Investing April 30, 2019

Providers Look to End the ESG Performance Debate

According to Mike Hunstad at NTAM, it may take some time for the retirement industry in the U.S. to fully embrace ESG as a positive-performance factor, but he says it’s already a best practice to think about ESG from a risk-management perspective.
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Michael Hunstad is head of quantitative strategies at Northern Trust Asset Management (NTAM). The role is a broad one, but a big focus recently for Hunstad has been the evolving topic of environmental, social and governance (ESG) investing in the realm of U.S. institutional investing.

According to Hunstad, outside of the U.S., almost all the institutional business NTAM engages in already involves the ESG lens to some capacity. He says institutions in Europe, Asia and Latin America have come to accept that ESG is a material issue when it comes to long-term asset performance—both as a source of risk and a potential source of return.

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“Is ESG a factor, say, in the way of stock value or momentum?” Hunstad asks. “There are two ways to look at this question. The first is to say that ESG is an independent source of risk that must be addressed. In my opinion, you simply cannot argue against this. Consider what happened with Volkswagen’s stock when the emissions cheating scandal came out. That is bad governanc,e and it is absolutely a source of material risk today that will impact your portfolio, if ignored. So if you can measure governance, and you can control the risk around governance, that’s enough for me to say that ESG is a factor that should be addressed during portfolio construction.”

The risk issue may be settled, Hunstad says, but it is equally important to ask the next question, i.e., whether ESG is a positively compensated factor? In other words, will an investor see excess returns for going overweight in ESG-conscious stocks?

“We have to be careful in this analysis,” Hunstad suggests. “I like to say that the best case for higher performance of ESG stocks is over the long-term.”

The case goes as follows. For those companies that have taken concrete steps to comply with environmental regulations or have strong cultures of governance and are globally and sustainably minded, these companies have already borne the cost of embracing this way of doing business. Crucially, the fact already shines through in their financial statements. On the other hand, those companies that have done nothing to consider ESG issues, their financials do not reflect these unknown future costs.

“The important point is to say that these companies will eventually have to bear these costs in the future, which will inevitably be a headwind for their stock price and financial performance,” Hunstad says. “More importantly, we have found that ESG absolutely can be a compensated factor when you weed out low-quality companies from your portfolio. There are stocks out there that rank highly on the ESG perspective that you don’t want to own from a financial perspective. If you get rid of those, the stocks that are left over, the high-qualit,y high-ESG-rated stocks, tend to do very well.”

NTAM rolled out a number of strategies that take this approach nearly five years ago, and Hunstad says the performance has been strong.

“All of them are blowing away the cap-weighted benchmarks,” Hunstad says. “We offer these through our wealth and institutional channels, and the growth has been very rapid.”

One example is the Quality ESG World Strategy, which has outperformed the MSCI World Index by 1.21 percentage points since inception in 2015. Notably, the portfolio holds just 291 stocks out of the benchmark index’s 1,635 holdings. The market capitalization of the Quality ESG World Strategy, however, is still about 80% of that of the MSCI World Index. A fact sheet provided by NTAM summarizes the strategy as follows: “Our process uses a proprietary quality screen that focuses on fundamental characteristics that differentiate a company’s level of quality. Portfolios are then constructed to take active exposures on securities based on their ESG rating and relative quality rankings.”

According to Hunstad, it may take some time for the retirement industry in the U.S. to fully embrace ESG as a positive-performance factor. However, he says, it’s already a best practice to think about ESG from a risk-management perspective. Many are arguing that ERISA, the Employee Retirement Income Security Act, already demands as much. 

“Thinking about ESG risk and about investments can be holistic,” Hunstad says. “You don’t have to silo yourself into an ESG lineup to take advantage of this way of thinking.”

Evolving industry consensus on ESG

Another expert to speak recently with PLANSPONSOR on the ESG topic is Timothy Calkins, director of fixed income at Nottingham Advisors. He agrees that institutional client expectations are, indeed, evolving rapidly around the question of how environmental, social and governance-focused investment approaches fit into the world of institutional asset management.

Even five or 10 years ago, Calkins says, the consensus was still that investors had to give up some performance by “doing good” in the markets. But more recently, especially since some big meta-studies published in 2015, the conclusion around ESG integration has moved to being either neutral or more often positive from the performance perspective.

In practical terms, Calkins’ firm is already using separately managed accounts (SMAs) as a way to deliver ESG strategies to clients. Some clients choose to really engage with risk management and return-boosting opportunities having to do with the environment, he explains, while others may choose to utilize a gender lens when reviewing the fund managers they use or the companies they invest in. As opposed to mutual funds or collective trusts, the SMAs can be customized to allow clients to uniquely implement their ESG perspective.

“Being able to offer customized ESG solutions is a big part of our future, we feel, as is finding new ways to clearly demonstrate the performance benefits of these strategies,” Calkins says. “Especially when it comes to serving clients under the Employee Retirement Income Security Act, we know the performance conversation is always going to be critical.” 

According to recent research from Morningstar, most investors, across ages and genders, have clear preferences for environmental, social and governance investment products.

This matches the experience of attorneys working with Stradley Ronon. The firm says its attorneys are already helping both registered and private-fund clients incorporate various ESG strategies. They are also advising fiduciaries on the implications of using ESG under ERISA, “such as how integration, shareholder engagement and divestment can be conducted in a manner consistent with ERISA.”

“We simply don’t see ESG going away anytime soon,” says George Michael Gerstein, co-chair of the fiduciary governance practice at Stradley Ronon. “Environmental, social and/or governance issues are a fact of life. Cybersecurity and climate change are two examples.”

According to the attorneys, one factor slowing growth in this domain is widespread confusion over what ESG actually means. In particular, clients want to know how “ESG investing” differs from “impact investing,” “socially responsible investing,” “economically targeted investing,” and “sustainable investing.” They also spend a lot of time explaining that the days are gone when ESG investing consisted primarily of either screening out or divesting from certain issuers/sectors because they do not meet some moral or other noneconomic test.

“Today’s ESG is much more driven by data linking one or more ESG factors and investment performance—an ESG factor can now be a material risk,” the attorneys wrote. “On an even more fundamental level, there is not unanimity on what constitutes an E, S or G factor. ESG is an umbrella term capturing as many as 40 different topics.”

Administration April 25, 2019

Recordkeeper Consolidation Creates a Smaller Pool of Plan Sponsor Choices

Recordkeeper consolidation is ongoing, but it offers an opportunity for plan sponsors to secure better services and software, and better fees.
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Art by James Yang
Art by James Yang
Art by James Yang

The announcement of Principal’s acquisition of Wells Fargo’s retirement plan business further reduced the list of recordkeepers from which plan sponsors can choose.

The trend of recordkeeper consolidation has been ongoing since at least 2009. In fact, an analysis of the top 20 recordkeepers by assets in 2009 versus 2017, performed by Brian O’Keefe, PLANSPONSOR’s director of research and surveys, finds only four have not pursued an acquisition-based growth strategy.

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O’Keefe notes that there seems to have been thematic windows of major consolidation. “The first window appears to have been from 2000 to 2006, when a lot of ‘unintentional derivative businesses’ were sold off—books of business relating to companies that have different core businesses, such as PwC, Aetna, Cigna, American Express, Northern Trust and Dreyfus, for example,” he says.

O’Keefe observes a second window from 2008 to 2010, when companies combined administration with other services in hopes of creating compelling experiences for the employer or participants. “You had the strengthening of providers offering ‘financial solutions’—for example the Wells Fargo/Wachovia Bank deal, the ING/CitiStreet deal, and the Bank of America/Merrill Lynch deal—and providers offering ‘employer solutions’—for example the Aon/Hewitt Associates deal and the Xerox/Affiliated Computer Services (ACS) deal,” he says.

According to O’Keefe, the next window appears to have run from 2012 to 2015 as a scale and positioning attempt, during which providers sought to achieve even greater economies of scale. Empower Retirement scooped up Great-West, which had previously acquired Putnam’s and J.P. Morgan’s recordkeeping business; MassMutual acquired The Hartford’s retirement plan business; and Transamerica and Diversified Investment Advisors, which had been consolidated, picked up business from Mercer.

O’Keefe’s analysis leads him to wonder, “What will 2028 look like?”

Robyn Credico, managing director of retirement at Willis Towers Watson, in Arlington, Virginia, says the primary reason for recordkeeper consolidation is that recordkeeping is not a big money-making business on its own. “Some providers want to get out of the business, some want to create scale because the more leverage and infrastructure, the more money a provider can make, and some want to move up market to serve larger plans,” she says.

Credico says that since there are not so many companies left, she doesn’t know how much more consolidation there will be, but she still thinks there will be some offloading of the recordkeeping business to focus on other business. She adds that she expects some smaller recordkeepers will issue an initial public offering (IPO) instead of being acquired.

“In the large plan market, there are not even that many vendors left. Some do all things themselves, so they wouldn’t be in acquiring mode,” Credico adds.

Chad Parks, founder and CEO of Ubiquity Retirement + Savings in San Francisco, believes recordkeeper consolidation has a lot to do with a broader consumer awareness of fees involved with various parties in the defined contribution (DC) plan recordkeeping market. “Recordkeeping, third-party administration, directed trustees, consultants to plans, advisers, actual investments themselves—when you add all that up, it can be quite expensive to administer a retirement plan,” he says. “When things started to change in the 2000s with fee disclosure rules from the Department of Labor (DOL) and increased transparency required, plan sponsors became more educated as to what they should be looking for and providers realized that in a more competitive environment they couldn’t afford to continue to charge what they had charged. They had to provide a more competitive offering, and one way was to consolidate and remove redundancy and align costs with the services provided.”

Parks adds that something retirement plan service providers asked themselves is what business they are in and how they want to make money. For example, investment providers realized they could use recordkeeping to have assets flow into their asset management business, but over the years they realized recordkeeping is complicated—and that demanding clients want complex administration support. But, if one looks at the constant top four or five recordkeepers today, they are clearly in the investment management business foremost, but found a way to break even at least on recordkeeping and fuel their investment management business. “Principal is a recordkeeper but also has trust management and other businesses. Principal’s move is saying it wants to stay a big player,” he says.

According to Parks, the demographic shift will have an impact on consolidation. Baby Boomers are entering their retirement years and starting to draw down retirement plan assets and Generation X and Millennials have competing financial priorities and are not saving as much, so recordkeepers have a risk of revenue declining as assets decline. “In 10 years, savings may not make up for the difference in outflows. A macro look sees consolidation is the forerunner of a business model shift, and going forward, recordkeepers will realize they have to charge a flat fee,” he says.

What recordkeeper consolidation means for plan sponsor service

“In general, I think plan sponsors will see improved services due to recordkeeper consolidation because typically the acquiring company would look at services offered by itself and the organization it acquired and pick the best of both worlds,” Credico says.

She adds that typically when one company acquires another, it commits to still charging fees of the acquired company. She notes that, in general, service provider fees have been getting compressed over the last several years, which is why some recordkeepers have gotten out of the business. But, Credico says, it appears fees could be leveling off now.

As for benchmarking or requests for proposals (RFPs), Credico notes there continues to be a smaller group among which to benchmark a comparable plan, and as far as a vendor search, there are fewer providers to compare. “One might expect that with less competition fees could increase. At some point, from a business perspective, the recordkeepers left standing will have to make money and will have to decide whether or not to raise fees,” she says.

She adds, “But, I don’t think that’s a bad thing. Plan sponsors don’t want their recordkeepers to go out of business.”

Parks wonders whether, with fewer choices in recordkeepers, plan sponsors will still have the ability to command the experience they want or to negotiate pricing. Recordkeepers will have to further differentiate themselves when there are fewer to pick from.

He predicts there will also be movement and consolidation at the software level. According to Parks, there hasn’t been much major improvement or investment in recordkeeping systems for decades. “How do recordkeepers deliver good experience with lower revenue and outdated software? There is some movement to build platforms, but it’s a major investment and not all can do that,” he says.

“Recordkeepers will see demand from plan sponsors that will drive change, but it will take time because modifying a 20-year software system is not easy,” Parks adds.

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