With increasing attention on racial injustice and COVID-19, many companies face pressure to offer Environmental, Social, Governance (“ESG”) funds for plan participants in their company-sponsored retirement plans. This attention has stirred the pot on a long-standing debate within the retirement industry and government regulators on the suitability of ESG funds in retirement plans.
Regulatory Spotlight on ESG
In June, the Department of Labor (“DOL”) issued a statement intended to “set forth a regulatory structure to assist ERISA fiduciaries in navigating these ESG investment trends and to separate the legitimate use of risk-return factors from inappropriate investments that sacrifice investment return, increase costs, or assume additional investment risk to promote non-pecuniary benefits or objectives.” The statement contained a notice called “Financial Factors in Selecting Plan Investments (“the Proposal”), aimed at clarifying obligations related to ESG fund suitability factors by fiduciaries who oversee their company-sponsored retirement plans.
Despite aiming to provide clarity, the Proposal created confusion and a modest uproar amongst retirement plan sponsors, advisors, and practitioners. This appears to be, in part, because of a failure to distinguish ESG integration and economically targeted investing (“ETI”). ESG integration is the consideration of ESG factors as part of prudent risk management and investment strategy to address those risks. ETIs are investments that aim to provide financial returns as well as collateral, non-financial benefits. The crux of the issue for plan fiduciaries is that the Proposal states that ERISA fiduciaries are obligated to integrate ESG factors into their investment analysis if they determine that those factors are likely to have a material economic impact on the investment. If a plan fiduciary, however, does not believe that ESG factors will have a material economic impact on the investment, in most circumstances, it will not be permitted to consider those factors.
Due to the Proposal’s lack of clarity, operational guidance, and enforcement regulations, it is safe to assume that the ESG suitability debate will not end any time soon.
As ESG funds are allowed in retirement plans today, most fiduciaries have access to provide ESG funds as investment alternatives in their retirement programs. We most commonly see investment lineups with a mainstream fund that satisfies the company’s ETI obligations as per their investment policy statement, as well as offering the ESG alternative. For example, a company’s plan may offer the sector’s leading domestic large-cap bled index fund as well as a large-cap blend ESG fund. Offering both options helps mitigate suitability concerns that plan participants have not been provided a prudent option in that sector.
Plan fiduciaries often have a plethora of options when shopping for ESG funds to add to their program. Some of the top considerations when searching to add ESG funds to a program are:
- Exclusion screening to avoid funds that hold detrimental industries (ex. no Tobacco, Firearms, or Oil);
- Impact screening for holdings from companies dedicated to benefiting society (ex. providing clean energy solutions, improving public health, or combatting climate change); or
- Thematic screening for holdings from companies that directly or indirectly commit to ESG-related ethical standards (ex. improving employee relations, combating child or forced labor, or committing to charitable causes)
These suitability discussions are par the course for retirement plan fiduciaries. Choosing the right investment menu for the company’s retirement plan is never as easy as just checking a box, but it does not have to be rocket science either. And at the end of the day, due diligence and prudence are the most important factors in the decision-making process.
If you have any questions or need guidance on your program’s fiduciary obligations, please reach out to your Sequoia 401k Advisor, or connect with them directly in HRX.
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Disclaimer: This content is intended for informational purposes only and should not be construed as legal, medical or tax advice. It provides general information and is not intended to encompass all compliance and legal obligations that may be applicable. This information and any questions as to your specific circumstances should be reviewed with your respective legal counsel and/or tax advisor as we do not provide legal or tax advice. Please note that this information may be subject to change based on legislative changes. © 2020 Sequoia Benefits & Insurance Services, LLC. All Rights Reserved