Less risk, more performance—it sounds like a spin on the classic Miller Lite slogan, “tastes great, less filling.” But it’s an approach to investing that has been working well for mutual funds employing environmental, social or governmental factor—so-called ESG investing.
The popularity of ESG investing has been rising quickly among institutional investors, and many observers have been looking to workplace retirement plans as the next big frontier of growth—until the U.S. Department of Labor stepped into the picture.
The DOL proposed a new rule this summer governing the use of mutual funds driven by ESG factors in 401(k) plans. The rule would require plan sponsors to demonstrate they are not sacrificing financial performance for participants by adding ESG funds. But that misses the point. A growing body of evidence suggests that using ESG factors can actually cut risk and boost performance.
The proposed rule takes square aim at the best chance for ESG funds to take root in 401(k) plans by forbidding plan sponsors to offer them as the default investment option in plans—most of which use a target-date fund that automatically reduces exposure to stocks as retirement approaches.
ESG isn’t much of a factor in 401(k) plans yet. In 2018, 2.9% of plans offered them, accounting for 0.1% of assets, according to the Plan Sponsor Council of America. But even a modest bump in those figures would be a big deal, considering the huge pool of assets sitting in workplace plans—they held a combined $7.9 trillion at the end of the first quarter this year, according to the Investment Company Institute.
Federal regulation on ESG in workplace plans has been a swinging pendulum for decades. “Going all the way back to the Clinton administration, there has been a series of sub-regulatory guidance with subtle nuances,” notes Melissa Kahn, a managing director and retirement policy strategist with State Street Global Advisors. “The underlying responsibility that plan sponsors have under ERISA has never changed—they must follow a prudent process and they have to keep the best interest of plan participants and long-term financial interests of the plan at the forefront.
“Under Democratic administrations, there's been a nuanced emphasis on being able to take ESG factors into account as part of a prudent process—if all else is equal, this can be a tie-breaker. But it’s gone back and forth between different administrations, and that has caused confusion.”
I asked Kahn if she thought that meant the current process is being driven by ideology. After a long pause, she said: “I would say that is an accurate statement.”
Considering the cautious, litigation-averse perspective plan sponsors take, the ongoing regulatory battle is likely to cool off interest in ESG in workplace plans for the foreseeable future—even if the proposed DOL rule doesn’t survive.
DOL has a strong incentive to finalize the rule this year—that was clear from the unusually short 30-day comment period allowed. If Donald Trump doesn’t win a second term, a Biden administration likely would try to unwind the rule—and that is easier to do if it is not final. Depending on the timeline, the rule could be overturned by Congress via the Congressional Review Act.
Pushback has been strong and broad-based. More than 1,000 comments have been filed, many of them critical. DOL is obliged to review and respond to all the comments, which have come from organized labor, public pension systems, state regulators, sustainability and environmental groups. Critical comments also have been filed by wealth managers, SIFMA, the CFA Institute, the American Bankers Association, the Investment Company Institute and the three largest plan administration companies—Vanguard, Fidelity Investments and T. Rowe Price.
A key critique of the proposed rule is that DOL misses the point of ESG by treating all social investing as though it were a single category.
The first wave of social investing was characterized by mutual funds with single themes, such as green investing, or exclusion (no fossil fuels or weapons). The earlier wave of funds often underperformed the market due to lack of broad exposure to market segments, high fees—or both.
ESG funds use ratings systems that score securities for their exposure to factors such as a company’s environmental impact, governance policies or how it treats employees or monitors its supply chains. The funds either underweight or eliminate securities that fund managers expect will have high risk associated with those factors, or tilt toward those that might have a positive impact.
Morningstar reports that during the extremely volatile first half of this year, 72% of ESG funds ranked in the top halves of their investment categories and that all 26 ESG index funds outperformed their conventional index-fund counterparts.
A second criticism is that the rule is too broad in its reach.
“If you read the preamble and the regulation, you see that the breadth of it is quite expansive,” says Kahn. “And even in the preamble, they talk about actively managed strategies in general, not just ESG—and the documentation requirements and the other types of requirements that plan sponsors are going to have to live by are quite onerous.”
A targeted prohibition
The rule would not prohibit use of ESG in 401(k) plans outright, but a key feature would have nearly the same effect. The rule would prohibit use of ESG funds as qualified default investment alternatives (QDIA) in plans. That’s a big deal because of two key trends among plan sponsors over the past decade: automatic enrollment of new workers and adoption of target date funds (TDFs) as their QDIA.
TDFs utilizing ESG factors have been slow to develop. The key player in the market so far is Natixis, which launched its Sustainable Future Funds target date series a little over three years ago. Sustainable Futures has established a strong investment record, and more than 100 plans have incorporated the funds, the company says.
Natixis stresses the business case for ESG funds, not a social argument. “They can be used to achieve a social or policy goal,” says Ed Farrington, head of retirement strategies at Natixis. “But we use these factors to improve our investment management process—it’s a more complete due diligence process before we deploy our capital.
And target date funds using ESG factors are especially relevant for younger workers, who are most likely to see the investment outcomes over time related to factors such as climate change and diversity in corporate management.
“We think these will be risks that show up in stock price over time,” he says.
Mark Miller is a journalist and author who writes about trends in retirement and aging. He is a columnist for Reuters and also contributes to Morningstar and the AARP magazine.