ESG and Retirement: What It Means for Your Plan

Emily Thomas:  Good afternoon and welcome to ESG and retirement and what it means for your plan.  We're so excited to be here with all of you today.  I am Emily Thomas.  I'm the head of the Investing with Impact Team at Morgan Stanley.

            And just a brief introduction before diving in, what really motivated me to enter finance was actually seeing the impact of micro loan and how empowering it was to a group of women artisans working to build a business to support their families.  So actually, entrepreneurs.  And fast forward over a decade in the financial services industry, I now have the privilege of helping our clients align their capital with their values.

            And just one other housekeeping item before diving in, we will have time for questions at the end.  And I'm really excited to make this as engaging as possible.  You should see a Q&A button at the bottom of your screen.  So throughout the presentation, please feel free to submit questions and we will be sure to answer them at the end of the call.

            For today's conversation, we've broken it out into three main sections, followed by a Q&A.  So first, an introduction.  What is investing with impact or ESG?  Second, we'll follow that up with an update on regulation.  I know how important that is to this group and to your clients.

            And finally, I'll pass it off to my colleague Juliana Granados, to talk through some actual implementation ideas.  So with that backing of what is it and the policy backdrop, how to actually think about implementing it in your plans?  And finally, we'll open it up for Q&A at the end.  

            Investing with impact is a really simple idea.  It's about combining financial goals and impact goals.  But what qualifies and is environmental and social impact?  Our holistic framework walks you through the various approaches so you can think about it from as you see in the kind of upper part, that dark blue box, an intentional investment approach.  So considering environmental, social and governance data in the investment process, but really, being intentional about it and documenting that approach.

            So this can look from screening, so taking companies out of the portfolio with lagging human rights or diversity records to actually just mitigate risk through ESG integration, actively incorporating environmental, social and governance criteria to both mitigate risk but also position for opportunities.  This can look like investing in companies that are leaders in creating more inclusive and diverse workplaces, or companies with sustainable business advantages such as a company producing a washing machine that uses half the water as competitors.

            So this gives the company advantage over the competitors in terms of selling their product, but also ultimately saves water, a key resource.  And it can always also go all the way through actual solutions, focusing on solving some of the world's biggest problems, which can look like investing in low income housing.  And actually, not just investing, but actually, some of the asset managers we work with also partner them with local non-profits to bring in key resources and services to that population or investing in renewable sources of energy.

            Following along all of these approaches, you can think about the second I, as we call it, influence.  So that's in the green box in the lower left-hand corner.  And this is recognizing that there's no such thing as a perfect company.  And so many of the asset managers that we partner with actually engage with portfolio companies to help them improve along environmental and social dimensions, often that are material to business lines.

            And a recent example just to kind of bring this to life.  One asset manager we partner with actually worked with a very large bank to get them to reduce overdraft fees.  And this is obviously something that impacts every one of their customers and actually could be a competitive advantage in terms of attracting new customers.  And I will raise my hand, I remember in college at least, I definitely had some overdraft fees, but the vast majority of overdraft fees are charged to people making less than $50,000 a year.

            So this change actually has an outsized positive impact on those that may be the least well-positioned to incur these charges.  So again, thinking about what's material to this business and helping them do well from a financial standpoint, but also thinking about that positive impact.

            And finally, the purple box inclusion.  So what is that?  This is really focused on diversity at the asset manager itself.  And why does that matter?  When we look at the disparity in diverse employees relative to the broader population, particularly in more senior roles, firms are really missing out on a huge percent of talent.  And we know that diverse and inclusive cultures provide a competitive edge.

            Researchers at the Wall Street Journal ranked industries and companies for diversity and inclusion and found that the 20 most diverse companies in the study had an average annual stock return of 10% over five years versus only 4.2% for the bottom 20.  But historically, the asset management industry has been far from diverse.  According to a 2021 study commissioned by the Knight Foundation, asset management firms owned by diverse individuals managed just 1.5% of assets in the US.

            So recognizing this, we elevated inclusion to be part of this broader framework with a focus on diverse-owned firms as well as diversity throughout the firm.  So looking specifically at senior leadership and investment teams and policies and procedures to create a more inclusive and diverse workplace.

            So just to summarize this framework, I know I just shared a lot.  Whether you're focused on the intentional investment process or how asset managers are influencing or engaging with portfolio companies or inclusion and diversity at the asset manager, this provides the framework for how you can think about investing with impact.

            But importantly, this isn't a new concept.  Sustainable investing has been around for over a hundred years from religious values investors initially focused on screening out certain areas of concern.  It has evolved dramatically since then to focus more on opportunities and how these factors can be material to business and investment decisions.

            BAccording to one source, today there is an estimated $17 trillion.  Otherwise, basically one in $3 in the US focus on socially responsible investing strategies.  So it's really grown significantly over that time.  And at the same time, we've seen regulation evolve as well, which I know is of utmost importance here with retirement plans.  

            In 2015, Department of Labor ruling facilitated the ability for employers to add Sustainable and Impact Investment fund options to their plan choices.  You probably likely know this very well, and most recently just a few weeks ago, this was codified, which we'll touch on shortly.  And we know there's demand here.

            According to a study from our Institute for Sustainable Finance, 88% of retirement plan participants are interested in sustainable investing, and that number will likely continue to grow as we see the next generation continue to increase as a percent of the workforce.  As you can see, kind of in the middle here, 95% of millennials are interested in sustainable investing.

            And importantly, this isn't an either or when you're thinking about investments.  I touched on upfront, this is about combining impact goals and financial goals.  And the data supports this.  The KLD 400 is the oldest ESG-focused index, and it has outperformed the S&P 500 since inception.  We've also seen data that shows that during more volatile periods, ESG can help protect during the downside.

            This is particularly the case when environmental, social, governance data is material to business.  So when you're looking at factors that are actually material to the business line, which is what most of the asset managers we partner with ar e doing.  It can actually be a helpful signal of potential future performance and a deeper understanding of the risks and opportunities of the investment.

            So now with that backdrop, the DOL, I know hopefully, probably top of mind for many of you as you think about retirement plans.  And they've recently issued a long-awaited final ESG rule titled Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights, which permits but does not mandate plan fiduciaries to utilize ESG and other non-economic factors in their investment decisions where appropriate.

            So what does that mean for you?  That's a lot of words.  And I know the regulation has shifted, but let's break it down.  So the final rule, unlike the 2020 rule, allows fiduciaries to include non-economic factors such as ESG in the investment decision where appropriate.  There's also the tiebreaker test.  The new rule removes the additional documentation required regarding how a fiduciary came to its decision to include investments based on ESG factors, as well as the obligation to provide additional disclosures to participants regarding such funds.

            So remove some of those additional barriers that were there historically.  Focusing on influence, that second I of our framework that we touched on earlier, it affirms that the fiduciary duty to manage plan assets extends to shareholder rights in stocks held as a plan asset.  That includes proxy voting.  And finally, this also permits ESG funds as qualified default investment alternatives.

            And one thing I just really want to touch on and highlight here is that the difference here from what we seeing historically with the changes with the DOL is that this is much more codified in terms of its a ruling.  And so it's something that has much more stickiness as we're thinking about going into future administrations.

           And so with this as a backdrop of what Investing with Impact is in current regulation, I want to turn it over to my colleague Juliana Granados, to actually talk you through implementation and what this could look like in your retirement plans.

Juliana Granados:   Thank you, Emily.  And hello, everyone.  I'm very excited to be here on the line with all of you today.  My name is Juliana Granados and alongside Emily, I'm part of the Investing with Impact team here at Morgan Stanley.  Essentially, very similar to Emily, I think I've wanted to have an impact with my work ever since I started on this journey.  I have a long journey in impact and sustainability.

            But what I do here every day is really look for ways to partner with financial advisors and with their clients in really translating their mission and their values into investment opportunities and into advice.  And making sure that the pools of capital for you as plan sponsors as well as for your plan participants, how can we help bridge that gap and help folks find ways to invest in a more mission-aligned way?

            And so let's take a look at how we can do that.  So we know that many of you are constantly working to improve your operations, to offer more sustainable and competitive products and services, and to align with your company mission.  So in a nutshell, we know you're trying to be intentional back to those three Is about the impact that you're having on the world, on your employees, and on the communities you serve.

            And we also know that your 401k offering is intrinsically tied to your company's climate impact for performance on key environmental metrics like your financed emissions, which are also known as scope 3 emissions.  A recent study by the CFA Institute shows that the carbon intensity of the average retirement plan is 33 times larger than the emissions produced by the carbon footprint of your own company business and operations.  Inadvertently increasing your and your plans participants' exposure to carbon intensive companies and hence to embedded environmental risks.

            By introducing a sustainable retirement plan offering, you can reduce financed or those scope 3 emissions and further reduce your overall carbon footprint and improve your performance across environmental metrics, which we know your key constituents like your plan participants, as well as your shareholders, care deeply, deeply about.

            So staying on that topic of demand, let's move over to the next slide.  We know that the demand for sustainable investment opportunities for plan participants is there, and we are seeing that grow over time, especially with younger generations and women, as Emily alluded to earlier today.  

            A study by the Morgan Stanley Institute of Sustainable Investing shows that 88% of plan participants that have access to sustainable options in their retirement plan and most importantly, folks that know about this offering actually select them as part of their plan lineup.  And what about those who are not so sure that these options exist, for those who work for employers who don't offer these options?  

            What we see here is a big, big opportunity, 69% of these individuals who either don't have that available in their retirement plan or who are not sure that that exists, have expressed interest in incorporating a sustainable option into their 401k.  And as you're well aware, this provides additional opportunities to engage with your participants and to participate in a $37 trillion market opportunity while providing an output for ongoing engagement with your key constituents.

            So let's move over to the next slide.  And we find that in addition to abiding with the new DOL guidelines, this also aligns well with your fiduciary responsibilities as per your ERISA guidelines.  And on the page you can ERISA's core fiduciary duties for plan sponsors.  But I want to highlight a few, which I believe to be very important in the context of sustainability.  

            And we know that as fiduciaries, you're required to act prudently and for the exclusive purpose of participants and beneficiaries in everything that you do, including making investment decisions, and proxy voting.  Both of these, but particularly the latter being a big focus of ESG managers as they exert that I of influence on their portfolio companies to improve their environmental and social outcomes.

            ESG funds also support portfolio diversification around investment and sustainability themes and with the proliferation of investment opportunities that we see available across all asset classes and styles.  And finally, we have also seen sustainable funds become more competitive from a fee perspective over time, which creates opportunities that can align with the plan's expense expectations moving forward.

            And so how do we actually do that?  Let's move over to the next slide.  We know that incorporating investing with impact or sustainability into a retirement plan can seem like a daunting task, but it really doesn't have to be.  There are many ways to get started and slowly build a sustainable offering for your plan participants.  And the first step to this is really about deciding to move forward.  And it is as simple as that.

            It's stating that commitment to sustainability and honestly, getting the buy-in from any important key decision makers in your organization.  But once you've decided to move forward, we recommend that you document this commitment in your investment plan or an investment policy statement using simple ESG language to delineate some of your key goals, perhaps some guardrails, or just highlight some specific impact themes or metrics that the plan is looking to emphasize through their investment selection.

            And then the third step is really about identifying suitable and appropriate options to add to that existing lineup or perhaps to replace some of the funds in that lineup.  And we are going to cover some of these opportunities in a minute.  And finally, I'm a very big believer that we can't manage what we can't measure.

            And so it's very important to have a way to measure the ongoing impacts of these investments and reflect back to both key stakeholders within your organization, as well as to your plan participants.  Making this an active part of your corporate dashboard or sustainability report, which can really differentiate you as a leader and signal to everyone out there your commitment to sustainability and to information transparency.

            And so let's look at some of the opportunities.  Let's move over to the next.  Here we can see a few different ways to get started.  And as I mentioned before, this doesn't really need to be overly complex.  You can think about replacing one traditional fund in your lineup with an ESG option.  This way, you don't have to add additional investment options to the menu, but you can significantly improve your positive environmental and social impact by replacing a fund that performs poorly across ESG metrics with one that better aligns to your values.

            So think back to the top of the hour and not 33 times larger carbon footprint of your pension plan.  You can identify a laggard and you can replace that option with one that scores better across key environmental metrics.  You can also add one broad ESG global and one US option to the roster to give plan participants opportunities to engage in some of the most represented asset classes and make that very easy for them.

            There are also meaningful opportunities in the passage space.  There are multiple sustainable funds that seek to track market performance versus outperforming it and not from a financial perspective.  But what those passive opportunities represent is actually a very big opportunity of outperformance from an impact perspective and really help you maximize and emphasize metrics on the things that you as an organization actually care about.

            You can also focus on funds that actively engage with companies in their portfolio.  Again, that I have influence that I know that we've mentioned a couple of times so far.  And then finally, and based on client interest, you can focus on a couple of the thematics that you and that we know matter the most to your client.  And we can see a couple of examples of that on the following slide.

            At Morgan Stanley, we typically tend to focus on these nine thematics, but these have come from years and years of experience in having these conversations with our clients, with our financial advisors, and identifying what matters most to that.  So you can focus on something that has more of a broad-based approach to sustainability, which is some of the options we covered before.  

            But you can also think through things like climate action, things related to diversity overall from a gender perspective or from an overall perspective.  You can think about improving lives from a corporate standpoint and making a more inclusive and better workplace or you can just think through more environmental things like circular economy, conservation or biodiversity or health and wellness.  

            And these are just a few different options but the idea really is to say you can go out there, you can figure out what matters most to your clients, and you can find ways to embed some of these themes into your lineup.

            And so I know we've covered a lot today.  Again, thank you so much for being here.