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Schroders For Financial Intermediary, Institutional and Consultant use only. Not for redistribution under any circumstances. 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). 6 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 to you for information purposes only as at today’s date and should not be relied on to predict possible future performance. Sectors/indices mentioned are for illustrative purposes only and should not be viewed as a recommendation to buy/sell. This newsletter is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument The material is not intended to provide, and should not be relied on for accounting, legal or tax advice, or investment recommendations. Information herein has been obtained from sources we believe to be reliable but Schroder Investment Management North America Inc. (SIMNA) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of facts obtained from third parties. Reliance should not be placed on the views and information in the document when taking individual investment and / or strategic decisions. The opinions stated in document include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized. Schroders has expressed its own views and opinions in this document and these may change. Past performance is no guarantee of future results. Portfolio holdings may change at any time. Further information about Schroders can be found at www.schroders.com/us. © Schroder Investment Management North America Inc. 875 Third Ave – 22nd Floor, New York, NY 10022 (212) 641-3800 ESG-401K