ESG Investing

ESG Investments Make Inroads in 401(k) Plans, but Hurdles Remain


Growth in ESG investment has seen the sector rise to more than $21 billion in the first quarter of 2021 alone, up from $51 billion for all of 2020. Yet the typical 401(k) plan keeps these investments at arm’s length—if not a 10-foot pole’s. Many reasons can account for the general exclusion of ESG factors in retirement planning, including a lack of education, perceptions of fiduciary obligations, and the ebb and flow of political tides.

As renewed support at the federal level puts wind at ESG’s back and encourages shifting investments in 401(k) plans into sustainable funds, impact investors can help widen the embrace.

Change from the Top

The US Department of Labor <a title="DOL Proposes proposed rules in October directed at making it easier for fiduciaries to include ESG factors in their decision-making, even allowing such funds to be the default setting. In fact, the proposed rules also included language blessing ESG and social good factors as potential tiebreakers in cases where two investments have similar risk and return profiles.

This is a particularly important change, as the typical 401(k) plan eschews ESG. In fact, fewer than 3% of 401(k) plans had an ESG option in 2019, representing 0.1% of plan assets. This is true despite the fact that assets using ESG factors now account for more than one-third of private US assets under management. Furthermore, 69% of 401(k) plan participants said they would or might boost their plan contributions if they had ESG options.

In addition to new DOL rules, legislators and advocates have taken steps to protect sustainable options in 401(k)s.

Fiduciary Responsibility and ESG

The reluctance thus far to incorporate ESG in 401(k) plans stems, in large part, from concerns about fiduciary responsibility. The Employee Retirement Income Security Act of 1974 (ERISA) requires that retirement plan administrators act solely in the interest of plan participants. As a result, ESG investments can be considered only if they are expected to perform as well or better than other options with comparable risk levels.

Many plans have feared that ESG funds could represent a breach of fiduciary responsibility, as there is no global standard for defining and measuring ESG performance. That gap has led to confusion about how best to assess potential investments and generally understand fiduciary duty and ESG Investing.

Meanwhile, seesawing guidance from the Department of Labor over the past few administrations regarding the inclusion of ESG funds in private sector pension plans has not built confidence. The Trump administration adopted two rules that would have hampered the inclusion of ESG options, reversing earlier efforts by President Barack Obama. These were then changed once more by the Biden administration.

Few Target-Date Funds

Fiduciaries have also been reluctant to include ESG options due to questions over target-date funds, which are designed to address different retirement horizons. Although these funds have typically comprised the default investment choice for 401(k) participants, plan sponsors generally prefer selecting options that have five-year track records, as such funds better meet the criteria for fiduciary responsibility in their thinking. However, few ESG funds have been around that long. The oldest fund, Natixis Sustainable Future funds, launched in 2017; BlackRock introduced a target-date ESG option only last year.

A Shifting Tide

In addition to new DOL rules, legislators and advocates have taken steps to protect sustainable options in 401(k)s. For example, bills pending in the US House and Senate would give participants in ERISA-regulated retirement plans the right to choose a sustainable investment option.

Another sign of shifting tides came in the form of a paper from the Defined Contribution Institutional Investment Association; published before the Biden Administration’s proposal loosening previous restrictions, it suggests “tactical steps” plan sponsors can take to incorporate ESG investing into 401(k)s even in the face of regulatory seesawing. “The regulatory approach toward sustainable investing may shift in the future,” the paper concludes. “However, if plan sponsors continue to demonstrably put plan participants’ economic benefits first, plans can be compliant even with current more stringent regulations.”

The paper’s recommendations included defining sustainability in 401(k) plan documents, adopting methods to measure and track sustainable investments that are consistent with the approach used for evaluating other investment options, and consulting with lawyers and investment experts when assessing ESG options.

Disclosure Standards and Inflows

Moves made in the fall to set global standards for ESG disclosure could also go a long way toward addressing fears held among some fiduciaries that there is no clear way to assess potential investments. The IFRS Foundation, an influential global not-for-profit organization established to develop and promote a single set of high-quality and enforceable accounting and sustainability disclosure standards, announced an important effort in early November: the formation of the new International Sustainability Standards Board to develop disclosure standards. Its goal is to build the foundation for global sustainability disclosure standards for financial markets.

At the same time, asset managers report an increased flow of investments from 401(k) plans into sustainable funds, according to Barron’s. Next year, the federal government’s $760 billion Thrift Savings Plan will begin offering ESG funds to federal employees and service members. “This is a sea change,” says CEO Trillium Asset Management Matt Patsky in the Barron’s article. “We’ve opened the floodgates to people feeling safe to select ESG options for retirement plans broadly.”

There is no straight path for ESG investing as it finds a place for itself in retirement planning. However, regulatory updates and rising standardization indicate that there may yet be a role for ESG funds for investors as they prepare for a better, more secure future—both the world’s and their own.

Any company, security, fund or other investment identified herein is provided solely for illustrative purposes and should not be construed as a recommendation or solicitation for the purchase or sale of any such investment.

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