ESG and Retirement: Considerations for Your Retirement Plan

The Current Landscape

In addition to the dynamic patchwork of regulations that make up the corporate retirement regulatory environment, the Department of Labor recently issued a rule (the Final Rule) related to a plan fiduciary’s duties with respect to selecting plan investments and exercising shareholder rights.¹

The Final Rule permits, but does not require, plan fiduciaries to utilize environmental, social and governance (ESG) factors in their plan investment decisions where appropriate.²

In other words, the Final Rule allows, but does not require, plan fiduciaries to include funds that prioritize ESG factors as investment options in workplace retirement plan investment menus.² In light of strong demand for inclusion of these funds by plan participants, plan fiduciaries may want to consider how they can fold ESG options into their plan’s investment lineup.

Here’s an explanation of what ESG is, how it works in a retirement plan investment context and how plan fiduciaries can think about incorporating ESG funds into their retirement plan investment lineup.

Demand for ESG Investment Options

Demand for ESG funds continues to be strong, especially among younger generations of plan participants. In fact, 79% of all individual investors, including 99% of millennial investors, are interested in sustainable investing.³ Moreover, Morgan Stanley’s Institute for Sustainable Investing found that around 69% of plan participants who reported not having access to or knowledge of a sustainable investment option in their employer-sponsored retirement savings plan expressed interest in selecting ESG funds if included in their plan’s investment menu.⁴

These findings suggest that including ESG funds in an employer-sponsored retirement plan lineup could positively influence employee participation, especially among younger employees.

What Is ESG?

ESG stands for “environmental, social and governance.” Environmental factors (E) may reference a company’s direct greenhouse gas emissions, use of natural resources or waste mitigation practices. The social element (S) includes factors such as workplace safety, pay equity and employee treatment. Governance (G) refers to how an organization is managed with respect to its anti-corruption policies or board independence, among other factors. Ultimately, ESG is a framework that stakeholders can use to manage investment risk and identify investment opportunities.

Consider ESG through the lens of Morgan Stanley’s “Three I’s of Impact” framework: intentionality, influence and inclusion. Retirement plan fiduciaries that are considering whether to incorporate ESG funds into their plan’s investment lineup may utilize this framework when selecting investment options for their plan’s investment menu.

• Intentionality indicates whether a strategy has a documented process for systematically evaluating ESG factors and the resulting alignment of underlying investment holdings.

• Influence looks at an investment manager’s shareholder engagement practices and how they aim to modify the behavior of portfolio companies to further improve the ESG impact of an investment strategy.

• Inclusion speaks to the diversity of an investment team and/or diverse representation across firm ownership.

Considerations for Plan Fiduciaries When Deciding Whether To Incorporate ESG Funds into a Retirement Plan Investment Lineup

Plan fiduciaries that are considering whether to incorporate ESG funds as an investment option in their retirement plans should begin by identifying their plan’s guiding investment principles. For example, an organization may provide services with a positive ESG benefit and wish to include plan investment options that are aligned with the organization’s broader mission. Alternatively, a plan fiduciary may wish to provide its employees with as diverse a menu of investment options as possible, including, but not limited to, ESG funds.

Where appropriate, plan fiduciaries can consider utilizing a plan’s Investment Policy Statement (IPS) to document these investment goals. This process may include identifying key stakeholders to manage the plan fiduciary’s investment decision process, considering which asset classes might be impacted and establishing how new impact considerations will fit into existing governance processes. While not a requirement to establish under ERISA, maintaining a clearly written IPS is a common approach many plan fiduciaries follow to establish and maintain a prudent investment decision-making process. It can also make for a useful addition to a fiduciary audit file.

Amending (or creating) a plan’s IPS to include language on the plan’s investment-related goals can help illuminate whether adding ESG investment options to your plan’s lineup aligns with your plan’s, and the underlying plan participants’, investment objectives.

The next phase is implementation of the IPS, where plan fiduciaries are able to contemplate the inclusion of ESG funds as an investment option to their plan’s investment lineup in accordance with the principles outlined in the IPS. This might result in a one-on-one replacement of an existing traditional fund with an impact fund (e.g., switching out a passive U.S. Large Cap fund with a U.S. Large Cap ESG fund), the incorporation of a fund focused on active shareholder engagement through proxy voting, or onboarding a fund focused specifically on one or more sustainability themes.

Conclusion

Ultimately, the strong demand for ESG investment options, particularly among young generations of plan participants, suggests that incorporating ESG principles into a plan’s IPS and including ESG options in a plan investment lineup can increase plan participation. In turn, this can enhance the plan’s use as a tool for talent retention. Consider speaking with a Financial Advisor to learn more about what might be the best fit for your plan and plan participants.