Money Management Institute Sustainable Investing Community
October 04, 2018
A suite of educational resources for engaging clients on sustainable investing

ESG Perspectives

A recent report published by the U.S. Government Accountability Office (GAO)* found a profound lack of sustainable investment options available to retirement plan participants. The GAO found that unlike comparable European and international retirement plans, few U.S. retirement plans incorporate ESG factors into their investment management. In our view, the report seems to imply that both plan sponsors and the Department of Labor (DOL) fail to recognize that investors are increasingly using ESG factors to assess a wide range of investment risks and opportunities -- factors such as the impact on climate change, workplace and product safety concerns, and good corporate governance practices. These important business issues can help identify organizations that are likely to deliver better performance and long-term value to investors.

GAO Favors Better ESG Investing
Rules for U.S. Retirement Plans
A recent report published by the U.S. Government
Accountability Office (GAO)* found a profound lack of
sustainable investment options available to retirement plan
participants. The GAO found that unlike comparable European
and international retirement plans, few U.S. retirement plans
incorporate ESG factors into their investment management. In
our view, the report seems to imply that both plan sponsors
and the Department of Labor (DOL) fail to recognize that
investors are increasingly using ESG factors to assess a wide
range of investment risks and opportunities -- factors such as
the impact on climate change, workplace and product safety
concerns, and good corporate governance practices. These
important business issues can help identify organizations that
are likely to deliver better performance and long-term value
to investors.
The GAO noted that based on the Forum for Sustainable and
Responsible Investment 2016 market survey, U.S. investors
are slowly but progressively incorporating ESG factors into
their investment management practices. U.S. investor assets
that considered ESG factors totaled $4.7 trillion in 2016, up
14% since 2014. This paled in comparison to global investors
that counted $22.9 trillion in ESG-focused investments, which
was up 26% from 2014.
September 2018
ESG Perspectives
Importantly, the report acknowledged that plan sponsors and
their investment managers may benefit from the consideration
of ESG-related factors by enhancing their overall investment
risk mitigation efforts. Moreover, the report also suggested that
it could benefit retirees’ financial health in the long run.
The Genesis
The GAO published its report because ESG factors are increasingly
a way for investors to evaluate additional and relevant information
about potential investment risks and opportunities that may not
otherwise be reflected within a more conventional investment
processes. In the report the GAO examined:
1) the use of ESG factors by U.S. retirement plans;
2) the use of ESG factors by a select group of large
retirement plans in other countries;
3) the DOL’s guidance on the use of ESG factors by
private U.S. retirement plans.
As illustrated below, defined contribution plans have become
the dominant employer-sponsored plan type in the private
sector, not only in number but also to the extent that these
plans have become the primary source for retirement benefits
for individual workers (54 million workers in 2015). In 2017
defined contribution assets totaled $7.3 trillion versus $3
trillion for private sector defined benefit plans.
U.S. Defined Benefit and Defined Contribution Retirement Plans, 1975-2015
Source: Form 5500 data from the U.S. Department of Labor
The GAO’s report found that only a small percentage of defined
contribution plans incorporate ESG-sensitive options within their
investment architecture or seek managers that utilize these factors
within the investment process. Evidence of this environment was
found in the Plan Sponsor Council of America’s (PSCA) 2016 annual
survey of 600 defined contribution plans, which identified that
only a meager 2% of plans offered any form of ESG-integrated
strategy as a selection option for participants. Additionally, the
report stated that Vanguard reported in 2016 that only about 8%
of the 1,900 defined contribution plans it served made an ESG-
factor integrated option available to plan participants.
In contrast to this environment, the report pointed out
that European Union countries will now require workplace
retirement plans to adopt frameworks to assess ESG risks,
including climate change and stranded assets**, by the end
of 2018. Given that 400 of the current 1,900-plus signatories
to the Principles for Responsible Investment (PRI) standards of
practice are U.S. domestic investment entities, many of whom
service investors that are based in the EU, it is apparent that
they will now need to abide by these new ESG requirements to
retain and compete for EU clients. We sense that these actions
will have positive spillover effects for U.S.-based investors
seeking competent ESG-focused investment expertise.
Some Promising Developments
To develop its report, the GAO interviewed a variety of retirement
plan sponsors, including four large public plans for state and
local municipal employees, all of which stated that unlike their
private sector counterparts, they indeed were incorporating ESG
factors into their investment management to some degree. This
revelation has been supported by announcements from other
public plans that have more recently pledged their support of
the PRI (Illinois, Hawaii, and Seattle) and are becoming more
engaged with the ESG integration investment process. These
trends should help influence and encourage the acceptance,
as well as ongoing development of, ESG-focused investment
strategies within private sector retirement plans.
The report also provided some evidence of this in citing the
GAO’s interview with the Thrift Savings Plan (TSP), a defined
contribution plan for federal workers and the largest public
retirement plan in the U.S., with $484 billion in assets as
of mid-2017. The GAO found that while the TSP does not
incorporate ESG factors into its core investment management
strategies or qualified default investment alternatives (QDIA)
for participants, an ESG option may soon be available to
participants. Beginning in 2020 the TSP plans to implement a
“mutual fund window” that will provide plan participants with
a wider range of outside investment options, which will likely
include some that actively incorporate ESG factors within the
investment process.
Hurdles to Overcome
Why do so few private sector retirement plans still avoid
incorporating ESG factors into their investment strategies
and virtually none have an ESG-fashioned QDIA? According
to the GAO report, first and foremost asset managers found
significant issues with the reliability and frequency of disclosed
ESG information. Although substantial progress has been made
by the Sustainability Accounting Standards Board (SASB) in
terms of standardization of ESG data disclosure, the managers
surveyed cited inconsistent, low-quality, incomparable ESG
data as key impediments.
Additionally, while the GAO found plenty of academic and
industry research to support the notion that incorporating
ESG factors within the investment process has a positive
or, at worst, neutral impact on financial performance, it also
found the persistent perception that it could negatively impact
performance. In addition to these unsubstantiated concerns,
the GAO was told that incorporating ESG factors into the
investment management process could increase cost to
retirement plans because of the additional research resources
that would be needed to support the effort. Moreover, industry
sources suggested incorporating ESG-focused strategies within
option lineups could increase the complexity of plans, adding
further confusion to already bogged down plans.
At Sage, we believe that most DC plans in America today
already suffer from an overload of non-ESG-focused investment
choices. Indeed, according to industry data, the average 401(k)
plan carries around 25 to 35 fund choices. The beneficial
introduction of ESG-focused fund selections could be easily
achieved while sponsors look to provide fewer, more effective
choices that suit the interests and values of their participants
at competitive costs and returns.
DOL Casts Doubt and Confusion
Inconsistent governmental guidance has proven to be a major
impediment to the adoption of ESG options within retirement
plans. The DOL’s guidance on ESG investing has changed with
different administrations, making plan fiduciaries wary with
respect to their ESG-integration efforts. Unlike its regulatory
counterparts in Europe, the DOL has released (beginning
in 2008 and more recently in 2015, 2016 and 2018) several
seemingly confusing and contradictory statements about ESG
investing and the reliance upon ESG factor information by
investment fiduciaries.
Each of the DOL’s past Field Assistance Bulletins included a
discussion about how an advisor’s fiduciary responsibility to
seek the best financial return on the behalf of clients should be
more important than the consideration of ESG-related factors.
It remains to be seen whether and when the DOL will provide
more clarity to investment fiduciaries regarding ESG factor
incorporation within ERISA plans. We at Sage remain optimistic
that more financial service providers and regulators will soon
acquiesce to the growing demand by investors, both here and
abroad, for beneficial ESG and sustainable investment choices.
ESG metrics and data reporting are quickly becoming more
standardized with the help of organizations like SASB, the credit
rating agencies, and the large research providers. In our view
these combined efforts will serve to expedite the normalization
of ESG factor integration processes within U.S. retirement plans.
Notes: *Retirement Plan Investing: Clearer Information on
consideration of Environmental, Social and Governance
Factors Would Be Helpful: U.S. Government Accountability
Office; May 2018
** Stranded assets are now generally accepted to be fossil
fuel supply and generation resources which, at some time
prior to the end of their economic life (as assumed at the
investment decision point), are no longer able to earn an
economic return (i.e. meet the company’s internal rate of
return), as a result of changes associated with the transition
to a low-carbon economy. (carbontracker.org)
However, each Bulletin also lacked a consistent, clear, and
definitive answer on a fiduciary’s ability to include ESG options
in their plans while still qualifying for protection from litigation,
especially in terms of ESG-focused QDIAs.
It was particularly noteworthy to find within the GAO’s report the
citation of a 2017 independent study commissioned by the DOL
on the incorporation of ESG factors in the investment process.
This study included a wide range of academic research published
on this subject between 2006 and 2016. Surprisingly, in this
study the DOL reported that “while some investors may continue
to perceive that incorporating ESG factors entails accepting
lower investment performance, its review of academic literature
suggests that incorporating ESG factors generally produced
investment performance comparable to or better than non-ESG
investments.”
The Road Ahead
The GAO found that the DOL’s interpretive Field Assistance
Bulletins allowed fiduciaries to consider ESG factors that are
material to financial performance, but it did not provide additional
information to clarify how they may go about doing so in their
investment management duties. The GAO also found that the
DOL did not provide enough information to fiduciaries on steps
they can take to effectively consider whether or how to use ESG
factors within the management and administration of QDIAs for
private sector retirement plans.
Upon conclusion if its review, the GAO provided a draft of the
study to the DOL, Pension Benefit Guaranty Corporation (PBGC),
TSP Board, SEC, and the U.S. Treasury and State Departments
for review and comments. The GAO made two important
recommendations to the DOL:
1) the Department should clarify whether an ERISA
plan may incorporate material ESG factors into the investment
management for a qualified default investment alternative
(QDIA) and clarify whether liability protection may be offered to
fiduciaries if they employ such considerations.
2) the Department should provide further information
to assist fiduciaries in investment management involving ESG
factors, including how to evaluate available options, such as
questions to ask or items to consider.
In response, DOL officials stated that they are evaluating
steps and methods to collect data on the use of ESG factors by
retirement plans. This past March officials said changes to the
Form 5500 are being considered that could help capture this type
of information for the Department.
Morningstar Sustainability Ratings
Methodology – How the New
Changes Affect Our Process
Morningstar introduced its sustainable fund ratings in April
2016, which provided a tool for ETF investors to assess the
sustainability profile of an ETF investment. Morningstar
recently announced some major changes and improvements
to its rating system, which should result in a higher level
of stability in the sustainability ratings and allow for better
comparisons among funds across categories.
At Sage, we evaluate the ESG quality of a fund under three
broad standards:
1) How well does a fund’s portfolio companies and
ETF sponsor align with positively material ESG practices?
2) What is the ESG profile of the fund relative to its
peers?
3) How consistent has the fund been in maintaining
its favorable ESG profile?
The coming changes to the Morningstar Sustainability Rating
methodology should provide fresh insight into an individual
fund’s consistency of ESG alignment in addition to its profile
versus a relevant peer group.
In our view, the biggest benefit from this includes the
integration of past sustainability scores. The sustainability
score now incorporates the past 12 months of Morningstar
Sustainability Ratings through a weighted average
methodology, and more recent scores have a higher weight.
The use of historical scores will result in less volatility of
ratings from month-to-month, as well as provide insight into
the stability of the ETF’s ESG profile. Since the Morningstar
rating is one of the inputs into our monitoring process, the
higher stability of the score should lower portfolio turnover
due to ESG ratings downgrades. Morningstar will also
increase the ratings coverage threshold from 50% to 67% and
expand a fund’s peer group from the Morningstar Category
to the larger Morningstar Global Category in order to bolster
additional month-to-month stability in the rating.
We examined the Morningstar Global Category for U.S.-listed
open-ended funds (ETFs and mutual funds) to determine how
many funds currently have sustainability ratings and the
distribution of those ratings before the changes are made (see
chart below).
Equity funds are well covered in the Morningstar universe,
because Sustainalytics, the company behind the ratings, provides
ratings on corporate issuers. Fixed income has less coverage,
with only 285 rated funds in fixed income, and none in the
money market and municipal categories. Most sustainability-
oriented funds reside in the equity asset class, where there is
more abundant data on corporations; however, we believe there
is room for growth in ESG strategies through an increase in
the numbers of strategies and the broadening of data on ESG
indicators. We launched the Sage ESG Intermediate Credit
ETF last year to contribute to the growth of ESG Fixed Income
strategies, and several other sustainability-oriented fixed income
strategies have come online in the past 12 months.
These changes will take effect in early November and the
resulting stability in the ratings should result in less turnover
and enhance the way we select our investible universe. These
changes should also ultimately lead to better performance and
ESG value outcomes for our clients.
Morningstar Sustainability Ratings by Global Category
Source: Morningstar as of 8/29/2018
Globe Rating
Mapping Municipal Bonds to the
SDGs: Quality Education
In August 2014, Manor, Texas Independent School District issued a
municipal bond totaling $116 million for the construction of a new
elementary school, which includes a pre-kindergarten program; a
new middle school; and a new high school. Construction of the
high school was completed in August 2018, making it the second
in the district. Its creation essentially splits Manor High School
in half, with freshmen and sophomores staying at Manor High,
and juniors and seniors moving to the new Manor Senior High,
making the new school the first of its kind in Texas to serve only
upperclassmen. By splitting the classes, the district is hoping to
keep class sizes small and tailored to students’ needs.
By keeping the class sizes small and specific, the school
can focus on its main goal, which is to prepare students for
their post-high school experience. Recognizing that a four-
year traditional college isn’t the solution for all students, the
district took the unique step of including features in the new
high school that would help facilitate and improve the learning
experience for the seven different career and technical
education classes that the school planned to provide.
The goal is to give students a hands-on experience in tech service
careers and also provide a blueprint for other public high schools
that want to provide alternatives for students who may not be
interested in pursuing a four-year degree. The school is outfitted
with a cosmetology studio, which will be open to the public and
include a full-service hair and nail salon; a veterinary medicine lab,
where students will work with live animals under the supervision
of a trained veterinarian; a mock courtroom for classes on law; and
a bistro-style culinary classroom that includes a fully operational
commercial kitchen that will double as the eating area for students.
In addition, as part of the 2014 bond, Manor ISD partnered with
Austin Community College to offer technical certifications that
can be obtained while earning high school credits needed to
graduate. These certifications include Certified Nurse’s Aide;
Electrical Pre-Apprenticeship; Heating, Ventilation and Air
Conditioning; Mechatronics; and Medical Assisting.
At Sage, we believe that Manor ISD has created an opportunity
that should positively impact the student base from an
educational standpoint and the community from an economic
standpoint. These impacts also clearly align with Sage’s ESG
impact framework and the relevant Sustainable Development
Goals. In the U.S., there is a shortage of employees trained in
technical and vocational trades due to two factors: 1) an increase
in students pursuing a four-year college degree and 2) an aging
trade workforce that is looking to exit their respective industries.
For students entering the technical and vocational trades, these
factors should create a positive post-education employment
landscape and improve the community in two ways. First, we
expect downward pressure on the unemployment rate as more
of the population is able and, more importantly, qualified to fill
open employment opportunities, especially in the skilled trade
area. Second, we expect a decrease in the overall poverty rate,
as household income increases and becomes more sustainable
in the long term. These factors make this a compelling municipal
issue from an impact investing standpoint.
Disclosures
Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. The information
included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions. This report is for
informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Investors
should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past
performance is not a guarantee of future results. Sustainable investing limits the types and number of investment opportunities available, this may result in the Fund investing in securities
or industry sectors that underperform the market as a whole or underperform other strategies screened for sustainable investing standards. No part of this Material may be produced in
any form, or referred to in any other publication, without our express written permission. For additional information on Sage and its investment management services, please view our web
site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.
5900 Southwest Parkway, Building 1 • Austin, TX 78735 • Phone | 512.327.5530 Fax | 512.327.5702 | www.sageadvisory.com
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