State Street Global Advisors (SSgA) recently released a research report entitled, “Into the Mainstream – ESG at the Tipping Point.“ It begins with a salient point: “ESG may well be becoming a mainstream trend, but every institutional investor – from pension funds to endowments to sovereign wealth funds – faces a unique mix of forces pushing them towards, or pulling them away from, ESG investing.” Indeed, asset owners and their managers are in fact subject to distinct standards of care, with ERISA’s fiduciary duties being the ultimate. In reviewing this report of global institutional investors’ reasons for addressing environmental, social and/or governance (ESG) factors in their investment decisions, and their reasons for not doing so, I considered the implications for ERISA fiduciaries, as “pension funds” were one of the institutional investors surveyed (along with endowments, charities, sovereign wealth funds and others). Consider also some of my prior analysis on the interplay of fiduciary duties under ERISA and ESG issues.
Here are the key takeaways:
- Fiduciary Duty: A Hurdle or Affirmative Duty to Incorporate ESG? A longstanding, significant obstacle to adoption of ESG by ERISA plans was whether it could be done in a manner consistent with ERISA’s fiduciary duties. The duty of prudence (Section 404(a)(1)(B)) has been the primary area of concern under an ERISA/ESG analysis, but duty of loyalty (Section 404(a)(1)(A)) and diversification (Section 404(a)(1)(C)) issues may also arise depending on the circumstances. Interestingly, the SSgA findings indicate that 46% of those surveyed viewed fiduciary duty as a push factor – i.e., an affirmative duty. If we drill down, the % of respondents who cited fiduciary duty as a lead push factor was highest in North America. If we drill down further, we see that, 41% of pension funds view ESG as a fiduciary duty. So, while pension funds seem less likely to view ESG as an affirmative fiduciary duty relative to other institutional investors, the fact that 41% do is notable. Again, this picks up pension funds globally and appears to cover private (i.e., ERISA) and public (i.e., governmental) plans.
- Risk Mitigation or Opportunity? The results also show that ESG risk mitigation is, at this point, (much) more of a basis/push factor to incorporate ESG factors into an investment decision than outperformance reasons (in North America, 42% (of all respondents – not just plans) cited risk mitigation vs. 1% who cited ESG as a way to generate higher returns). Various other studies make the point that ESG can present both mitigation and return opportunities, so it is interesting that institutional investors have gravitated toward mitigation rather than return. Perhaps lack of standardized disclosures and metrics is a reason, but it would seem that would affect both downside risk and return on any given investment. Perhaps another reason is that the outperformance takes longer to materialize. The DOL has reiterated that integration is examined under the regular prudence test and not the heightened tie-breaker test.
- Obstacles: A continuing theme, now picked up by this new SSgA report, is that the lack of standardized and transparent ESG data remains a primary obstacle to adoption (e.g., inconsistent scoring across the various providers). SSgA, in this report and over time, has helpfully examined the correlations of the major data providers in terms of a specific company’s ESG coverage. In one example, the ratings of companies by two prominent providers had a correlation of (only) .53. The lack of expertise in ESG was also cited as a top reason for not incorporating ESG factors – a valid reason for not making a particular investment under ERISA (fiduciaries are not expected to be all-knowing, but are expected to seek outside expertise when doing so would be prudent). Perhaps this explains why more and more ESG-related questions are showing up on questionnaires sent to investment managers.
- Governance: Respondents reported better measurement of governance (G) factors than environmental (E) or social (S) factors. For ERISA fiduciaries using integration, an analysis/documentation of how the respective E, S and/or G factor affects performance is important under DOL guidance. It is also important for investment managers and appointing fiduciaries to be clear on whether one or more E,S or G factors will be incorporated for any particular mandate, and to confirm that doing so would be in accordance with plan documents.
Many sponsors of private funds, particularly hedge funds, rely on the 25% or significant participant test in order to avoid holding plan assets under ERISA. Equity participation in an entity by benefit plan investors is “significant” on any date if, immediately after the most recent acquisition of any equity interest in the entity, 25 percent or more of the value of any class of equity interests in the entity is held by benefit plan investors. Investments by the fund’s investment manager and its affiliates are disregarded. There is little guidance in terms of what constitutes separate equity classes. Some ERISA attorneys will look to see how “class” is defined under the securities laws, such as the Exchange Ac or the ’40 Act. Yet others consider other factors, as well. Is it described in the offering materials as a class? Would the different features (e.g., different fees, liquidity terms, etc.) render it a different class under local law?
One of the most versatile and popular ERISA exemptions used by discretionary investment managers is the QPAM Exemption. Embedded in the exemption are financial requirements (i.e., capital and assets under management requirements) applicable to the investment manager based on the manager’s prior fiscal year.
The DOL explained that the minimum capital and assets under management requirement are designed to ensure that the investment manager (i.e., the QPAM) is large enough to ward off undue influence over its decision-making by parties in interest. This can prove very challenging for brand new managers because the exemption requires the manager have a prior fiscal year under its belt. There can be work-arounds for new managers, but they should be carefully considered before sending out an investment manager agreement that includes a representation that the investment manager is a QPAM.
Gearing up for the ERISA panel. We plan to address ERISA litigation trends (proprietary funds/services, alternatives in TDFs, Valeant, etc.), rollovers, anticipated DOL guidance, trap doors under the QPAM Exemption, private fund hardwiring, etc. I was hoping to have seen any new DOL guidance on proxy voting at this point, but no such luck.