A plan sponsor resource FAQ
The marketplace has struggled to develop a clear and consistent definition for this type of fund. The first Socially Responsible Investment (SRI) fund, PAX World, started in 1970. Since then, the industry has evolved and grown from SRI to Economically Targeted Investments to Responsible Investments to ESG (Environmental, Social, and Governance). While the other categories still exist, ESG is now the dominant name for this investment category. ESG investment funds seek to emphasize environmental, social, and governance themes and factors in the decision-making and portfolio construction process. Funds can be marketed as a distinct ESG investment fund, or traditional active managers can use ESG components as part of their investment process for selecting securities. The latter has increased in the recent past and has become a component of investment manager research due diligence.
Prior to launching a distinct set of ESG funds for participants, an investment committee should consider their current funds to determine if ESG is already integrated into your investment menu.
No, ESG funds can be actively- or passively-managed. Actively-managed funds may use bottom-up analysis that includes ESG factors to select portfolio securities. Alternatively, actively-managed funds can use exclusionary screens to avoid certain securities or industries or use screens to construct portfolios that accentuate the desired ESG attributes.
ESG funds are also offered through passive strategies. These funds are designed to track the performance of an index. In this case, the index happens to be an ESG index rather than a more familiar index like the S&P 500 Index.
Due to a variety of factors (e.g., fundamental beliefs, marketing, investment objectives, etc.), the marketplace does not have a common definition of Environmental, Social, and Governance factors. Within the broad ESG investment category, there are numerous subsets, including green, natural resources, housing, micro-lending, SRI-screened, and products that include religious values. It is important to have a detailed discussion of the broad opportunity set before embarking on a selection process.
Yes, but it’s reasonable to ask the question. The decision to offer any investment, including an ESG option, to plan participants carries fiduciary responsibility. As such, the investment committee should undertake a thorough analysis and discussion and document the benefits and factors considered before adding any investment, including an ESG investment fund.
In our opinion, the selection criteria and ongoing monitoring factors should be defined in advance of adding an investment fund. We suggest that these items can be the same used for ESG and non-ESG funds alike. The criteria that we use are:
Below is a sample investment menu that combines the concepts (described in our guide to investment menu construction) into a concise set of investments designed to meet participants ‘where they are.’ The investment menu provides a range of possibilities from multi-asset class single funds through style-specific active funds that seek to provide differentiated return patterns for participants wishing to express their specific investment views. The ESG-specific funds build upon this concept through a fourth tier of investment options. The ESG tier covers the same broad asset classes of fixed income, U.S. equity, and international equity, but by emphasizing ESG themes in their portfolio construction. While committees frequently enjoy spending time on the investment selection and monitoring process, determining an investment choice architecture for the plan and its participants arguably has a far more meaningful and long-lasting impact on retirement readiness.
In late November of 2022, the DOL issued a final rule titled “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights.” The title does not mention Environmental, Social, and Governance (ESG) factors in making investment decisions, but the rule does address this issue. This final rule replaces a rule that was enacted in November 2020 by the previous administration. That rule required all investment decisions to be made based on ‘pecuniary’ factors and would have limited the ability to use ESG investments in retirement plans. In 2021, the DOL issued a notice that it would not enforce that 2020 rule until it had completed a review. According to the DOL, the 2020 rule ‘resulted in the undesirable effect of discouraging ERISA fiduciaries from using [ESG] considerations, even in cases where this consideration served the plan’s financial interest.’
The new rule removes several provisions of the old rule and will make it easier for retirement plans to use ESG factors and ESG-focused products.
There are four components of this new rule: