Few 401 (k) plans have an ESG investment option. We asked the lawyers on each side to offer their best arguments as to why this should or shouldn’t change.
Investors are investing record amounts in mutual funds and exchange-traded funds that review their holdings based on environmental, social and governance (ESG) factors.
Chances are, however, that most people won’t find an ESG fund option in their 401 (k) retirement savings plan. According to the latest data from the Plan Sponsor Council of America, only 2.6% of 401 (k) plans had an ESG option in 2019.
Amid Wall Street lobbying this year, the Department of Labor opposed enforcing a Trump-era rule that would have made it harder to add ESG funds to retirement accounts. It remains to be seen whether and when more specific guidelines will come.
Proponents say there’s no good reason to keep ESG funds out of 401 (k) plans. Opponents say that adding such funds to 401 (k) s would be a breach of fiduciary responsibility as there is no global standard for defining and measuring ESG performance.
It is important to offer employees the opportunity to invest in environmental, social and governance (ESG) funds in their 401 (k) retirement plans. If individuals make it clear that they have the opportunity to invest this way, there is no good reason to deny them the opportunity to do so in their 401 (k) accounts.
The general demand for ESG investments is growing. According to fund researcher Morningstar Inc., record values of 51.1 billion US dollars flowed into sustainable US funds in 2020, more than double that of 2019 and almost ten times the total volume of 2018.
The argument that ESG funds only serve a “feel-good purpose” but do not generate adequate returns is a misunderstanding. Research that I have conducted with colleagues has shown that companies with good ratings on “financially material” ESG issues – that is, ESG issues relevant to the sector in which a company operates – deliver excellent stock returns. Similarly, an analysis by S&P found that from March 2020 through March 2021, 19 ESG exchange-traded funds and mutual funds with assets under management of more than $ 250 million outperformed the S&P 500 by 0.2-27.9 percentage points / p>
It’s clear that not only is ESG a real investment strategy, but the growing demand also means that adding such funds to 401 (k) lineups could attract even more people to join their employer-sponsored retirement plan.
However, choosing ESG funds wisely can be a challenge. There are many articles about « greenwashing » by companies that claim to be more environmentally friendly or sustainable than what their actual activities would attest. Among the ESG funds, there are those that are mandated to build sustainable portfolios, while others have just been renamed to the green wave.
Some critics say the lack of transparency in ESG funds is one reason these investments should be excluded from 401 (k) plans. I believe the opposite is true. Including ESG funds in 401 (k) plans would likely put pressure on fund companies and regulators to improve transparency, which would lead to long-awaited standards and reporting requirements on what makes an investment sustainable.
Fund managers and investment firms need to be more open about quantifying ESG goals and sustainability in the stocks and other assets in their portfolios. You must also make the fees you charge transparent and justify any premium. Just because fees for ESG funds have fallen in recent years, it doesn’t mean that fund managers can save on stock selection or communication of their investment strategy.
The regulators must also act by demanding more transparency, particularly with regard to the investment criteria of the fund managers. The United Nations Responsible Investment Principles (UNPRI), which requires signatories to submit an annual transparency report on their ESG investment practices, was a good first step. However, other research I did with a colleague found that few funds actually improved their ESG scores after joining UNPRI, while the rest were simply using their status to attract capital.
Somewhat more promising is the European Union’s Sustainable Finance Disclosure Regulation (SFDR), which lays down rules for sustainability-related information that financial companies must disclose. The U.S. The Securities and Exchange Commission is catching up quickly and is likely to take up ESG disclosure, if only for the simple fact that investors want and need these standards as a decision-making aid.
This is where 401 (k) plans can have a significant impact by including ESG funds in their investment decisions. Including ESG funds in 401 (k) plans would not only be a big step forward to make ESG even more mainstream and credible, but it would also increase the need for standards in this area. Not only would that be good for 401 (k) plans in determining the best fund selection, it also provides much-needed transparency for all investors looking to invest their money in ESG.
Prof. Yoon is Assistant Professor of Accounting & Information Management at the Kellogg School of Management at Northwestern University. He can be reached at [email protected].
When companies provide 401 (k) retirement accounts to their employees, they have a fiduciary responsibility to ensure that the funds offered under these plans are as they are described.
With some funds – for example passive funds that track the performance of indices like the S&P 500, Nasdaq-100 or Russell 2000 – this is quite easy. However, it is far less clear that funds that claim to advance environmental, social and governance (ESG) goals are actually achieving their goals.
The problem with ESG funds stems from the fact that there is no global standard for defining and measuring ESG performance, which has created a great deal of confusion. Therefore, including ESG funds in the mix of 401 (k) investment options would only exacerbate the investment challenge for the nearly two-thirds of people who say they don’t fully understand 401 (k) plans >
Granted, ESG investments are in high demand right now. According to a Bloomberg analysis, ESG assets under management worldwide could reach $ 53 trillion by 2025, which is more than a third of the projected global assets under management of $ 141 trillion. In the US, a report by Morningstar Inc. showed that capital inflows into ESG funds reached $ 51.1 billion in 2020 – more than double the inflows of $ 21.4 billion in 2019 and 24% of total inflows into US equity and pension funds over the past year.
With more attention being paid to ESG investing, it is logical to assume that participants in the 401 (k) plan would find such investment options attractive. The danger, however, is that they equate popularity with outperformance, and that’s just not the case. There is evidence that ESG funds perform as well on average and on a risk-adjusted basis as their benchmarks – but neither better nor worse.
At the same time, ESG funds tend to be more expensive than other funds. According to another Morningstar study, the asset-weighted average expense ratio of US ESG funds was 0.61% in 2020, compared to 0.41% for all US open-ended mutual funds and ETFs.
Even small differences in the expense ratio can add up over time. For example, I calculated that an investment portfolio of $ 100,000 with an annual return of 8% over 30 years would grow to about $ 898,000 at an expense ratio of 0.41%, compared to about $ 849,000 with an expense ratio of 0, 61% – a difference of $ 49,000.
This begs the question: If ESG funds do not outperform on average but are more expensive than other funds, what are investors paying for?
Even those willing to pay extra for sustainability and a “green” agenda cannot be sure that ESG funds will do that too. The question is, does a highly rated ESG company actually have a sustainable impact on the environment or society “is a company really doing good” by pursuing sustainability while trying to “do well” financially? This distinctiveness problem is exacerbated when stocks are aggregated into funds and then across the funds themselves.
It is difficult to determine if a stock or fund is really driving ESG goals because the investment industry lacks a comprehensive framework for measuring ESG. There are attempts to clarify things like the Sustainable Finance Disclosure Regulation (SFDR) in Europe, which requires investment managers to explain how they consider ESG and other factors as part of their portfolio selection process. However, no such criteria have been implemented in the US and beyond, leaving investors wondering about the sustainability of their investments – and whether this pursuit of sustainability improves performance.
With this in mind, do companies really want to offer their employees ESG funds in their 401 (k) retirement accounts? At the moment, ESG investing seems to be more of a fad than a rational investment option. Given the ongoing confusion and lack of clarity about what ESG investing is, and its impact on fund performance and the ESG impact, this appears to violate a company’s fiduciary responsibility to its 401 (k) members.
Prof. Braun is the clinical professor of finance and vice chairman of finance at the Kellogg School of Management at Northwestern University. He can be reached at [email protected].
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