The Challenges for ESG Investing in Retirement Plans

Environmental, social and corporate governance (ESG) investing, sometimes known as socially responsible investing, is increasingly drawing the attention of regulators.  As discussed below, term “ESG investing” is not tied to a precise, commonly used industry definition.  At a high-level, the term generally refers to investment strategies that look beyond pure financial metrics by taking a range of other factors, such as carbon emissions, societal impacts and workplace cultures to guide investment decisions. ESG investing is controversial because it is not always clear how ESG-themed investment strategies apply these factors.  In particular there is widespread debate over whether ESG investing properly advances investor interests or, in some cases, is being improperly used to pursue political and social agendas at the expense of long-term investment returns. We describe some of the potential challenges associated with ESG investing below.

ESG has no precise legal, or industry, definition.

The Securities and Exchange Commission has expressed concern over “greenwashing” (i.e., that some investment firms may be charging premiums for strategies that claim to be climate-friendly or otherwise socially responsible, but that may not deliver added value).  The SEC has indicated an interest in developing new, standardized disclosures concerning ESG with a view to providing investors with the means to evaluate the effectiveness of ESG approaches.

Current events, or “public mood” may influence the ESG factors that are given priority.

ESG-focused strategies sometimes shift their priorities to reflect changes in public sentiments.  For example, some ESG-themed funds have excluded defense industry issuers from their portfolios in the past. The Russian invasion of Ukraine has in some cases changed public perceptions toward American defense contractors, leading fund managers to re-think those exclusions.

ESG investment ratings can be subjective.

The Chartered Financial Analyst (CFA®) Institute is working on a common standard, as none currently exists for measuring ESG elements in the investment industry. Most investments rely on the ratings of companies with expertise in ESG metrics, and there is little consistency in scoring/rating from one scoring system to the next.

A fundamental principle of ESG investing proponents is that companies with sustainable business practices that rank high on ESG metrics will outperform over the long term. To a large extent, this fundamental principle remains unproven, and is likely to remain so until an accepted scoring system is developed.   

The Department of Labor has warned fiduciaries that they may not subordinate plan investment interests to the pursuit of social and political objectives through the use of ESG strategies. At the same time, DOL has observed in recently proposed regulations that, when properly applied, ESG factors may support prudent fiduciary investment processes. At the state and local government levels, some public pension systems have moved to prohibit the use of ESG strategies altogether.  Given the high-level of regulatory scrutiny plan fiduciaries will want to monitor developments in this area and to exercise care when deciding whether and how to use ESG factors.

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