. Its goal is to shift 1% of members’ retirement assets (amounting to some US$10 billion) into ESG-oriented investments by 2020. The task force will produce two toolkits for plan sponsors addressing questions such as: ‘what is sustainable retirement?’ and ‘how to develop a sustainable retirement plan’.

Another project underway is the ESG Subcommittee of the Defined Contribution Institutional Investment Association (DCIIA), a non-profit membership organization with the mission to “enable America’s workers to retire with financial security.” The membership includes corporations, consultants, asset managers, law firms and record keepers. The ESG Subcommittee is open to all members and its objective is to “encourage best practice for the incorporation of environmental, social, and governance factors in defined contribution plans.” It provides a forum for promoting and conducting research, sharing best practice, producing thought leadership, and influencing policy makers.