Hazards of the glide path

The sustainability movement has plenty of targets. One of the most prominent is the 2015 Paris Agreement goal of limiting global warming to 1.5 degrees Celsius above pre-industrial levels. During the United Nations Climate Conference (COP26) in Glasgow, many nations and corporations updated their carbon neutrality targets. Then there are the 17 Sustainable Development Goals (SDGs). There are actually 169 objectives within these broad categories, making it a very ambitious, though certainly needed project.

But there’s another goal-centered product earning the attention of sustainability-oriented investors recently: target-date funds. There’s no question why they remain immensely popular some 30 years after their debut. Their convenience and low maintenance fit particularly well with retirement accounts. The problem is that an asset-allocation formula can mean less oversight of individual investments. Most target-date funds shift the weightings of different asset classes on a fixed glide path without paying attention to the markets. They might add more bonds when interest rates are rising or sell stocks after market prices have plummeted. Of course, active investment managers do not possess a crystal ball, but they can adjust when an unforeseen event arises or when attractive opportunities present themselves.

The emergence of the Environmental, Social and Governance (ESG) movement has brought a new criticism to target-date vehicles. For one, the vast majority do not report how many of the underlying investments have formally incorporated ESG analysis. But more troubling is the perception that a portfolio’s gradual shift from equities to fixed income and cash lowers all risk. In theory, rebalancing a fund from aggressive investments to less-volatile ones has tended to preserve capital. But material ESG risks don’t disappear simply because a fund has more of a company’s bonds than of its stocks. If a business treats its employees, customers or the environment poorly, the potential legal liability or brand destruction won’t discriminate between asset classes. And if a target-date fund only vets a few of its underlying holdings for these long-term risks, one should question what additional issues exist in the rest of its portfolio.

Engagement model portfolios, only recently introduced in the market, offer a potential solution to this shortfall in the retirement space. They are built from the ground up with the incorporation of ESG factors across all asset classes. Proactive interaction with a company’s board and management on sustainability in addition to traditional financial concerns provides a powerful tool in the long-term holistic evaluation of an investment. Crucially, this means that any asset class involving a corporation or entity, be it stocks or bonds, are being actively engaged by stewardship specialists. And just as important, because effective engagement is ongoing, it is naturally aligned with the mechanics of a target-date fund.

As 401(k) and other retirement plans expand to offer more ESG-oriented options, the key will be to understand their ingredients fully. This subject has increased in relevance now that the Department of Labor has proposed new guidance making it easier for fiduciaries to consider these factors when selecting investments. The degree of transparency of ESG integration and the amount of engagement activity will determine the future leaders in this critical and evolving space. It’s all about reducing risk and helping investors reach their goals—the most important targets of all.