As plan sponsors focus on their retirement plan fund
lineups, they must carefully consider the types of investments to offer. Their
options cover a wide range: core asset classes, alternative asset classes, or
differently structured options. An additional question is whether the plan
sponsor should offer funds that invest in companies that act with a social
conscience--should a fund array include investments in “responsible funds.”
Interest in responsible investments has expanded
significantly over the past several decades. The first responsible investing
mutual fund was the Pioneer Group, which started in 1921. Today, The Forum
for Sustainable and Responsible Investment lists 146 funds covering all
major asset classes.
Types of Responsible
Funds
The three main categories are:
- Socially Responsible Investing (SRI) — a process
that uses ethical guidelines to avoid investing in certain companies, by using
negative screening;
- Impact Investing — a system of investing in
companies that actively pursue social and environmental change; and
- Environmental, Social and Governance investing (ESG)
— a process of screening companies in which to invest by incorporating
environmental, social and governance aspects into the company analysis.
While SRI was the most popular form of responsible
investing, its processes, along with those of Impact Investing, impose
constraints. SRI & Impact Investing specifically use the values of the
investor/organization to determine in which companies to invest. This results
in a significantly restricted pool of potential companies from which to choose,
because their operations must be consistent with a particular social
mission.
ESG Investing is not mission-based. It is used as a tool to
augment the investment return of a portfolio. By seeking to identify companies
whose performance is enhanced by its attention to ESG factors, an investment
manager can develop a strategy for long-term profitable returns in addition to
social good.
Problems with
Responsible Investing
Fiduciary
Responsibility
A concern with offering responsible investment mutual funds
is the potential to generate lesser investment returns than those of other
non-responsible funds in the same asset class. The reason for the concern is
that the managers of the responsible investment funds have to eliminate from
consideration certain potential companies, due to their business models, governance
policies or specific industry. They will, therefore, be precluded from the same
level of success as those managers who are not restricted by similar
limitations. Historical data from Morningstar indicates that while many of
these responsible funds excel in their asset categories, on average,
responsible funds do lag their non-responsible fund counterparts by a small
margin.
For retirement plan sponsors, this may pose a potential
problem. The fiduciaries of a retirement plan governed by ERISA have a
responsibility to ensure that the investment options offered in the plan are
competitive. That does not mean that they must always select the top performing
fund in each asset class, but the funds selected must be reasonably similar and
competitive to the associated benchmark and the median performance for the
asset class.
Plan fiduciaries can expect no relief from this standard
just because the fund operates with a social conscience. In 2008, the Employee
Benefits Security Administration re-affirmed that characteristics beyond the
fundamental risk and return profile of the fund may not be used as a factor in
selecting investments.
Diversification
Another matter for plan sponsors to determine, when they
incorporate responsible investments in a fund lineup, is how best to enable a
participant to fully diversify his/her account, using only responsible
investments. Most participants who opt for responsible investments are 100%
socially conscious; they want to be able to allocate their entire portfolio
among responsible investments. If the fund array only offers one responsible
fund in an asset class that is either all equity, such as Large Cap Blend, or
all fixed income, such as Intermediate Term Bond, the lineup would not allow
full diversification using only responsible investments. The participant would
be too heavily allocated towards just one asset class.
As a result, if plan sponsors are going to offer only one
responsible investment option, many elect to provide a balanced fund, or an
allocation fund. If the plan sponsor is going to offer a pure equity option,
then they will typically also present a pure bond option as well, to allow for
diversification. The problem with this model is that if one of those funds
underperforms to the point that it requires replacement, it must be replaced by
another responsible fund in that same asset category. The more specialized the
asset class, the fewer replacement options available.
Underlying Social
Criteria
Not all responsible investments employ the same criteria for
the selection of responsible companies. Even funds that fall under the same
broad category, such as SRI or ESG, may use widely disparate screening systems
and principles. These divergences in the funds’ criteria may derive from
religious or ethical ideals that may not align with either the plan sponsor’s
preferences or those of its participants. This can be another limiting factor
in either the initial selection of a responsible fund, or the search for a
replacement fund. Not only must the plan sponsor committee find a responsible
investment option in the appropriate asset class, but it may also seek to find
a fund that fits its particular social agenda.
Comparing
Performance
The difficulty of comparing performance between responsible
funds poses another challenge. Once the asset class has been selected and the
non-responsible funds have been screened out, how do the remaining funds
compare to one another in performance? Do the variances in return reflect the
judgment of the manager and his/her investment selections, or is it a function
of the screening criteria? Given the limited number of responsible investments
in each asset class, once the screening criteria are compared with each other,
are any two funds truly alike and suitable for an “apples to apples”
comparison?
Potential
Solutions
Vigilance in the due diligence process for fund selection is
obviously critical. Close monitoring on an ongoing basis is also important. In
addition, plan sponsors can provide participants with access to the universe of
responsible investments, either SRI, ESG or Impact Investing funds, in a Self-Directed
Brokerage Account (SDBA) without incurring a fiduciary oversight necessity.
A drawback, however, is that the SDBA is most appropriate
for an investment savvy participant, or for someone working with an investment
adviser to recommend investment selection. These windows make available mutual
fund investments of all shapes and sizes tempting the novice investor into
allocating his/her account into risky options that have not been vetted by the
plan sponsor investment committee. This might not lead to the best outcome for
the participant’s retirement account.
Plan sponsors using a tiered array structure for their fund
lineup have been exploring another route, of placing these options into the
bottom tier. In a typical 3-tiered investment array, the first tier is a TDF
series intended to capture the majority of participants, particularly those
with less investment experience and knowledge. The second tier is usually a core
array of investment choices that allow participants to develop a diversified asset
allocation on their own.
The bottom tier is typically either a SDBA, or an expanded
array of investment options for which the plan sponsor expressly states that it
is not conducting due diligence. Thus, participants who are allocating towards
these investments are on their own. A plan sponsor could include a diversified
array of responsible investment options in that bottom tier, allowing for
socially conscious investors to select funds that align with their goals, while
not subjecting the plan sponsor to the required fiduciary oversight of the
funds in the other tiers.
This solution may be viable, particularly for plans not
subject to ERISA. For plans subject to ERISA, it is unclear whether or not this
latter model can be used. Although a plan sponsor may state in its Investment
Policy Statement that the investments in the bottom tier are available for
investment, but will not be reviewed and vetted by the plan fiduciaries, there
is no guarantee that the DOL will approve that arrangement. The DOL could take
the position that the investment is subject to the same requirement for
scrutiny and oversight as any other investment in the overall lineup. Since
this strategy has not been fully tested or challenged, it is critical that plan
sponsors speak with their plan legal counsel to review the concept before
implementing such a program.
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