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ESG Doesn’t Trump Fiduciary Principles

For plan sponsors, ESG investing is a hot topic of discussion. However, like #BlackLivesMatter and #MeToo, ESG can be seen as a highly politicized buzzword that often means different things to different people. Retirement plan fiduciaries should dig below the surface.

Lawmakers on Capitol Hill have introduced legislation that would amend ERISA and allow for the offering of ESG options, and for the consideration of ESG factors within retirement plans. Importantly, the proposed statutory language offers that while ESG considerations maybe taken into account, traditional fiduciary principles (such as, prudence, acting solely in the interest of plan participants, exclusive purpose of providing benefits, defraying expenses, and diversification) still apply.

In other words, fiduciary principles can’t be sacrificed in favor of a push towards ESG investing, simply because ESG is a hot topic

However, we maintain that best practices concerning ESG are not at odds with fiduciary principles but promote and advance fiduciary obligations. ESG factors can be included in the investment analysis process – but should not be the purpose of it.

It was just over 15 years ago when the term ESG Investing entered the collective consciousness of investors. Fast forward to today, and we still don’t have a universal framework for its implementation. It can feel like a gray area for investors, so it’s worth defining what we are actually talking about when we use the term ESG. Basically, it involves incorporating Environmental, Social and Governance factors in the analysis of investments because they are relevant to an investment’s expected performance.

ESG however, is not to be confused with “Socially Responsible Investing” (SRI) which often seeks to screen out investments that derive revenues from morally or ethically questionable activities or countries. SRI came first and was more widely adopted by even the largest institutional investors from the beginning. Many public pension plans, often prompted by state legislatures, avoided and eliminated investments with ties to Iran or Sudan for instance. Some, like CalPERS, decided in 2000 that they would divest from all tobacco stocks which, according to the Wall Street Journal, cost them about $3.5 billion over the course of the next 16 years. (https://www.wsj.com/articles/calpers-dilemma-save-the-world-or-make-money-11560684601)

The presumption here, is that directing investments away from politically or socially objectionable entities, will move society towards a better place. Maybe, maybe not. But at the end of the day, SRI investing isn’t necessarily about assessing risk and return.

ESG, on the other hand, most certainly can be implemented with the intent of improving risk and return. For retirement plan fiduciaries, that puts incorporating ESG factors into investment decisions, squarely into play. But there are boundaries that they must adhere to in order to stay out of the hot seat of ERISA litigation. So how should a retirement plan fiduciary proceed when it comes to including ESG options in a plan? Stick to your knitting and ensure that investments incorporate ESG factors with the goal of increasing returns and reducing risk.

In order to do this, plan fiduciaries need to understand how an investment manager assesses ESG related risks and how they determine what impact, if any, these risks have on an investment’s enterprise value going forward. What are the factors they are using in scoring investments and how do they integrate those scores into the process? For example, when looking at two similar companies in the energy sector, if Company A relies solely on fossil fuels in its business, and Company B has started to phase in green and renewable sources of energy, Company A will likely have the higher ESG risk. That higher risk can affect the value of the company and that valuation analysis can inform a risk/return assessment. What the investment manager shouldn’t be doing, is eliminating Company A because they aren’t adhering to a preconceived notion of what a portfolio should and should not hold.

As ESG considerations are becoming more and more commonplace in markets today, assessing and understanding how various factors can add or detract from an investment’s overall growth potential, should always be the objective of a retirement plan. Notwithstanding the proposed statutory language, fiduciaries cannot forget that first and foremost, they remain subject to traditional fiduciary duties at all times. The legislation may provide a safe harbor for implementing ESG factors, but it doesn’t otherwise take fiduciaries off the fiduciary hook. And that is a good thing. 

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