In a previous RPA Edge column, I reviewed some of the arguments against ESG-focused investing. The sources cited in that article focused on the academic case and low ESG-fund adoption rates among plan participants.
A prevalent argument in favor of including ESG factors in developing a plan’s fund lineup is that consideration of ESG is a fiduciary responsibility. From the DOL’s October 2021 proposed rule: “As appropriate economic considerations, such ESG issues should be considered by a prudent fiduciary along with other relevant economic factors to evaluate the risk and return profiles of alternative investments. In other words, in these instances, the factors are not “tie-breakers,” but “risk-return” factors affecting the economic merits of the investment.”
The SEC has also weighed in. The agency’s 2022 examinations priorities’ statement stated that “Examinations will typically focus on whether RIAs and registered funds are accurately disclosing their ESG investing approaches and have adopted and implemented policies, procedures, and practices designed to prevent violations of the federal securities laws in connection with their ESG-related disclosures, including review of their portfolio management processes and practices.”
In late May 2022, the SEC followed up with a proposed rule that included “proposed amendments to rules and reporting forms to promote consistent, comparable and reliable information for investors concerning funds’ and advisors’ incorporation of environmental, social and governance (ESG) factors. The proposed changes would apply to certain registered investment advisors, advisors exempt from registration, registered investment companies, and business development companies.”
Not So Fast
The regulators have locked in on ESG, but some plan consultants are pushing back.
Cassandra Toroian,founder and chief investment officer with Bell Rock Capital in Rehoboth Beach, Del., said the ESG emphasis is misguided. The firm has about $400 million in 401(k) plans for which it serves as the 3(38) or 3(21) provider and is involved in determining the investments available for the plans’ lineups. Toroian is blunt in her criticisms of the shift to ESG.
“Generally speaking, our firm does not believe in this ESG mandate from the SEC, nor do we believe it is proving to deliver the absolute best results for plan participants, which, as fiduciaries, is the most important aspect of selecting any investment for a plan,” she said. “The fact that somewhere, some group a few years ago decided that ‘ESG’ should be the most important thing that companies must focus on and be judged on is absolute rubbish to us.”
Toroian expands on her critique. “What makes the U.S. government decide to mandate that ESG should be the chosen group of characteristics by which our society must measure the investment worthiness of a company?” she asked. “Why not other characteristics, such as religion or the number of American-made products sold by a company, American labor used, etc.?” Bell Rock Capital doesn’t prevent its plan-clients from considering ESG, she added, although to date none have expressed an interest. Should a sponsor do so, the firm will conduct its due diligence to identify the best available options, she explained. In the meantime, the firm’s analysis focuses on traditional measures such as market share, strong management, increasing dividends, funds’ Sharpe ratios and a variety of other fundamental factors.
The firm’s objection to the ESG emphasis isn’t just based solely on regulatory pushback, though. Bell Rock Capital has conducted an “enormous amount of due diligence” on ESG, including work that predated the market’s current interest, according to Jackie Reeves, head of portfolio strategy and research. The results of that research revealed problems with ESG company ratings, classification and analysis. “What are the rules of the road that allow different companies to be in these ESG funds?” Reeves asked. “There's no consistency, there's no measurement tool—there's a whole lot of speculation. We want to be able to take better care of the environment and all those good things. I think it's just going to take an enormous amount of time for the measurement tools, as well as the profitability angle and social justice to really come together to have it be a powerful tool.”
The SEC is working toward the clarification that Reeves mentions. Per the agency’s press release on its March 2022 proposed rule: “Funds focused on the consideration of environmental factors generally would be required to disclose the greenhouse gas emissions associated with their portfolio investments. Funds claiming to achieve a specific ESG impact would be required to describe the specific impact(s) they seek to achieve and summarize their progress on achieving those impacts.”
Stick to the Process
Regulators’ approach to ESG investing has evolved under different administrations and is likely to keep evolving. In the meantime, Bonnie Treichel, founder and chief solutions officer at Endeavor Retirement, recommended advisors should continue to be consistent with their prudent process under ERISA. “At the heart of what advisors should be doing is ensuring that their recommendations are consistent with the spirit of ERISA Section 404, which requires the duty of care and the duty of loyalty,” Treichel said. “This means that advisors are putting the financial interest of participants and beneficiaries first and following a prudent process.”
From an include-or-exclude ESG perspective, the decision is whether that investment option meets the criteria outlined in the investment policy statement or other stated investment objectives and if that investment option meets ERISA Section 404 by adding investment return or reducing risk. If it does, that investment is an appropriate investment for an ERISA-covered plan, Treichel explained.
“Where confusion sets in is when advisors or their plan sponsor clients try to lead with social or other ESG factors in making their decisions, which isn’t appropriate for an ERISA-covered plan,” Treichel added. “By following their same screening process and adding ESG factors that are additive to investment return, advisors will be well-situated to add ESG as a part of their investment philosophy while still meeting ERISA fiduciary duties.”