The U.S. Department of Labor’s (DOL) proposed rule discouraging the consideration of environmental, social and governance (ESG) issues for pension plans subject to the Employee Retirement Income Security Act (ERISA) undermines the Department’s commitment to the long-term financial interests of millions of Americans saving for retirement.
We fully agree with the DOL that managers investing assets on behalf of ERISA pension plan participants have a fiduciary duty to maximize the probability of attractive long-term returns. That means considering the full range of risks and opportunities that have a material effect on investment returns.
Here it is important to distinguish between investment strategies that align with an investor’s ESG preferences and explicitly prioritize impact over returns (“values-driven investing”) and “value-driven” ESG investing that incorporates analysis of material ESG risks and opportunities in the same way that traditional financial metrics are considered. It is also appropriate to remind fiduciaries that plan assets are not to be used to advance objectives that conflict with that financial imperative.
The reality, however, is that a growing body of research demonstrates that what the DOL calls “pecuniary factors” include material ESG issues.1 Moreover, ESG issues are growing in significance, as structural shifts in economies and business models driven by technology are elevating the value companies derive from intangible assets, most notably brand value, which are enhanced by positive corporate attributes like corporate culture, employee loyalty and engagement, and other ESG considerations.2 Traditional financial accounting information is becoming less complete for investment decision-making as knowledge-based companies leverage intellectual property and talent as major sources of competitive advantage rather than the tangible assets of manufacturing-dominated business models.
It is hard to argue that long-term investors should ignore how companies are governed or their exposure to the non-linear risks of climate change. Now COVID-19 has also reinforced the importance of social responsibility characteristics as a measure of a company’s resiliency during a time of crisis. In fact, recent research using State Street flow data showed that the stocks of companies with strong ESG characteristics, such as strong employee safety practices, effective supply chain management, and agile operations repurposing products to meet new market needs, suffered lower declines during the worst of the equity market sell-off in March than the shares of competitors with comparatively weaker ESG characteristics.3
Increasingly, stock prices are reflecting investor awareness of the beneficial financial impact of more positive ESG characteristics during a novel period of economic and financial stress in which business model resiliency is paramount. Stronger cash flows, lower borrowing costs and higher valuations are common features of companies focused on managing material ESG risks.4
Especially for ERISA plan participants with long investment time horizons, the DOL should welcome ESG as an effective framework for promoting a long-term investment focus on value creation in a world that is often overly concerned with the short term alone.
But we acknowledge that there are grey areas between material and non-material ESG issues and that fiduciaries must incorporate ESG issues into their risk frameworks with the same degree of rigor and transparency that other financial risks and value drivers are analyzed. That is why we call upon policymakers, plan sponsors, researchers and investment managers to engage with investor-led frameworks developed by the Sustainable Accounting Standards Board (SASB) and the Taskforce on Climate-Related Financial Disclosures (TCFD) to help develop better metrics, methodologies and reporting standards for ESG issues. Important inroads are already being made by researchers to help investors better measure the financial impact of intangible ESG value drivers like human capital development.5 Improving the quality, consistency and comparability of ESG information is in everyone’s interest and will help clarify the relationship to financial materiality.
As the investment profession’s standard setter for professional conduct, the CFA Institute is already including ESG in its CFA Program curriculum and teaching that “ESG information can often be material or otherwise useful in the investment decision-making process…[leading] to a better understanding of a company’s complete story.”
We believe that appropriately integrating ESG adds value and constraining consideration of these material issues for ERISA plan strategies runs contrary to the DOL’s stated objective of focusing on financial factors that affect investment returns for plan participants. In an uncertain world in which ESG matters more, not less, to strong corporate resiliency and sustainable performance, promoting material ESG considerations in investment decision-making is good for the long-term retirement security of millions of American savers.
1 Mozaffar Khan, George Serafeim and Aaron Yoon, “Corporate Sustainability: First Evidence on Materiality,” Harvard Business School, March 2015.
2 See, for example, Jonathan Haskel and Stian Westlake, Capitalism Without Capital: The Rise of the Intangible Economy (Princeton: Princeton University Press, 2017).
3 Alex Cheema-Fox, Bridget R. LaPerla, George Serafeim, Hui (Stacie) Wang, “Corporate Resilience and Response During COVID-19,” Harvard Business School Working Paper 20-108.
4 Oxford University, Arabesque Asset Management, “From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance,” https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2508281, 2014.
5 Sakis Kotsantonis and George Serafeim, “Human Capital and the Future of Work: Implications for Investors and ESG Integration,” 2019.
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