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ESG: How not to tick the box
in 401(k)
Building a better
default series
Schroders Building a Better Default Series: ESG in 401(k)
How should fiduciaries implement an environmental, social
and governance (ESG) approach into their 401(k) plans, given
the updated guidance from the Department of Labor (DOL)?
Our view is that ESG considerations should be incorporated
into default selections, not just as a choice option. In the long
term, we believe the ability of companies to create shareholder
value is intrinsically linked to their ability to navigate changing
social and environmental pressures. Environmental and social
trends are long term in nature and well aligned to the time
horizon of the contributions in the default, which typically
remain untouched for many years, if not decades.
Our analysis shows that a successful ESG strategy could
increase the savings balance of a 401(k) by 16% over a
savings period of 40 years.
Just as the younger generations investing in 401(k) are
increasingly spending more on products from sustainable
companies, they are looking to sustainable investments as an
extension of this and a way to express their values. To date,
they have been more concerned than the Baby Boomers
and current retirees about investing in companies that have
positive social and environment impacts and avoiding those
with lower ESG standards.
1
Schroders Building a Better Default Series: ESG in 401(k)
Can ESG improve
the outcome
for participants?
The DOL’s recent guidance states that ESG issues “may have a direct relationship
to the economic value of a plan’s investment” and so should be a proper
component of a fiduciary’s primary analysis.
Before we look at the evidence, it is worth briefly covering some of the
acronyms and jargon in this particular area of investing, many of which are used
interchangeably and with very different meanings. We consider ESG investing to
be ‘an approach to investment that explicitly acknowledges the relevance to the
investor of environmental, social and governance (ESG) factors’.1 Sustainable
investing is both broader and arguably longer term than this approach as
it comprises qualitative and quantitative factors to identify companies with
sustainable business models that support the generation of long-term shareholder/
bondholder value.
Results of ESG/sustainability studies have been mixed regarding the financial
benefits of this approach to investing but some larger, wider ranging meta-studies
have now confirmed a positive impact. One study,2 covering more than 2000
studies, published in November 2015, concluded that “ESG outperformance
opportunities exist in many areas of the market. In particular, we find that this
holds true for North America, Emerging Markets, and in non equity asset classes”.
Another by the University of Oxford,3 showed that 88% of studies found a positive
correlation between sustainability and operational performance of companies.
1
Introducing Responsible Investment http://www.unpri.org/introducing-responsible-investment/
ESG and financial performance: aggregated evidence from more than 2000 empirical studies - Gunnar Fried, Timo
Busch, Alexander Bassen (November 2015). See Appendix for more details.
3
From the Stockholder to the Stakeholder: how sustainability can drive financial performance – Gordon Clark, Andreas
Feiner, Michael Viehs, Smith School of Enterprise and the Environment, University of Oxford and Arabesque Asset
Management (March 2015). See Appendix for more details.
2
2
Schroders Building a Better Default Series: ESG in 401(k)
Pinpointing the amount of value added by ESG/sustainable approaches, i.e. the
ESG return premium, is even more difficult. A recent study by MSCI4 into passive
ESG tilted and momentum strategies showed that these had added value of
1.1% p.a. and 2.2% p.a. respectively, although this was over a fairly short time
period. Similar conclusions are corroborated in a paper5 supported by the Harvard
Business School (HBS) which compares ‘High Sustainability’ companies with
comparable ‘Low Sustainability’ companies between 1993 and 2010. In this
analysis, the High Sustainability peer group outperformed the Low Sustainability
peer group by 1.3% a year using an equal-weighted portfolio and 2.5% a year
using a value-weighted portfolio (see Appendix for further detail).
To judge the amount of the value that can be added to a 401(k) account, we have
modeled the impact of an ESG premium using a value of 1% p.a. on equity returns
within what we consider to be a ‘typical’ target date fund. In the context of the
aforementioned HBS and MSCI studies we believe this is a conservative estimate
as it does not assume the high levels of outperformance will persist over long timeperiods and in all market conditions. Our analysis shows that even at this level, the
compounding impact of these increased returns over the 40-year average saving
period for a 401(k) saver in a typical target date fund results in a savings balance 16%
higher (see Figure 1). This is equivalent to an additional 1.5% p.a. of contributions.
Figure 1 – Additional returns of 1% p.a. can add 16% to the size of a 401(k) plan
401(k) account balance
800,000
16% increase
in savings
balance
700,000
600,000
500,000
400,000
300,000
200,000
100,000
25
30
35
40
45
Age
Without ESG
50
55
60
65
With ESG
Source: Schroders. Allocation based on average target date fund glide path with 90% in equities, 10% in bonds at 25 reducing down to
30% equities, 70% bonds at age 65. Contributions of 9% p.a. on a starting salary of $40,000. Inflation assumed at 2% p.a. with salary
inflation of 2.5% p.a. Equity returns of 5.8% p.a. without ESG and 6.8% p.a. with ESG. Bond returns of 2.6% p.a. For illustration only.
There can be no guarantee that any investment strategy or technique will achieve future outcomes. Please refer to the back of this report
for important information.
4
Can ESG add alpha? An analysis of ESG Tilt and Momentum Strategies - Zoltan Nagy, Altaf Kassam, Linda-Eling Lee
(June 2015)
5
The Impact of Corporate Sustainability on Organizational Processes and Performance – Robert G Eccles, Ionnis
Ioannou, George Serafeim (March 2012)
3
Schroders Building a Better Default Series: ESG in 401(k)
What type of ESG investing
is right for 401(k) plans?
One of the problems with ESG investing is that there is no clear definition and this
can cause confusion about the appropriate approach to take.
Narrow interpretations (such as ‘green’ investing or ‘non-harmful’ investments) often
lead to screening, where stocks are either included (positive screening) or ruled out
(negative screening). While we do see a place for some focused investments or for
excluding the most egregious offenders, we believe that an integrated approach of
investing in companies that have a sustainable approach to all stakeholders is more
appropriate for long term default investments. The universe of suitable investments
is wider, resulting in more opportunity to add value over time and provide for
outcomes that we believe would be less susceptible to individual stock risk.
Contributions that are invested in the default fund are rarely moved, particularly as
the vast majority (86%6) of defaults are now age-based target date funds, which
results in a very long-term investment horizon. This is aligned with the key features
for successful sustainable investing that include long-term investing, maximizing
returns after allowance for risk and intergenerational soundness.7
Passive tilts vs.
Active Engagement
Successful engagement with companies involves engaging on issues such as
human rights, governance, business ethics and labor standards. Where this is
carried out successfully, it has been shown to generate positive returns. A recent
study8 investigating this approach demonstrated that engagement resulted in
+2.3% return on average after the year of engagement. When those engagements
led to successful outcomes, returns of +7.1% (on average) were achieved in the
year after the initial engagement (see figure on next page). It is not clear that these
extra-ordinary benefits will continue as this approach becomes more mainstream
but active asset managers who concentrate on the process of engaged ownership
should be better placed to add value.9
6
2016 Defined Contribution trends. Callan Investments Institute
We need a bigger boat: Sustainability in investment, Towers Watson (August 2012)
Active Ownership – Elroy Dimson, O uzhan Karaka b, Xi Li (August 2015)
9
The added value of ESG/SRI on Company and Portfolio Levels – What can we learn from research? Lars G Hassel and
Natalia Semenova (January 2013)
7
8
4
Schroders Building a Better Default Series: ESG in 401(k)
Figure 2 – Engagement can add significant value
Cumulative abnormal return (%)
9
8
7
6
5
4
3
2
1
0
-1
-1
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
Event window (months)
All engagements
Successful engagements
Unsuccessful engagements
Source: Dimson, Karakas and Li (2015). Fama-French size decile returns from Professor French’s website
Successful engagement requires a collaborative approach between the asset
manager and companies in which they invest.10 This is a process that demands
the skills of an active manager. The study outlined above highlights that the
engagement required in order to produce benefits is sustained, targeted and
specific with regard to the actions required by the company. Additional studies
show that engagements are more likely to succeed if they have business legitimacy
and are focused on material matters. While passive managers also have an
incentive to engage in order to improve returns, they focus mainly on voting
proxies and consequently are biased towards governance. In our view, active fund
managers with their focus on the fundamental drivers of a company’s performance
are better placed to identify specific opportunities that may not be captured by a
sector screen or proxy vote.
While activism may take the headlines, in our view engaged ownership should be
able to deliver a proportion of this added value making a significant difference over
the long term to the outcomes that a participant receives.
10
Toward a Theory of Stakeholder Identification and Salience: Defining the Principle of who and what really counts –
Ronald K Mitchell, Bradley R Agle and Donna J Wood (October 1997)
5
Schroders Building a Better Default Series: ESG in 401(k)
It’s not just about equities
The meta-study that we referred to earlier in this paper found that an ESG
approach applied to equities, bonds and real estate had a positive impact in the
majority of studies analyzed and that “more than two-thirds of studies [relating
to bonds and real estate] uncover significant positive performance relations to
ESG criteria”. While real estate plays a relatively small role in most 401(k) plans,
fixed income is more significant in defaults, particularly in target date funds as
participants age.
An ESG or sustainable approach in fixed income when applied to credit portfolios
typically involves portfolio managers considering the impact of issues such as
employee safety, litigation risks and board governance on the future financial
success of, and risks inherent to, a business. The aforementioned study by the
University of Oxford3 found that rating agencies tended to give better ratings to
issuers with good ESG policies and these with significant environmental concerns
paid higher credit spreads.
As a result, we believe fiduciaries should consider their approach to ESG in multiple
asset classes and how this may impact the outcomes that participants receive over
the long term.
Catering to the
needs and wants of
younger generations
Studies in the US have shown that Generation Xers (born between 1965 and 1982)
and Millennials (born between 1982 and 2004) have been more concerned about
investing in companies that have a social or environmental bias than previous
generations (see figure on next page).
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Schroders Building a Better Default Series: ESG in 401(k)
Figure 3 – Investor attitudes about social impact investing
It is possible to achieve market rate returns investing in
companies based on their social or environmental impact
I would rather invest in companies that have a positive social
or environmental impact than avoid investments in companies
that are harmful
My investment decisions are a way to express my social,
political or environmental value
0%
Age 69+
Baby boomers
10%
20%
Gen X
30%
40%
50%
60%
70%
80%
Millennials
Source: 2014 US Trust Insights on Weatlh and Worth - Annual survey of high-net-worth and ultra-high-net-worth Americans
Another study11 highlights that, after financial performance, Millennials rank issues
such as pay and conditions of employees, record on human rights, impact on the
environment and diversity of the company board as factors they consider more
important than their older colleagues in how their savings should be invested
(see figure 4).
Millennials’ investment preferences are not isolated from the companies that
will increasingly rely on their patronage. We think their distinct priorities and
perceptions will feed changes in consumer markets, talent pools and other
areas of society over time as their economic importance grows, underpinning
the commercial value of the companies they choose to buy from, work for or
otherwise support. Put another way, we believe the regard younger generations
have for companies they perceive to share their values will become an increasingly
important competitive and value driver for those businesses.
Figure 4 – Millennials rank ESG issues as more important than their older cohorts
70%
60%
50%
40%
30%
20%
10%
0%
Recent financial
performance
Pay and
conditions of
employees
Level (and
structure) of
management
pay
18 - 34
Record on
human rights
35 - 54
Impact on the
environment
Record on
Diversity of
health and safety company boards
55+
Source: Dimson, Karakas and Li (2015). Fama-French size decile returns from Professor French’s website
11
NAPF and Optimum Research: What do pension scheme members expect of how their savings are invested?
July 2014. 1,064 adults surveyed.
7
Schroders Building a Better Default Series: ESG in 401(k)
The proportion of people investing through the default of their 401(k) plan is
increasing, particularly as auto-enrolment captures new joiners. This means that
the preferences of Millennials are unlikely to be acted upon in reality given the
current design of 401(k) defaults. It is therefore arguable whether fiduciaries are
appropriately considering all the participants when designing the default.
Conclusion
The positive evidence for incorporating a ESG approach into investments is
growing. Its use has been limited in 401(k) plans but with the recent ruling from
the DOL, in our view it makes sense for fiduciaries to re-evaluate its suitability for
their plan.
Our analysis shows that an additional 1% p.a. from sustainable investing could
result in a 16% increase in the savings balance of a plan – supporting an additional
two years of retirement funding. If asset managers are heavily engaged/activist
and could achieve a further 1% (total 2% ESG premium), this could result in a
further four years of retirement funding.
Next steps for plan fiduciaries
 Written guidelines – Develop a formal written policy to capture beliefs and
actions. This will help drive decisions and can be used with participants to
explain how engagement works.
 Manager engagement – As most investment is delegated, it is the actions
of the portfolio managers that will determine effectiveness. It is therefore
important to understand how each of your existing managers incorporates
an ESG approach into their investment approach.
 Incorporate in tenders – When searching for new managers, include
questions about their policy on engagement and question areas where this
doesn’t match your beliefs and guidelines.
 Overall plan design – Consider how changes can be made to incorporate
ESG guidelines into the default option.
8
Schroders Building a Better Default Series: ESG in 401(k)
Appendix - academic studies
In November 2015 the Journal of Sustainable Finance
and Investment published a study entitled “ESG and
financial performance: aggregated evidence from
more than 2000 empirical studies.” The study collated
the academic research that contains a quantitative
conclusion on the topic that has been generated over the
last 40 years. In total, 60 papers containing 2,200 unique
primary studies were included in the analysis. Both vote
count and meta-analysis reports were weighted based
on the underlying studies. Overall, approximately 90% of
studies found a non-negative relationship between ESG
and corporate financial performance. In the underlying
results, 62.6% of meta-analysis results and 47.9% of
vote-count studies found positive connection between
the two. There was no bias in the sub-effects within
the categories E, S & G as all had positive effects in the
range of 55-63%. On a regional level, North America
and Emerging markets showed a higher level of positive
outcomes, as did non-equity asset classes. The positive
correlation between ESG and corporate financial
performance has remained consistent over time as there
has been no material change in the findings of studies
since 1990.
The University of Oxford paper “From Stockholder to the
Stakeholder” reviewed 51 academic studies that cover
the relationship between sustainability and a company’s
operational performance. The underlying research covers
periods as early as 1970 that investigates one or all of
the ESG components. Of the studies, 45 found a positive
impact from the factor or factors considered (being 88%
of those reviewed). The research looked at the individual
elements finding a link between operational performance
and Governance issues such as board structure,
compensation and incentives, Environmental topics such
as resource efficiency and pollution abatement and
Social factors including good workforce practices and
employee relationships.
9
The Harvard Business School sponsored paper “The
Impact of Corporate Sustainability on Organizational
Processes and Performance” analyzed the performance
of 90 companies which had voluntarily adopted
sustainability policies by 1993 compared with a control
group of comparable companies which had adopted
almost none of these policies. Investing $1 in the
beginning of 1993 in a value-weighted (equal-weighted)
portfolio of High Sustainability companies would have
grown to $22.6 ($14.3) by the end of 2010. In contrast,
investing $1 in the beginning of 1993 in a valueweighted (equal-weighted) portfolio of control companies
would have only grown to $15.4 ($11.7) by the end
of 2010. On the basis of these figures, an equallyweighted portfolio of High Sustainability companies
outperformed an equivalent portfolio of Low Sustainability
companies by 1.3% a year over this 18 year period. The
outperformance was higher at 2.5% a year if portfolios
are assumed to be constructed on a value-weighted
basis. In relation to risk, the paper states ‘we find that
the High Sustainability portfolio significantly outperforms
the control portfolio in 11 out of 18 years, and exhibits
lower volatility. Whereas the standard deviation of monthly
abnormal returns is 1.43% and 1.72% on a valueweighted and equal-weighted base, respectively for the
High Sustainability group, the corresponding estimates,
for the Low Sustainability group, are 1.72% and 1.79%’.
In relation to survivorship bias, the paper states ‘We find
that both portfolios exhibit statistically significant positive
abnormal performance relative to the market that may
be attributed, to a considerable extent, to the way we
selected our sample (i.e. survivorship bias). However, the
relative performance difference is not affected since, by
construction of our sample, both groups are equally likely
to have survived.’
Schroders Building a Better Default Series: ESG in 401(k)
Lesley-Ann is Global Head of Defined Contribution at Schroders. In this role
she is responsible for Schroders view on DC best practice and ensuring that
there is a global strategy to deliver the best outcomes for DC members/
participants. Previous to this, Lesley-Ann was the Head of the Global
Strategic Solutions team, which is responsible for designing solutions for
complex global clients. Lesley-Ann joined Schroders in July 2011 and has
worked with pension funds in North America, Mexico, Brazil and Asia.
Lesley-Ann
Morgan,
Global Head
of Defined
Contribution
Lesley-Ann has over 20 years of experience in providing investment
solutions to defined benefit and defined contribution plans globally.
Jessica is responsible for the Environmental, Social and Governance (ESG)
strategy at Schroders. She oversees the integration of ESG factors into
investment processes across geographies and asset classes and leads a
team of nine dedicated ESG analysts.
Jessica Ground,
Global Head of
Stewardship
Jessica has fund management responsibility for Schroder’s Stewardship
range of products. She is a member of the Prime UK Equity team, which
manages £9bn of assets for institutional and retail clients.
She is also Chair of Schroders’ UK Corporate Governance Committee.
She has been a research analyst covering pan-European financials and
utilities. Jessica started her investment career when she joined Schroders
in 1997 on the Graduate Programme.
Special thanks to Paul Marsden, Greg Cooper, Duncan Lamont and Allan Duckett.
10
SCH R O DE RS BUILDING A BET T ER DEFAULT SERIES: ESG IN 401(K)
Important Information: The views and opinions contained herein are those of the Global Defined Contribution team and the Responsible Investment team and may
not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. The hypothetical results shown must be considered
as no more than an approximate representation of the portfolio’s performance, not as indicative of how it would have performed in the past. It is the result of statistical modelling,
with the benefit of hindsight based on a number of assumptions and there are a number of material limitations on the retrospective reconstruction of any performance results from
performance records. For example, it may not take into account any dealing costs or liquidity issues which would have affected the strategy’s performance. This data is provided
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