Op-Ed: ERISA Prudence Demands Healthy ESG Skepticism

Neal Shikes agrees that ESG factors can be an important part of institutional investors’ methodologies, but he also says retirement plan fiduciaries should be skeptical of some claims about what todays’ ESG investments can actually deliver when it comes to confronting climate change.

There is nothing wrong with injecting environmental, social and governance (ESG) factors into an investment methodology. However, if the outcome of doing so is lower returns, higher volatility, ineffective benchmarking and higher expenses, then prudence is not being exercised.

As is always the case for fiduciaries charged with stewarding participant assets in accordance with the Employee Retirement Income Security Act (ERISA), investment methodologies that produce outcomes that demonstrate prudence and loyalty—while remaining free of conflicts of interest—are the goal. Methodologies that produce these outcomes will not favor making quantitative, pre-determined exceptions for any variable.

There is no doubt that we should be concerned about climate change. Similarly, there is no doubt that fiduciaries and money managers must make security selection decisions based on market dislocations, future likelihoods, past outcomes, investment mandates, correlations, volatility data, costs and the interrelated technical patterns of all of these things. All things considered, fiduciaries may use ESG factors, but they must also be wary of the possibility of political or profit agendas when it comes to the flourishing of ESG investing among U.S. institutional investors.

Whatever their personal views are about the causes and effects of climate change, fiduciaries are at risk when they have insufficient expertise to identify and incorporate any factor that is included into their methodology, whether or not it is ESG related. Despite the nobility of the effort, plan fiduciaries must remain cautious when it comes to telling participants they have successfully incorporated “climate change considerations” instead of “ESG considerations” into their investment methodologies.

To be clear, weighing ESG considerations in one’s investment methodology—such as the potential impact of one’s investment choices on global biodiversity and ecological health—is a very worthy endeavor. So are quantifying behaviors that impact equality in the workplace and the health and safety of workers. It is also about time that ethical behavior, board diversity, conflicts of interests, executive compensation and shareholder’s rights are looked at closely.

What is difficult today, and what will remain difficult, is incorporating new investment decision processes with little historical data in an attempt to address extremely broad and complicated issues that are so wide in scope as to make the likelihood of positive outcomes highly difficult to quantify. Case in point, can a single investment fund really claim to address the issue of climate change?

At this juncture, it seems unrealistic and potentially misleading—and beyond the scope of retirement plan fiduciaries’ duties and the data available to them—to claim to be assessing such a vast and evolving issue within a single investment review. For now, at least, addressing these macro issues is an important task arguably better suited for local and global civic engagement—by voting in elections where political and social agendas are debated, refined and pursued on their own terms, not as investment factors.

A final point to make is that, up until recently, investments considered to be ESG focused were rather opportunistic and more suitable for the private markets. As such, it is worth considering to what extent the new push for ESG investments in the retirement plan marketplace represents an opportunity for active investment managers to secure more assets in the public markets.

In the end, Department of Labor (DOL) enforcement and ERISA class action proceedings will continue to focus not on any specific outcomes, but on the prudence of fiduciaries’ behaviors and the plausibility that they have caused damages via poor methodologies.


About the author:

Neal Shikes is managing partner of MJN Fiduciary LLC (The Trusted Fiduciary), based in New York City, which provides employer-sponsored retirement plan and fiduciary consulting.

Editor’s note:

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services or its affiliates.