What Will ‘Impact’ An Advisor’s 401k Fiduciary Obligations?

There is no doubt about the strong growth in assets deployed to impact investing—up 76 percent from 2012 to 2014. However, that pace has undoubtedly been suppressed by lingering, and largely unfounded, fiduciary concerns expressed by some financial advisors and institutional consultants.

Specifically, the perceived problem—in our opinion, myth—is that investment fiduciaries who consider factors that promote the interests of society at large must inherently be neglecting or working at cross-purposes to the interests of the investors they serve.

Despite recent clarifying rule releases from both the IRS[1] and the Department of Labor[2], we often hear some version of this misperception: “I can’t recommend that this account be invested in vehicles that consider environmental benefits or social values because it’s against my fiduciary duty.”

Let’s break down the facts.  Regardless of whether you are a fiduciary to an individual client, pension plan, 401(k) plan, foundation or endowment, fiduciary conduct involves two fundamental duties:

• Loyalty: the obligation to serve the best interests of your clients and avoid conflicts of interest, and
• Care: the obligation to act with the skill, diligence, and good judgment that is reasonably expected of others serving in a similar capacity – the proof is in the process applied, rather than the outcome

To be loyal to your clients and serve their best interests means you, as a fiduciary, need to consider a reasonably robust range of economic risks and investment opportunities. A “reasonable” range of considerations would include those that are material to sound decision-making, are relevant today and are expected to be relevant during an investment portfolio’s time horizon.

Overwhelming evidence shows that sustainability considerations have a material impact on financial assets, especially as the investment time horizon lengthens. For many legacy-minded individuals and most institutional portfolios (retirement plans, foundations and endowments, sovereign wealth funds, etc.), the time horizon is quite long, and in some cases is essentially infinite.

For example, stranded assets and other climate change-related risks are real and potentially highly impactful for large, highly-diversified, and essentially perpetual portfolios. In this case, externalities created by some companies in a portfolio may negatively impact other holdings. For example, companies that rely on fossil fuels may contribute to climate change that adversely impacts property and casualty insurers. Not only does this influence investment decisions, it may lead to greater shareholder activism to change corporate behavior for both societal and investment reasons.

The concept that serving the interests of society imperils the interests of its members is logically flawed, especially as it relates to investment fiduciary responsibility. This point is specifically addressed in “Fiduciary Duty in the 21^st Century,” a report published by the United Nations Environment Programme Finance Initiative (UNEP).

Al Gore and David Blood sum it up well in this excerpt from the foreword to the report:

“Fiduciaries are tasked with the decision to buy, sell, or hold assets. There is no passive behaviour as a fiduciary; there is no ‘do nothing’ task. Those who defend an obsolete interpretation of fiduciary duty sometimes justify the active omission of sustainability considerations by asserting that sustainability dynamics somehow have no impact on financial assets. Overwhelming evidence now shows, however, that they are simply mistaken. Sustainability is an important factor in the long-term success of a business. Therefore as with any other issue related to the prudent management of capital, considering sustainability is not only important to upholding fiduciary duty, it is obligatory.”

Conformity with the fiduciary duty of care requires consideration of potential benefits and costs for investors. This includes managing both risks and returns.  Many fiduciaries rely heavily on index strategies to track widely known benchmarks, like the S&P 500 Index. These benchmark-tracking approaches make it relatively easy to explain performance fluctuations as, “well, that’s how markets are performing right now.”

But they also erase the opportunity for outperformance (i.e. production of alpha) that may be enhanced through thoughtful evaluation of the risks and opportunities associated with factors that are known to impact our lives, the economy, and the investment marketplace—such factors as climate change, resource scarcity and widening income and wealth inequality.

Climate change is a good example of a known phenomenon with real and directionally predictable implications. From an investment perspective, it presents both risks and opportunities. Contributors to climate change are likely to be increasingly penalized in the marketplace. Companies that combat climate change through commercially viable innovation are likely to be rewarded. Picking winners and losers is never easy or certain. Nevertheless, prudent fiduciaries will need to consider whether the strategies of companies, industries, and investment vehicles are aligned to factors and trends that are directionally predictable and potentially underestimated in the marketplace today.

The UNEP report states that consideration of environmental, social, and governance (ESG) factors is widely and increasingly viewed as a fiduciary obligation. While this conclusion has not yet become widely accepted as legal doctrine in the U.S., we think it will in the not too distant future.

Former U.S. Securities & Exchange Commission (SEC) Commissioner Bevis Longstreth has gone so far as to suggest that investing in fossil fuel companies will one day be viewed as a fiduciary breach, saying “At some point down the road towards the red light of 2 Degrees Centigrade, … it is entirely plausible, even predictable, that continuing to hold equities in fossil fuel companies will be ruled negligence.”

Mr. Longstreth has evaluated the current risk paradigms and feels strongly that not only is it entirely within a fiduciary’s role to invest client assets in fossil fuel free strategies, they may be ruled negligent if they don’t factor in all of the material risks known to us today to make a prudent decision about how those risks can be mitigated in the best interests of their client. Safeguarding client assets from long-term systemic risk is an integral part of the fiduciary duties of loyalty and care, and much needs to be done to educate fiduciaries about what this means and how it can be done prudently.

While you may disagree with Mr. Longstreth’s specific dire forecast for the fiduciary implications of investing in fossil fuel companies, responsible fiduciaries should take to heart the need to consider ESG factors in investing. Society and investors have much to gain and nothing to lose when they do so.

(From 401(k) Specialist Magazine Issue 4, 2016) 

[1] – At the time of publication, this article linked to https://www.philanthropy.com/article/New-IRS-Rule-Likely-to-Make/233227, an external webpage, that is no longer available. The original source link is now broken or has been removed.

[2] – At the time of publication, this article linked to https://www.investmentnews.com/article/20160113/FREE/301179999/socially-conscious-investing-gets-a-boost-from-the-dol-fiduciary-rule, an external webpage, that is no longer available. The original source link is now broken or has been removed.