Need more clarity on sustainable investing (even with DOL’s final ESG rule)?

The DOL has published its final rule related to the consideration and use of ESG factors within retirement plans, highlighting that they may have a material effect on financial risks and returns. Also included is a new provision clarifying the permissibility for participant preferences to be considered when constructing a menu of prudent investment options (Schroders’ retirement survey indicates that 87% of participants do indeed want investments aligned with their values).

The rule makes clear that ERISA’s core principles, which require plan fiduciaries to focus on material economic factors and not sacrifice investment returns or take on additional investment risk to secure a collateral benefit to plan participants, continue to govern. But it also clarifies that use of sustainable investment and ESG integrated products is not inherently incompatible with these core principles.

Now that this highly anticipated step forward has been finalized, the question is no longer, “Are plan sponsors allowed to consider ESG factors and provide sustainable investment options?” but rather “How do sponsors go about assessing and implementing ESG-integrated and/or sustainable investment options?”

When it comes to this question of implementation, we believe that there are several milestones that are essential for plan sponsors to keep in mind.

#1: Do the research, decide on an approach, and review the potential investment options

A variety of potential approaches exist across the spectrum of ESG and sustainable investing:

• An ESG-integrated approach involves rigorous analysis to understand the ESG trends and factors that affect investments. The primary goal is to achieve better returns by identifying and managing critical investment risks effectively. Excluding companies is typically not the goal of this approach. Instead, engagement with issuers can revolve around the management of issues across the ESG spectrum to ensure earnings growth, cash flow durability and a resilient business model.
• Sustainable investments seek outcomes as a goal of the investment process, while remaining focused on investment returns. If an ESG-integrated approach is about anticipating financial risks and opportunities affecting a company today, a sustainable approach seeks to identify businesses that will thrive in the long run. Exclusions based on economic analysis may apply here, depending on the investment philosophy and definition of sustainability.
• In our view, Thematic investing with a sustainability angle is about pursuing investment themes that align with and target the United Nation’s Sustainable Development Goals (SDGs). These themes can include climate change, responsible consumption, or sustainable infrastructure, to name a few. Thematic investing is a way to capture direct exposure to trends that are gaining global momentum, such as the energy transition and other areas of innovation and disruption. Thematic investments may be narrow and exposed to structural and cyclical risks, such as slow policy momentum, rising rates, and supply chain disruptions; therefore, time horizon is an essential consideration, particularly for multi-decade trends.
• At Schroders, we define Impact investing (aligned with the International Finance Corporation definition) as investments made in companies or organizations with the intent to contribute measurable positive social or environmental impact, alongside a financial return.

While Thematic and Impact approaches to investing have become more common in recent years, we will need to keep an eye on whether plan sponsors seek to include these types of strategies in plan lineups in the near term. Plan fiduciaries will need to carefully analyze individual funds or strategies before including them in a DC lineup.

#2: Educate plan participants on the new options

If a sponsor has decided on a sustainable investment approach, communication to plan participants is essential. Education is the best tool in this instance, and can take different forms:

• Product level: What is the fund’s sustainable objective (if any)? What will reporting look like? If there is no sustainable outcome, will engagement and voting information be reported? Are there examples demonstrating what sustainability or an integrated approach looks like in practice?
• Broader education: What are the macro policies driving system-level changes? What are the emerging themes that have become investment opportunities? What are the different approaches to ESG investing and where does a plan option land on the spectrum?

Related: ESG investments lower than expected, totaling $8.4 trillion: Here’s why

If sponsors are to provide sustainable investment options, helping participants make informed decisions on the choices offered and how they can fit into their overall retirement investment portfolio is a significant value-add.

#3: Monitor, measure and report the results

Once a sustainable investment option has been implemented, relevant criteria should be measured and reported to plan participants and the plan investment committee. Plan sponsors will have to work with their managers to set reporting expectations, including a clear link to the investment approach taken. For example:

• ESG-Integrated: Since sustainable outcomes are not the goal, a documented understanding of the approach to considering sustainability risks and opportunities will be important. This may include ongoing reporting of sustainability-related engagements and votes.
• Sustainable: Reporting demonstrating alignment to the defined sustainable outcome.
• Thematic: Reporting aligning to the relevant Sustainable Development Goals or other measurement demonstrating thematic alignment.
• Impact: Ongoing reporting capturing progress of the key indicators of intended impact.

What next?

Although the DOL’s ruling on ESG implementation in retirement plans is an enormous step forward, more is needed to significantly impact the adoption rate of sustainable investing. This includes clear definitions, increased transparency, and evidencing outcomes.

As far as regulation is concerned, the latest DOL ruling is just the beginning. The SEC’s proposals on ESG disclosures for registered investment funds and the so-called “names rule” are now in the spotlight. These rules would require managers to identify whether a fund is “integrated,” “sustainable” or “impact,” require fund names to accurately reflect the investment strategy, and mandate that reporting of fund progress is aligned with the objectives. This may lead to an easier process for plan sponsors of identifying potential options based on their stated investment and sustainability approach.

Lazaro Tiant is Sustainability Investment Director, North America at Schroders.