The Curious Dilemma Of ESG Investing And Your Retirement

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Jason R. Escamilla, founder and CIO of ImpactAdvisor LLC in San Francisco, has seen it all before. It was nearly 30 years ago when he initially tried Socially Responsible Investing ("SRI"), the predecessor of ESG. And he was cool with it. Until everything changed.

"ESG/SRI used to be about selectivity and choice," says Escamilla. "I first got involved with SRI/ESG investing in the 90s. For decades, it was about selectivity and choice or preferences -- primarily among institutional investors/clients. Funny thing happened on the way to going mainstream. ESG became the bully. The divestment movements ushered in powerful attention and support from the 'non-investment class' only a few years ago: students. Large pools of investment capital: university endowments adopted the cause. I still remember three years ago when CNBC's Jim Cramer recommended permanently disinvesting from fossil fuels based on this force."

As a professional investment advisor, Escamilla saw firsthand the results of this aggressive movement.

"Now that it's mainstream, ESG and sustainability preferences get integrated into a wide range of investment products in many cases by default," he says. "It's not surprising to those 'on the other side of ESG' to get offended or even bullied. Elon Musk/Tesla's experience is a great example: Recycling from before: 'Tesla has been the single most important force in EV transition for decades. But its low 'G' and 'S' scores got the company kicked out of the S&P 500 ESG index.'"

Indeed, a case study published by impak Analytics concluded: "Apple, Microsoft, and Alphabet have some of the best ESG scores on the planet. According to Yahoo Finance, they respectively hold 7th, 3rd and 1st place among the Top 12 ESG companies of 2022. However, an impact analysis of these NASDAQ darlings on E, S, and G factors shows -- using impak's solution -- that Alphabet, Apple and Microsoft each have an impak Score™ lower than 200 points out of 1,000, making them more laggards than leaders."

So, exactly "what ESG is" remains a bit of a mystery. Still, Washington seems to be on board with allowing ERISA fiduciaries to consider incorporating what they believe ESG means into the portfolios they manage.

Now that the battle between the legislative and executive branches is over (that doesn't mean the judicial branch won't have the ultimate say), what does the new DOL Fiduciary Rule mean for ESG investments and your retirement?

At the most basic level, ESG is "a term that was created by someone to mean that your company cares about social issues," says Lyle B. Himebaugh, managing partner at GGA Retirement in Stamford, Connecticut.

In a broader sense, "ESG stands for 'Environmental, Social, and Governance,' and it refers to a set of criteria that investors use to assess a company's performance in areas like sustainability, diversity, and board composition," says Andrew Latham, director of content of SuperMoney.com in Raleigh, North Carolina. "Essentially, ESG factors help investors evaluate a company's impact on society and the environment, not just its financial returns."

Think of ESG as just another series of data points. It's more of a subjective rating system than an objective accounting system.

"ESG factors are often used like other factors, such as the Q score, which measures the familiarity and the popularity of entities and their products, to help select investments," says Albert Feuer of the Law Offices of Albert Feuer in Forest Hills, New York. "They may be used to analyze investment approaches, investment funds, or individual entities. They may also be used for non-investment approaches such as to craft regulations."

Just because it may be subjective doesn't mean it's not useful.

"ESG factors, like Q scores, may be used to improve the financial performance of investments by improving the economic analysis of investments," says Feuer. "ESG factors, like Q scores, may be used to choose between investments with equivalent financial risk-return profiles. ESG factors, like Q factors, may also be used to choose investments, even though they have inferior financial risks and returns. Either approach may be described as an ESG investment approach."

If ESG and how to use it confuses you, you're not alone. Even financial professionals have differing views. Feuer sees people falling into two groups.

"First, those who recognize two facts," says Feuer. "ESG factors can provide useful financial insights. There are often many investments with equivalent risk-return profiles, in which case it is sensible to choose the one with ESG factors that are attractive, although that leaves the question of attractive to whom."

This is the problem with subjective analysis: who gets to decide what's important? That's the big problem right now with ESG. As the examples brought by Escamilla and the impak Analytics study show, ESG is in the eye of the beholder, and different eyes might not behold the same thing.

Feuer sees the second group as "those who are willing to sacrifice financial performance to align their investments to their ESG preferences. The regulations that the President preserved do not permit employee benefit plan fiduciaries to make such investment choices. On the other hand, those individuals may use that approach in their own personal investments and their individual retirement plans. The so-called Friedman market advocates have no trouble with using ESG factors, Q scores, or any other factor that they believe will give them an advantage in making investments. They agree with Deng Xiaoping, the late Chinese Communist leader, 'It doesn't matter whether a cat is black or white, as long as it catches mice.'"

Like the Trump Fiduciary Rule it replaced, the Biden Fiduciary Rule requires fiduciaries to prioritize financial interests (or, as the Trump Rule called it, "pecuniary interests," which means the same thing). If ESG is to be considered by your retirement plan fiduciary, it must be considered in this light.

"Those who oppose elevating ESG factors in retirement investments generally believe that the primary purpose of investing is to generate financial returns and that any social or environmental considerations should not be taken into account. Introducing such factors into a portfolio could lead to decreased returns or increased risk," says Andrew Pickett, Attorney at Andrew Pickett Law based in Melbourne, Florida.

The risk is some may misinterpret the DOL's Fiduciary Rule as requiring ESG investments be placed in 401(k) plans. It does not. But you might not know that based on what you hear from both sides in Washington.

"Politicians unable to coax the electorate to embrace their ESG goals force fiduciary money managers that supervise huge amounts of investors' money to ignore their fiduciary responsibility and base their selection of monitoring of investments on progressive goals rather than on the best rate of return," says Terry Morgan, President of OK401k in Oklahoma City.

The real issue, though, isn't that ESG's use is mandated, but that any encouragement to use it may put professional fiduciaries at risk and may disappoint retirement investors who think they're getting something they're not.

"The problem is that it is a title without a solid definition," says Lawrence (Larry) Starr of Cornerstone Retirement, Inc./Qualified Plan Consultants in West Springfield, Massachusetts. "It's supposed to be a set of standards to be applied to a company's behavior with regard to 'equity, social, and governance' that 'socially conscious' investors can use in determining what entities they are willing to invest in. In 'simple terms,' neither E, S or G is well defined."

And while we've seen what appears to be the definitive Rule from the DOL, the SEC also has a say in this, although more from a securities law standpoint rather than from an ERISA perspective.

"It is important to note that we are still waiting on clarity from the SEC as to what defines an 'ESG Investment,' but many will interpret this DOL rule as allowing ESG-labeled strategies to be permitted in ERISA plans (since it authorizes the use of ESG factors)," says Andrew Poreda, VP and ESG senior research analyst at Sage Advisory Services in Austin, Texas. "No one (or at least anyone influential) is advocating for ESG-labeled strategies to be a requirement within ERISA plans."

These are the very early innings in the ESG ballgame. For now, early adopters might jump in. No one is required to use ESG. If you're the least bit concerned, there's nothing wrong with sitting back until the dust settles.