Rosy Returns: The Case for ESG Factors in Target Date Funds

They appeal to younger participants, in particular, and are a proven catalyst for positive enrollment behavior. So why aren’t more target-date providers incorporating environmental, social and governance (ESG) options in their offerings? The reasons are what you would (and would not) expect.  

esg, 401k, retirementOne investment, two goals.

Anyone in the 401k business for a considerable length of time is aware of the Vice Fund, a strategy that invests in the decidedly non-ESG/SRI “sin stocks” of tobacco, gambling and alcohol, among others.

In a bit of guerrilla marketing pique (or genius, depending on the point of view), matchbooks with the Vice Fund’s logo were distributed in ashtrays at the hotel bar hosting the Morningstar Investment Conference some years back.

Founder Dan Ahrens’ philosophy was simple: aim for maximum return, take the profits and then donate to charitable endeavors of choice. Indeed, it was long argued by critics of SRI, ESG and related strategies that performance was too often (and unnecessarily) sacrificed for someone to “invest in their values.”

Until now.

While a growing body of evidence has suggested a correlation between environmental, social and governance (ESG) factors and the positive performance of companies that adopt them, a high-profile research report released late last year from MSCI added the all-important causal link.

Specifically, it identified the relationship between ESG information and the performance of companies, “both through their systematic risk profile (lower costs of capital and higher valuations) and their idiosyncratic risk profile (higher profitability and lower exposures to tail risk).”

The report gave asset managers the academic heft needed to justify the investment beyond feel-good bromides about “doing well by doing good” and the “importance of sustainability,” especially in an environment of increased fiduciary awareness and its litigation fellow traveler.

So how, specifically, will it affect the 401k space? Will advisors begin to push for ESG inclusion in plan sponsor investment menus? What about target date funds—will more fund families offer the option to complement glide path allocations and timing offerings?

“The Natixis Sustainable Future and the GuideStone MyDestination target-date series are the only ones that I’m aware of that have an ESG approach,” Jeff Holt, Morningstar’s TDF analyst, said in response to the latter question. “These are also the only two series with funds marked as ‘yes’ for the data point ‘socially conscious.’”

If present trends continue, however, it’s likely to change.

Natixis was first into the breach, releasing its Sustainable Future Funds suite in February 2017.

It selects securities based on ESG criteria that one would expect—fair labor, anti-corruption, human rights, fair business practices and environmental impact, and it seeks “a diversified portfolio of investments that contribute to a more sustainable future.”

The company quoted its own research in illustrating demand for target dates of this type, noting that 82 percent of respondents “want their investments to reflect their personal values.”

Interestingly, for plan sponsors looking to increase enrollment and encourage savings, Natixis found that 60 percent of respondents would be more likely to contribute, or increase contributions, to their retirement plan if they knew their investments were involved in social good.

Ed Farrington, executive vice president for Retirement Strategies, quoted the MSCI study in making the case for combining TDF and ESG.

“I would say there are two primary reasons,” he argued. “Performance is first, and the growing body of evidence that ESG delivers is quite good. If a company has a strong adherence to ESG, it most likely has strong financial performance as well.”

The second involves participant behavior, with interest in ESG most pronounced among millennials and women, but rising overall in almost every demographic cohort.

“As an industry, we’ve spent years on things like auto-enrollment and auto-escalation,” Farrington noted, his enthusiasm palpable. “But if you look at our data, for the first time we’re seeing investment menus that can act as catalysts for behavioral change, and act as a strong incentive to participate at the right level. It’s extremely exciting.”

He went so far as to call the TDF/ESG combination “nirvana” for plan sponsors looking to increase enrollment and participation rates on the part of their employees, while providing a solid investment choice based on strong(er) fundamentals.

“Almost 80 percent of the value of the typical company included in the S&P 500 is based on intangibles,” he added. “A lot of it comes from its brand and legal contracts. Most people don’t understand how fragile that is. One bad headline and it can be punished in its stock price very quickly. Because of the added due diligence and screening involved, those that incorporate ESG factors are potentially better insulated from it happening.”

It sounds great. So why, then, isn’t ESG adoption in TDFs happening at a faster rate?

Regulation (of course) for one.

The Department of Labor signaled its understanding of the appeal of including ESG options in investment menus and target date options. Yet recent reinterpretations and clarifications of DOL guidance on the subject have caused confusion among advisors, sponsors and just about everyone else, leading to an increased wariness on the part of TDF fund families to offer ESG strategies.

Interpretive Bulletin 2015-01 stressed the importance of considering ESG factors in pension fund investment platforms.

Prior to the bulletin’s release in 2015, ESG factors were largely treated by investment managers as “tiebreakers.” If two investment strategies delivered similar risk-adjusted returns, yet one did so with the added benefit of ESG, it was the one ultimately to be chosen.

However, the Interpretive Bulletin went a step further, noting that ESG issues are “not merely collateral considerations or tiebreakers, but rather are proper components of the fiduciary’s primary analysis of the economic merits of competing investment choices.”

Many took that to mean ESG ranks right up there with risk, return, alpha, beta and all the other parameters by which managers evaluate potential investments.

However, true to form, the DOL threw another wrench in late-April, releasing a Field Assistance Bulletin (FAB) to its regional offices that warned, “fiduciaries may not sacrifice returns or assume greater risks to promote collateral environmental, social or corporate governance (ESG) policy goals when making investment decisions.”

“ERISA fiduciaries must always put first the economic interests of the plan in providing retirement benefits,” it said. “The FAB … advises that fiduciaries of ERISA-covered plans must avoid too readily treating ESG issues as being economically relevant to any particular investment choice.”

While interpreted by some as a rollback to the Obama-era Interpretive Bulletin, others believe it simply clarified that ESG factors must be evaluated in the same manner as more traditional factors when performing due diligence for possible inclusion in a plan.

“The Trump Administration, for the first time, is actually putting ESG exactly on par with any other investment,” said one industry insider. “It actually just leveled ESG with every other investment class. Around 80 percent of the companies in the S&P 500 publish corporate sustainability reports. If you’re a fiduciary and not reading them, are you really performing proper due diligence? So ESG is not adding anything, necessarily, to the process; you should be looking at it anyway.”

In other words, fiduciaries must act in the best interest of participants by maximizing return. As with any other asset class, if an ESG investment can satisfy that requirement, it should be included; if not, it should be removed.

“The latest DOL Bulletin asserts that a fiduciary must construct a menu based on underlying investment strategies, and we certainly agree,” Farrington argued. “I’m speaking for our company when I say this, and not the industry, but we believe ESG drives performance over time, not just with the impact it makes, but in every part of the investment process. If picked correctly, it can be an excellent investment for long-term investors.”

The DOL made clear the selection criteria cannot include any considerations other than the merits of the investment’s economic benefits, “and ESG absolutely falls into that [consideration].”

“If you believe, like we do, that adding ESG to an investment process helps identify themes and what great managers are thinking about when adding risk and so forth, it stands to reason target date funds with ESG underpinnings can achieve that. We ask for no special concessions or tradeoffs when selecting our range versus others, but ESG can generate performance that is directly in line with a fiduciary duty and in driving positive outcomes for participants.”

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