Executive summary

The case for ESG incorporation by US private sector retirement plans has evolved over the last 30 years; from articulating that ESG is not prohibited, to demonstrating that ESG incorporation creates clear benefits for investors, to now viewing ESG incorporation as a core element of fiduciary duty.

This report explores the US private sector retirement market that is regulated through the Employee Retirement Income Security Act of 1974 (ERISA) and the policy, governance and specific stakeholder factors that could drive the growth of ESG assets.

In the United States, private sector retirement plans are subject to the provisions of ERISA, which sets standards for fiduciaries of defined benefit (DB) and defined contribution (DC) plans based on the principle of a prudent person standard. In recent years, DC plans have replaced DB plans as the dominant structure for private pension plans. This shift has created an agency problem, with misaligned incentives as plan sponsors determine plan structures and investment options, but the beneficiaries bear the investment risk. While the path to driving ESG incorporation in DB plans is clearer, depending primarily on the actions of institutional players, decision making in DC plans is increasingly driven by individual beneficiaries.

This report follows the April 2018 Department of Labor (DOL) Field Assistance Bulletin and the May 2018 US Government Accountability Office (GAO) publication, both of which address the use of ESG factors in retirement investing. The former emphasizes the importance of prudent decision making and not sacrificing investment returns. The latter examines the use of ESG factors by US retirement plans and makes two specific recommendations to DOL: to “clarify whether the liability protection offered to qualifying default investment options allows use of ESG factors”; and to “provide further information to assist fiduciaries in investment management involving ESG factors, including how to evaluate available options, such as questions to ask or items to consider”.

However, recommendations in this report focus on stakeholder engagement, rather than policy. As policy makers debate whether or not ESG is a core component of the investment process, this report focuses on how to engage stakeholders – particularly plan sponsors and beneficiaries – to encourage ESG incorporation in the US pension market.

Growth in ESG assets will depend on untangling the roles, incentives and challenges of the key ERISA plan stakeholders (see below).

As decision making becomes less centralized, the continued growth of ESG options in ERISA plans will depend upon grassroots engagement strategies and aligning the business objectives of plan sponsors with the preferences of plan beneficiaries.

Recommendations to untangle the stakeholder chain depend upon motivating plan sponsors to embrace change. The primary leverage point is the value of aligning plans with corporate values, which is increasingly recognized as a way to engage and increase participation by and contributions of millennial plan beneficiaries. This becomes the foundation for convincing ERISA plan sponsors that it is part of their fiduciary duty to incorporate ESG into plan investments.

Some tactical steps for plan sponsors include:

• Incorporating ESG into DB and DC investments as an expression of corporate social responsibility (CSR) and as part of efforts to attract and retain talent.
• Establishing best-practice ESG governance through:
  • Developing investment beliefs that address ESG incorporation;
  • Ensuring investment consultants have ESG expertise by including ESG selection criteria and questions in consultant requests for proposals (RFPs);
  • Updating Investment Policy Statements to require ESG analysis when selecting and monitoring investments;
  • Requiring investment consultants to ask investment managers how they incorporate ESG;
  • Selecting a recordkeeper with ESG products on its platform;
  • Requiring investment consultants to include ESG analysis in all performance and monitoring reports; and
  • Providing education to DC beneficiaries so they understand what it means to incorporate ESG into investments and whether options are included in the core line-up.
• Creating beneficiary-oriented ESG surveys – framed around alignment with corporate values – to assess demand for ESG options in DC plans and stimulate action by plan sponsors.
• Piloting the use of ESG-oriented preferences in independent advice provider/engines. This can address a key constraint limiting ESG fund use.
• Promoting the standardization of ESG disclosure requirements for investment managers and consultants, including a push for transparency of ESG products.
• Joining industry initiatives, to improve collaboration between plan sponsors and service providers and tap economies of scale.