Climate Change and ESG

Over the last 50 years, investors have slowly broadened their objectives, from solely seeking maximum returns to enhancing the welfare of society—emphasizing investments that care for the environment, fulfill the social contract, and exercise fair and just corporate governance. Environmental, social and governance (ESG) investing, as this philosophy is known, now comprises $12 trillion in professionally managed assets in the U.S., up 38% since 2016, according to The Forum for Sustainable and Responsible Investment, or US SIF.

While U.S. institutional investors have embraced ESG principles—about $9 trillion of the total resides in pension and endowment funds—ESG has made little headway in defined contribution (DC) plans. The investment philosophy is admittedly complex, and there is no clear advantage in returns, so the reluctance from both sponsors and participants is understandable, prospective social benefits notwithstanding.

Not that DC participants are indifferent to the world around them. “What we hear is that, following any major news event, HR [human resources] departments receive increased calls questioning their plans’ investment options,” observes James Veneruso, senior vice president at consulting firm Callan Associates, in Summit, New Jersey. “Following the [school shooting] tragedy in Parkland, [Florida,] clients told us that participants had been asking about policies for investment in gun manufacturers.” Participants also express interest in companies trying to stem climate change.

Sponsors are showing preliminary interest, as well. “ESG has been a part of the conversation with virtually every sponsor over the last year,” says Ross Bremen, a partner at NEPC, a consulting firm in Boston. “But while the conversation is taking place, it takes years for things to play out in the DC space.”

“The interest is focused on employees wanting to use their time, skills and expertise to make a positive impact beyond their day-to-day jobs,” notes Julia Wilson, director of global responsibility and sustainability at data analytics giant Nielsen Holdings in New York. “That can be using their own skills to make a difference at a nonprofit, or donating to charities or, in this case, using their retirement savings to make a positive impact. Employees are waking up to the full set of opportunities, and employers are doing more at the same time.”

“We serve over 20 million investors in the retail channel, and many of those have DC accounts, as well,” says Matt Brancato, head of Vanguard’s portfolio review group, in Malvern, Pennsylvania. “We’re hearing investor interest in incorporating more than just a return strategy. They want to broaden their investing to include a greater stakeholder focus and ESG.” Vanguard’s FTSE Social Index Fund, with $4.7 billion in assets as of last November, is a popular choice among those plans offering ESG options.

But sponsors encounter several obstacles in evaluating ESG. One is finite bandwidth and the demands of higher-level plan issues. “For us, the idea of a sponsor requesting a specific investment has been rare,” says Scott Everhart, founder and president of Everhart Advisors in Dublin, Ohio. “Their focus continues to be on implementing fiduciary practices and ensuring they have an elite 401(k) plan, as well as employee engagement and financial wellness.”

More directly challenging the idea of ESG is the regulatory climate. Last April, the Department of Labor (DOL) issued Field Assistance Bulletin (FAB) No. 2018-01, which did not advise against ESG investing but seemed to reverse prior accommodative guidance. “The regulatory landscape is confusing,” says Brancato. “The DOL has opined in various ways on ESG mandates in DC plans, and sponsors are confused on their regulatory obligations. It feels like a seesaw.”

“It’s important to note that while that bulletin had a negative tone, nothing really changed,” says Veneruso. “But it provided another head wind to adoption, and it did slow the number of new conversations.”

There is also a fear that ESG investments might produce subpar returns. However, academics have thoroughly studied ESG’s results and generally have found no disadvantages. In the case of the Vanguard FTSE Social Index Fund, returns have beaten those of the Standard & Poors (S&P) 500 over the last three-, five- and 10-year stretches.

From the participant perspective, the prospect of lower returns can get in the way of social objectives. “Sponsors tell us that participants ask about ESG investing—Millennials and others whose philosophical beliefs line up with that,” says Ed McIlveen, director of research at Francis Investment Counsel, an advisory firm in the Milwaukee suburb of Brookfield. “We conduct online surveys, and our experience has been that nearly all participants have said, ‘Yes, we’d be interested in that sort of investment alternative.’”

He adds: “But when we ask whether they would be willing to give up returns in exchange for a greater alignment with their philosophy, we find that, about 75% of the time, participants favor the return objective over ESG goals.”

With all of these hurdles, adoption of ESG has been slow. In its 2018 “How America Saves” study, Vanguard reported that, of those participants in its DC plans offered socially responsible options in 2017, just 3% allocated funds to them. Callan Associates reports that, for the third quarter of 2018, ESG investments made up just 1.2% of plan assets overall—a level similar to that of niche funds investing in emerging markets or high-yield debt.

Still, there are pockets of interest in ESG. In Callan’s 2018 DC survey, only 5% of corporate sponsors responded that they offer ESG funds, versus 43% of public and nonprofit organizations. And sources reported a concentration of interest at health care organizations, as well as law firms where younger associates make up much of the participant base.

Nielsen added an ESG fund option to its $1.5 billion 401(k) plan last July. “We make an effort to be as sustainable as possible in our day-to-day operations,” says Wilson. “That includes all of the traditional things, but we have a unique opportunity to create value through using our data resources to help clients on their sustainability journeys or by donating [such resources] to nonprofits and community organizations.

“We’ve seen an uptick in interest over ESG issues and heard positive things from our employees over how Nielsen walks the walk on our commitments,” she continues. “It’s a perfect win-win-win, to align not just with the company’s values but their own, as well, and making a positive impact with their investments.”

Nielsen’s early results have been good. “We’ve gotten about 3% of our participants into the fund and about 1% of fund assets in six months,” notes Brendan Perkins, vice president of global benefits and mobility. “We didn’t expect 20% of our people to be investing immediately, but we’re happy with the progress, and the number continues to grow.”

What catalyst does ESG investing need? Some of the effort lies with managers, says McIlveen. “Products have not differentiated themselves enough for investors to understand what beneficial outcomes they can expect,” he says.
Advisers play a role, too. “I see very little grassroots activity from participants,” says Kirk Welch, a principal at advisory firm MRP, in Sandy, Utah. “Even at one client where the ESG option was driven by participants, those funds are just 2.5% of plan assets.

“If ESG is really going to take root,” he adds, “ultimately it’s going to come down to advisers and consultants pushing the idea. More people are going to feel that how they invest their money is important. But to reach the levels the industry expects, it may take a generation.”
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Art by Alex Eben Meyer