Investing November 5, 2021

Finding Fixed-Income ESG Investments for Retirement Plans

Fixed income is important for defined benefit plans and defined contribution plan participants, so how can plan sponsors incorporate investments focused on sustainability?
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Art by Ellen Weinstein

Sustainable investing has become more important to all types of investors in the past few years. And now, many in the retirement plan industry expect plan sponsors will include more environmental, social and governance (ESG) investments in their plans since the Department of Labor (DOL) has issued a proposed rule that is more amenable to ESG investments in retirement plans than regulations issued by the previous administration.

Much of the focus on ESG investing has been on equity investments. However, defined benefit (DB) plan sponsors following a liability-driven investing (LDI) strategy allocate heavily to fixed income, as do defined contribution (DC) participants who are nearing retirement. Other DC plan participants, even those in target-date funds (TDFs), also invest a portion of their accounts in fixed income for diversification.

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In a paper, “An Asset Owner’s Guide to Fixed-Income ESG Integration,” Josh Palmer, head of fixed-income ESG research at Willis Towers Watson in London, says one-third of all U.S. assets under professional management now use sustainable investing in their strategies. He notes that fixed-income ESG investments are already on the market, and the number of such funds continues to rise.

He says plan sponsors can look at investment labels and how they are marketed to find options, then do their due diligence to make sure those choices are appropriate. They can also engage with managers that run non-labeled ESG products with the aim of improving their ESG reporting. This will enable them to see how they are integrating ESG factors, if at all.

Plan sponsors can find green bonds, corporate debt issued by sustainable companies and debt with proceeds used for sustainable projects, Palmer says. “The U.S. is one of biggest issuers of green debt,” he says. “There is green infrastructure debt and green real estate debt—for example, financing the construction of offices with a low carbon footprint.”

Palmer adds that green bonds are more common in DC plans because these investments require lower management fees and are more liquid.

“There are labels on ESG fixed-income investments as there are for ESG equity investments,” says Brendan McCarthy, head of defined contribution investment-only (DCIO) at Nuveen. “For example, one of our top-selling and top-performing ESG fixed-income investments is our Core Impact Bond Fund.”

The Willis Towers Watson paper notes that the “ESG integration framework for fixed income has historically been opaque, either overly reliant on an equity model or not specific enough on what ESG metrics are relevant for bonds.” It says the diversity of the asset class, which includes corporate bonds, sovereign bonds, securitized credit and private debt, requires plan sponsors to take a nuanced approach to ESG investing.

The paper says asset owners’ questions for bond managers should include:

  • Does the manager have a framework to assess ESG risks?;
  • How does the manager integrate ESG approaches to add alpha (as exclusionary approaches could be limiting)?;
  • Similarly, does the manager create its own ESG ratings, or use an external provider (which may be less robust)?;
  • Does the manager seek to benefit from lack of detailed ESG coverage on specific issues/issuers (acknowledging this may be short-lived as more managers expand capabilities)? Has this “ESG alpha” been isolated and are there any examples to support this?;
  • Are there dedicated fixed-income corporate ESG resources? If not, what overlap exists with equity ESG analysts and how are the gaps filled?; and
  • Have all relevant fixed-income analysts and portfolio managers received sufficient ESG training?

Looking at ESG Fixed-Income Investment Managers

“The way plan sponsors can find [ESG fixed-income investments] is through sustainability-oriented manager due diligence,” Palmer says. “That’s how we find sustainable investments in fixed income.”

Palmer explains that fixed-income managers might provide reports with examples of how they’ve been investing sustainably, their sustainability metrics and the average ESG score of their portfolios. In addition, a manager might have separate sustainability targets—such as reducing emissions over time—in creating allocations to investments with real-world impacts. Managers also might have exclusions in place, he adds, and their sustainability scorecards could include a positive screen strategy in addition to excluding bad investments.

“We assess transparency, risk metrics and portfolio ESG scores, as well as manager-level ESG scores,” Palmer says.

In addition, plan sponsors and their consultants can look at manager engagement.

“We look at engagement reports from managers, which provide a summary of all engagements with issuers and other stakeholders,” Palmer says. “That helps ensure a manager is an active investor and a good steward of capital. It’s taking the extra step to make sure investments are being managed well.”

Evaluating ESG Fixed-Income Investments for DC Plans

McCarthy says sustainability efforts can be as impactful, if not more so, within fixed-income investments as they are within equity investments. He says it is prudent for DC plan sponsors to look at ESG approaches within fixed-income investments and how they can benefit and mitigate risk for participants nearing or in retirement.

McCarthy suggests that, to identify the universe of available fixed-income ESG investments, DC plan sponsors should enlist the help of an investment consultant to ensure they can incorporate ESG benefits into portfolios in a prudent way.

“ESG factors can improve performance and reduce risk,” he says. “But it is important that the evaluation of ESG investments is done properly, and a consultant can help.”

Unlike equity investments, finding successful fixed-income investments is more about avoiding losers than picking winners, McCarthy explains. So screening for ESG in fixed-income investments can help mitigate downside risk by adding another assessment of business risk. “These areas of risk are not often identified with traditional financial analysis,” he says.

McCarthy says the evaluation of fixed-income investments should always start with investment performance. Even if they’re using an investment consultant, plan sponsors need to understand an investment manager or issuer’s process.

“Plan sponsors need to ensure they are looking under the hood. Ask, ‘what does the investment mean by ESG or sustainable?’” he says. “Sustainability is a subset within ESG that has two fronts: Environmental relates to climate change, renewable energy, etc.; and social relates to community, such as help providing affordable housing. And, as a fiduciary duty, plan sponsors must assess strategies within an investment portfolio for pecuniary effects.”

McCarthy adds, “We will not sacrifice performance or distort risk in pursuit of impact. It is important for plan sponsors to understand they can invest sustainably in a responsible manner and still put investment performance and risk management first.”

McCarthy says it is also key to understand the philosophy of the investment manager and the pecuniary impact of that philosophy. “In light of the DOL rule back and forth, plan sponsors can’t alleviate themselves from focusing on good investments for the plan,” he says.

As with any other investment, McCarthy says, plan sponsors should document the process for investment selection. In addition, for DC plan sponsors, it is important to effectively communicate to employees about what the product means. “ESG is more understood than it used to be, but there are still some misunderstandings, so plan sponsors need to educate employees,” he says.

‘Greenwashing’

Palmer notes that greenwashing can be an issue. S&P Global describes greenwashing as “making exaggerated or misleading environmental claims, sometimes without offering significant environmental benefits in return.” However, S&P says there’s little evidence of the practice among sustainable investments.

Palmer says European officials are developing regulations to protect investors from greenwashing. “If greenwashing becomes an issue in other markets, we might see more regulations,” he says.

Compliance November 3, 2021

Getting Retirement Plan Help From the IRS

Retirement plan sponsors have several avenues for getting help from the IRS with general questions, technical issues and corrections.
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Art by Lior Hizgilov

When it comes to helping individuals with tax problems, the IRS has a reputation for being unhelpful and difficult to reach. However, sources say the agency is more responsive to plan sponsors looking for plan direction.

“The IRS staff in the employee plans department is generally knowledgeable and very willing to speak to plan sponsors or their advisers,” says Ari Sonneberg, partner and chief marketing officer for the Wagner Law Group in Boston. “They’re usually very helpful to the extent that they can be over the phone.”

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Still, the agency has become harder to reach since the COVID-19 pandemic pushed many workers into remote positions, and it’s helpful to know exactly whom to contact within the employee plans department rather than calling the general helpline. So plan sponsors and their advisers still need a game plan if they want IRS help.

Plan sponsors might need assistance with issues including the creation or termination of a plan, or correcting a failure of either documentation or administration.

“It’s critically important that people don’t even informally rely on guidance from people at too low a level at the IRS,” says Michael Wieber, a partner with Quarles & Brady LLP in Milwaukee. “You want to get an agent in the appropriate area if you want any comfort that the IRS would see things the same way that as that person.”

Help Reaching the IRS From Plan Sponsor Providers

Many retirement plan professionals pay for access to a private IRS directory that includes information on who to call based on the IRS code in question, says Jared Johnson, a partner in the tax group at White and Williams LLP in Philadelphia. Or they have their own contacts they’re built up at the agency through helping other clients with similar issues, says Steven Sokolic, of counsel at Retirement Law Group in San Diego.

So it often makes sense to work with an adviser, a retirement plan consultant, an enrolled retirement plan agent (ERPA) or certified public accountant (CPA), says Johnson. “Retirement plan specialists can interface directly with the IRS counsel’s office.”

Plan committees should meet at least twice a year to review their plan for any potential failures and determine whether they need to take corrective action with help from the IRS, Johnson says. If the answer is “yes,” the sooner a plan sponsor can begin the process, the better.

“Don’t wait until the last minute to make decisions, especially on things like vesting or participation if the issue is looming,” Sonneberg says. “Plan sponsors think they can call the IRS and quickly get an answer, but it can take weeks depending on how backed up it is.”

Online Help

A phone call is typically only the beginning of the process, since oral advice is always considered advisory and not binding on the agency, according to the IRS’ website. The IRS also says it does not orally issue rulings or determinations in response to oral requests.

The first step, of course, is determining whether you need to go to the IRS at all, Sonneberg says. In general, the IRS can help with participation, vesting, funding and tax issues, while fiduciary concerns should be addressed by the Department of Labor (DOL).

For basic, straightforward questions, the best route is to go through the IRS website, says Elizabeth Thomas Dold, a principal with Groom Law Group, Chartered, in Washington, D.C.. In recent years, the agency has bolstered its self-help offerings with both written and video content aimed at answering frequently asked questions (FAQ). In particular, the agency’s “Issue Snapshots” and “Fix-It Guides” may answer many plan sponsor questions, she notes.

“The IRS has taken great strides over the past 10 years or so to make the retirement plan section of the website as user-friendly as possible,” Johnson says.

Even issues that used to require IRS guidance, such as implementing a correction through the Employee Plans Compliance Resolution System (EPCRS), can now often be done by the plan sponsor entirely online without human interaction with an agent, Dold says. Plan sponsors might use the online process to correct issues such as a miscalculation for a hardship distribution or a using an incorrect definition of compensation for safe harbor testing.

Components of ECPRS include the Self-Correction Program (SCP), the Voluntary Correction Program (VCP) and the Audit Closing Agreement Program (Audit CAP).

You fill out the forms on the website and submit your proposed correction,” Sonneberg says. “[The IRS staff] generally offer their blessing, if it’s a reasonable correction and it makes the participants whole again.”

VCP applications, the most commonly used, typically take about four months to process, or maybe longer if there are errors or other issues with the compliance statement, Dold says. New rules from the IRS will eliminate the ability for a company to submit a VCP anonymously, but a pre-conference procedure for a VCP can still be done anonymously.

Determination Letters and Letter Rulings

For more complicated issues, plan sponsors can take several routes to get IRS help. For questions related to preventing future problems when starting a new plan, terminating an existing one or merging two plans, for examples, plan sponsors might request a determination letter, Wieber says, which, according to the IRS website, costs $275. The IRS recently changed the rules to allow plan sponsors and their advisers to apply for letter rulings and determination letters electronically.

“Those are more focused on the language of the documents themselves, as opposed to interpretations or facts that may not be accurately stated or may change over time,” Wieber says.

To get a determination letter, a plan sponsor will need to submit a complete statement of facts and a detailed description of the transaction. In general, the IRS will not provide a ruling on one step of a larger transaction, preferring to rule on the overall transaction, according to the IRS website.

Plan sponsors with pre-approved documents can get an opinion letter, in which the IRS essentially gives its blessing that a plan’s format is acceptable and written in a way that satisfies the legal minimums for what a document should look like, Wieber says. “That gives the plan sponsor comfort that if it starts from this place and fills in the blanks, the document will meet the technical requirements,” he adds.

Fixing Mistakes

More common than questions about new plans, however, are questions on compliance resolutions for plans that have failed in one way or another and do not qualify for the VCP program.

“If the method of correction is unclear or there are multiple ways that you might reasonably correct something, you can get the IRS to rule on your correction method through a private letter ruling [PLR],” Wieber says. In that case, the IRS is making a specific judgment on a specific situation. PLRs are helpful to plan sponsors, but they’re pricey, he notes. According to the IRS website, depending on the issue addressed, a sponsor could owe $5,000 to $38,000. PLRs can also take months or a year to complete, which can cause significant problems for a plan that has an immediate issue or question, says Wieber.

“That’s a lot of money and a big commitment,” says Dold. “So, most people ask whether there’s another avenue.”

In those instances, plan sponsors will need to discuss with their lawyer whether it makes sense to go through the PLR process or to simply make their best good faith decision and move forward.

“I can’t tell clients who do that that there is no risk,” Wieber says. “But most employers are taking bigger risks every day in their business. This is about taking a reasonable position based on what’s out there.”

Plan sponsors that go this route should document the decisionmaking process, including by getting an opinion letter from an attorney, which can go a long way toward protecting them in the event of not only a fiduciary claim but also to show the IRS that they were attempting to do the right thing.

“Even if the IRS ultimately disagrees with you, you may be able to avoid or reduce penalties and interest by showing that you were trying to be prudent in your approach,” Wieber says.

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