Should ESG investment options be included in your company’s 401(k)?

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With the swearing in of each new administration, regulatory changes follow. One of the most recent changes to come from the Biden administration is the Department of Labor’s new proposed rule for retirement accounts involving environmental, social, and governance (ESG) funds. The change would block the previous administration’s proposed rule that plan fiduciaries can only consider investment-related factors, such as risk and return, when selecting investment options in 401(k)s or other Employee Retirement Income Security Act (or ERISA) plans.

The Department of Labor’s new rule for retirement accounts now allows fiduciaries to consider other factors, such as ESG-focused funds, when selecting investment options. This, however, doesn’t change the core requirements of ERISA plan fiduciaries. Their duties of prudence and loyalty to plan participants are still intact, and they must focus on material risk-return factors. Plan fiduciaries can’t sacrifice investment returns or take on additional investment risk unrelated to the provisions of benefits under the plan.

The new rule makes it clear that ESG investment options could be considered by fiduciaries. The Biden administration believes that because of the long-term effects on capital markets, fiduciaries who are considering a long-term investment horizon should be allowed to take into account the effects of climate change and other environmental and social factors with their investment choices. Of course, there are plenty of investors to support such a move.

Weighing the pros and cons of ESG investing in retirement accounts

According to Morningstar, sustainable funds attracted a record number of new assets in 2019 alone. What’s more, 72% of people in the U.S. have at least a moderate desire to invest more sustainably. Providing retirement plan participants with ESG investment options is an opportunity to cater to this growing group of investors.

Contributing to ESG investment funds is not only about portfolio growth for investors, but also playing a part in combatting climate change, social injustice, gender inequality, and similar issues. The long-term advantages of this investing style include extending the benefit of business growth and wealth to all relevant stakeholders rather than shareholders alone. Because of this, allowing ESG investment options in a company’s 401(k) could improve the overall employee retirement account experience — potentially increasing employee satisfaction and retention rates in the process.

More than just an attractive option for value-based investors, ESG investment funds are profitable. In fact, ESG fund performance has recently surpassed that of non-ESG portfolios, providing better returns for investors. Time will tell, however, whether this indicates a long-term trend.

Regardless, as with any investment strategy, ESG-focused funds have downsides. For one, many employees might not fully understand the differences between ESG investment options and non-ESG funds. Contributing to ESG investment funds could provide a different risk and return profile compared to non-ESG counterparts. When introducing or offering this investment option, education will be key for workers to make informed decisions about their employee retirement accounts.

Beyond that, ESG-focused funds sometimes exclude certain industries or companies. Although the exclusions might fall in line with the values of many investors, this can increase the risk of their portfolios — and even more so if the fund’s entire investment strategy focuses on a single sector. Diversification will be a crucial component to ESG fund performance, just like any other fund. In addition, a solely ESG-focused fund would be difficult to justify as a default fund for employers and employees.

Incorporating ESG-focused funds in employee retirement accounts

Regardless of the pros and cons of ESG investing for employee retirement accounts, ESG investment funds are much like any other fund. As such, they should be subject to the same processes when offered to employees. Refer to the plan’s investment policy statement (or IPS), which will outline those processes if your participants decide to embrace ESG investing.

For my clients, I make sure two standards are met prior to inclusion. First, the fund should be in line with clients’ IPS — in other words, I ensure it’s a low-cost, diversified, process-oriented fund with a sizable asset base and at least a three- to five-year track record. If a fund doesn’t meet that standard, I don’t include it in my clients’ lineup.

Second, I look at participant demand. ESG-focused funds are still new. As such, offering this option to all employee populations doesn’t always make sense. I have clients who’ve asked for the option and understand the nuances between ESG and non-ESG funds. In those instances, I felt comfortable reviewing with the plan fiduciaries and then adding certain funds (provided they met the IPS). Always be sure to meet with plan fiduciaries before deciding to add ESG-focused funds.

Despite the Department of Labor’s new rules for retirement accounts, ERISA law still calls for a documented process when introducing funds. More importantly, you should be acutely aware of how much we don’t know about ESG investment funds even now. Although they have improved greatly in the last few years, the amount and reliability of data surrounding ESG factors are still limited. With this in mind, it’s still important to use caution and do your research when expanding employee retirement account investment options to include ESG-focused funds.

Matt Baisden (CFA, QKA) is a retirement plan advisor at Plancorp, a full-service wealth management company serving companies and families in 44 states and managing more than $5.5 billion of client assets. Matt’s team specializes in 401(k)s for businesses, managing Department of Labor test issues, resolving service provider failures, benchmarking fees, and designing profit-sharing to maximize key employee benefits for clients.