While target-date funds have traditionally been a one-sized-fits-almost-all solution, innovation to integrate environmental, social and governance-oriented strategies into these funds is coming just as plan members are seeking more sustainable investing options.

“The vast majority of Canadians say ESG integration is important in their investing,” said Wylie Tollette, executive vice-president and head of client investment solutions at Franklin Templeton Investment Solutions Franklin Advisors Inc., during Benefits Canada’s Defined Contribution Investment Forum in January.

According to a recent poll by Franklin Templeton, 68 per cent of Canadian DC plan members said it’s important for them to have ESG-integrated options when making an investment decision. The idea of ESG target-date funds is relatively new in the global DC marketplace, he said, noting it’s still early for plan sponsors to customize their ESG preferences through those funds. “There hasn’t been a ton of innovation in the ESG space in the defined contribution landscape.”

Read: Is ESG in DC plans all talk and no action?

Integrating ESG into DC plan investments can lead to better risk-adjusted returns over the long term, added Tollette, noting companies that are proactively addressing ESG issues “may be better prepared to capture those future opportunities,” which will be reflected in their returns and share price.

ESG investing can also be a form of risk mitigation, he said, citing the devastating impacts of mining waste spills on communities and the environment in Brazil and India as an example. “Companies that deal with their mining waste effectively actually don’t suffer the same dramatically negative returns, because they don’t tend to suffer the degree of catastrophic events that we’ve seen.”

A sustainable investing lens can also take advantage of mis-pricing opportunities in the market, where companies that may not be appropriately recognized yet for their ESG activities are undervalued because the data around these risks and opportunities is not fully mature. “As data and disclosure becomes more prominent, their price will begin to reflect their actual activities.”

Read: More standards required for pension funds using ESG data, indices and scores

To incorporate sustainability into all stages of a target-date fund, Franklin Templeton integrated ESG considerations into long-term capital market expectations for Canada, the U.S., Asia-Pacific and other regions, by evaluating those economies’ reliance on fossil fuels and ability to transition to new sectors that could benefit from a low-carbon future. It also integrated them into the dynamic asset allocation portion of its target-date funds, which have a time horizon of one year. Finally, when selecting the building blocks to construct its target-date funds, the investment manager evaluates how its underlying managers incorporate ESG. 

However, bringing a sustainability lens to target-date funds isn’t without challenges, said Tolette. The numerous ratings firms in the ESG space often have widely different views of the same company. As an example, he noted that MSCI, S&P Global, Refinitiv and Sustainalytics have diverging views on Apple Inc.’s environmental scores alone. This disagreement has often led to charges of “greenwashing,” he added. “As an investor, this creates a real challenge because where there’s such huge discrepancies in data, there’s got to be both risk and opportunity baked into that.” 

Read more coverage from the 2022 Defined Contribution Investment Forum.