Investing April 1, 2021

Asset Managers: Financial Factors Are Important Part of ESG Investment Selection

Investments should rank well on both financial and ESG metrics, and plan sponsors should know how their asset managers approach ESG investments.
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Although there are some retirement plan sponsors that have in-house staff members who manage plan investments, most delegate the selection of investments to an asset manager that is given a guideline, says Sean Kurian, head of institutional solutions at Conning.

However, plan sponsors should consider how an asset manager approaches environmental, social and governance (ESG) investing when they’re selecting one. “In an arrangement where the investment manager evaluates assets, now it’s sort of best practice to consider ESG investments,” Kurian says.

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It is important to consider financial metrics in addition to ESG metrics when evaluating an investment, says Mike Hunstad, Ph.D., head of quantitative strategies for Northern Trust Asset Management (NTAM). “When we think about ESG, we think it is the future of investing, but when we put on our fiduciary hat, we have to be concerned that some companies that are highly ranked from an ESG perspective have relatively poor financials,” he says. “We want to be cognizant of both. Companies strong in ESG but also strong from a financial objective tend to get lower risk profile and better risk performance.”

It is very difficult to measure financial factors or ESG factors in isolation, Kurian says. “The financial factors will also include regard about how ESG plays a part in the portfolio,” he says. “Some may be silent on that, but most would usually include that information, especially if there’s a framework for it.”

For defined benefit (DB) plan investment committees, fiduciary responsibility is paramount, Kurian says. “The fiduciary responsibility is ultimately to make sure the plan can meet its benefit payment obligations,” he says. “If fiduciaries are only considering ESG factors in investment selection and the investment performs poorly, it will hinder their overall duty to the DB plan.”

“We do believe integrating financial metrics with ESG factors helps us do our fiduciary duty better,” says Matthew Daly, managing director and head of corporate credit research at Conning. “It’s difficult to elevate one metric over another; if an investment scores very well on ESG metrics but the business is not sustainable, it’s problematic.”

Financial Factors to Consider

Some companies have no profitability, low cash flow or bad balance sheets, Hunstad says. For example, he says, some solar companies have been very highly rated on ESG factors but have very little profitability. He says there’s often a perception that those companies with high ESG orientation also have high financial metrics, but that is not necessarily the case. That’s why it is so important to bring both metrics into the evaluation.

“Asset managers want to consider the quality factor. When combined with strong ESG metrics, investments tend to perform much better,” Hunstad says. “That is why we introduced the ‘Quality ESG World’ strategy. We didn’t design it based on the DOL [Department of Labor] rule, but we are cognizant of what the DOL is trying to say.”

The DOL regulation says plan fiduciaries should only consider “pecuniary” factors when assessing investments of any type—which is to say that they should only use factors that have a material, demonstrable impact on performance.

“When thinking about ESG investing, we want to make sure clients are in it for the long haul and not surprised by an unintended outcome of the investment all of sudden not performing with its intended benchmark,” Hunstad continues. “We can help ensure this through quality metrics. We want to make ESG more ‘sustainable.’”

He explains that profitability is measured by metrics such as return on assets, profit margins and more classic asset turnover metrics. When looking at cash flow, asset managers want to make sure companies have enough liquidity to meet short- and long-term obligations.

“It is widely accepted in the industry that when cash flows become challenged, it’s an early warning of problems with both the balance sheet and profitability,” Hunstad says. “We look at accruals. If a company sells something but that doesn’t turn into cash, it’s a receivable, and they have less cash. It’s a signal of bad cash management. Structuring the cash flow cycle to always have liquidity on hand is a good sign.”

Hunstad says NTAM looks at balance sheets to see whether management is using capital resources in an effective manner. “Broadly speaking, we look at how much debt and equity a company has and how much growth there is in those categories. There are concerns about companies growing too rapidly compared to their peers,” he says. “Issuing too much debt or equity is a red flag. We like stability in the balance sheet to make sure from a long-term perspective that a company can remain solvent and not be challenged financially at some point in the future.”

“When we approach ESG, our framework is one of integration, so we’re integrating ESG risk factors directly into the financial analysis,” Daly says. “ESG factors are included in material nonfinancial information. We consider more holistic information to assess companies, including a company’s creditworthiness and financial sustainability.”

He says Conning would also consider common metrics such as the leverage of the issuer and the forecast for leverage improving or declining, cash flow and revenue outlook. He adds that ESG considerations can provide additional information, for example, by thinking about the evolving regulatory environment and whether that would create additional costs that could affect margins and cash flows.

“One of the big areas we consider is transition risk. How is the company positioned for a lower carbon-emissions environment from a regulatory and technological innovation standpoint? Those things can impact financials,” Daly explains.

“We look at how a company is positioned competitively in relation to its peer universe,” he adds.

It’s also important to consider a company’s trajectory, Daly says. A company may score poorly right now on ESG metrics but have a positive long-term outlook. He says that is a good place to allocate capital.

“The concern is that companies with high ESG ratings are challenged financially; plan fiduciaries want to make sure they are using investment options that are good on both metrics,” Hunstad says. “If the company has no profitability or declining profitability over time, that is not a good representation of doing your fiduciary duty.”

Kurian reiterates that it is hard to separate financial factors from ESG factors. “The way it was done a few years ago was to create silos—here is my ESG box and here is rest. But the landscape has changed and studies have shown how ESG is highly correlated to certain companies outperforming,” he says.

Values-Based Investing Is Different

Previously, plan sponsors might have practiced what was called “socially responsible investing (SRI),” divesting from companies that were either found to be doing business with bad characters or that were perceived to be in the production of harmful products, e.g., firearms or tobacco.

Kurian says SRI relates to the culture of the company, but he notes it’s tricky, especially if those investments that are excluded are doing well. “Plan sponsors have to answer whether their portfolios represent the value of their organizations,” he says.

“What we’ve been talking about is the integration of ESG factors in the overall assessment of investments, but values-based investing is different,” Daly says. “Whether one wants to dedicate capital or not to, for example, tobacco companies is very specific to the plan sponsor.”

Compliance March 17, 2021

How This Year’s Plan Financial Audit Could Be Different

Auditors might be reviewing more transactions and processes, and they’ll need more time to handle audits remotely.
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The COVID-19 pandemic has affected many plan sponsor processes. Staff furloughs, layoffs and terminations, a move to remote work, as well as new distribution and loan provisions of the Coronavirus Aid, Relief and Economic Security (CARES) Act had them shifting gears.

As Nancy L. Cox, partner at The Bonadio Group, points out, as a result, retirement plan financial audits performed with Form 5500s will be affected.

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Cox says that depending on the plan sponsor’s situation, there could be a lot of changes to the audit process—or relatively few. Plan sponsors were not required to adopt the coronavirus-related distribution (CRD) and loan limit provisions of the CARES Act and some plan sponsors didn’t have to deal with the transition to remote work, as their employees continued in their normal workplaces. For those plan sponsors, the audit process might be business as usual.

But for plan sponsors that did adopt provisions of the CARES Act, auditors will have to look at more types of distributions, says Beth Garner, national practice leader for BDO’s employee benefit plan audits practice. The CARES Act created the new CRD, for example. Garner says auditors could possibly increase the number of samples they examine, but the type of evidence the auditor asks the plan sponsor to provide for distributions will be the same.

The CARES Act also expanded the limits on loan amounts and allowed participants to choose to defer loan repayments. Garner says this means auditors’ testing of loans will be different.

“They’ll have to look at whether a participant wanted to defer loan repayments or whether the participant truly defaulted on a loan,” she says. “The auditor will be looking at what the plan sponsor did to distinguish between the two and whether it properly processed loan defaults.”

If there were larger distributions and more loans in number and volume, auditors will make larger sample selections, so the audit might take longer, Cox says. “Plan with the auditor ahead of time, so if they need additional information, they can let plan sponsors know so sponsors can start putting information together.”

Auditors are always supposed to look for fraud, Garner says, but the pandemic might have created a situation where plan accounts are more susceptible to fraud with working remotely, children at home and other distractions.

“One thing auditors will ask is, ‘In 2019, your process was this. Did that process change?’” she says. “Auditors will want to know what the new process is and how plan sponsors know that a person can’t do something to divert contributions or take something they shouldn’t be taking. They will look for oversight of distribution or loan approval.”

Garner says while they’re working remotely, plan sponsors must be more diligent about knowing who their named and functional fiduciaries are and tightening up roles. They also should make sure computer system firewalls are good and employees do not use public WiFi. Also, plan sponsors should look at plan transaction reporting monthly, or at least more often than quarterly or yearly.

In addition, Cox says, plan sponsors should work with providers to make sure they have proper security measures in place. “Ask them to provide you with information showing they have proper controls. Plan sponsors can look in their service agreements to see whose responsibility it is to make sure information is protected, who’s responsible if there is a breach and who pays for remedies,” she says.

Cox notes that each service provider has an audit of its own processes—a Service Organization Control (SOC) 1 report or Statement on Standards for Attestation Engagements (SSAE) No. 16. Auditors obtain a copy of the report, which discusses provider information technology general controls, and will make sure there aren’t huge exceptions or gaps in a provider’s processes that would concern plan fiduciaries.

Because of the COVID-19 pandemic, there might have been turnover in human resources (HR) or payroll at the plan sponsor or furloughs, meaning there could have been a period of time when there were not as many resources dedicated to plan administration or when resources were dedicated to other things. Cox says plan sponsors should make sure there were no issues or errors during that time frame. For example, auditors will pay particular attention to the proper definition of compensation being used, make sure no eligible participants are being missed and confirm there’s no delay in depositing employee deferrals. “If plan sponsors have been depositing deferrals and loan repayments within two days of them being withheld from paychecks, the DOL [Department of Labor] holds sponsors to that standard,” Cox says. “If there was a lag, plan sponsors need to identify that and they could have to pay lost earnings.”

She notes that plan sponsors can self-correct such errors through the DOL’s Voluntary Fiduciary Correction Program (VFCP) or the IRS’ Self-Correction Program (SCP) or Voluntary Correction Program (VCP). Even if errors are not identified until the financial audit is processed, plan sponsors can self-correct.

Cox says there should be proper controls over every amount that comes out of the plan. If a plan provider makes determinations for withdrawal or loan eligibility, the plan sponsor should get a report monthly and make sure everything looks reasonable, she says. She adds that this is another reason to look at a provider’s SOC 1.

Auditors will be looking at partial plan terminations more closely in 2021. Generally, if there is a 20% reduction in eligible participants, it can trigger a partial plan termination and plan sponsors would have to make all participants 100% vested, Cox explains. However, Congress has said if an employee was furloughed and hired back, he or she is not considered in that 20%. Plan sponsors also have until March 31 to determine whether there was a partial plan termination.

“Auditors should help with determining whether a partial plan termination has occurred, but plan sponsors are ultimately responsible,” Cox says. She adds that for small plans with no audit requirement, sponsors can look to service providers to help with the determination.

The audit might be performed differently because people are still not in their offices or are not comfortable with having others in their offices, Garner says. “The audit might be done via email and Zoom. Some firms have been doing them remotely anyway, but we have not because we think the DOL and AICPA [the American Institute of Certified Public Accountants] expect auditors to do their due process, and there’s a lot involved to make sure everything is covered in a remote environment,” she says. “It’s a lot harder. Good communication will be key to getting the audit done well and in a timely manner.

“Obviously, some audits are being done remotely at this point, and that is definitely doable,” Cox says. “Since audits deal with a lot of sensitive information, ensuring it is protected is No. 1. When sharing information with auditors, plan sponsors should use secure portals or password protection for everything.”

Garner adds that auditors and plan sponsors might need more time to get information back and forth; auditors will not move forward without documentation. She suggests that plan sponsors ask for a detailed list of items the auditor wants and what items they’ll need if there is a question.

“Keep tabs on each level of review. Plan sponsors will need notification from auditors of where they are in the process,” she says. “If there’s time, plan sponsors should start the audit process earlier than usual, but the best thing is to ask the auditor for items up front and have them ready to go on the date the auditor says he needs them.”

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