Thoughts About ESG Investing in Your 401(k) Plan: The Problem Is Choice (Pop Culture Nod to the Matrix)
ESG stands for “environmental, social and corporate governance”. In very broad strokes, ESG consists of criteria used to measure a company’s socially responsible behavior. Although the contours of ESG are still vague, there are various concrete factors that fall within each of these three categories, such as carbon emissions (E), diversity and inclusion (S) and board structure and transparency (G), to name just a few examples.
In the private pension and retirement world, ESG is somewhat controversial. Our federal pension law (ERISA) tasks fiduciaries to make prudent investment decisions solely with plan participants’ financial best interests in mind. Said differently, investment decisions should take into account only factors that relate to risk/return. Factors that may reflect broad social concerns should not be taken into account if they do not ultimately correlate to risk/return. As presidential administrations have changed over the past twenty years, we have experienced a sort of regulatory ping pong, with Republican administrations expressing skepticism that socially responsible investing can be achieved while adhering to ERISA’s standards of prudence, and Democratic administrations being more receptive to the notion that social responsibility and prudence are not mutually exclusive.
The latest regulations proposed by the Department of Labor are the most overtly receptive, and they attempt to remove any chilling effect on ESG wrought by guidance under prior administrations. They reiterate the long-standing requirement under ERISA that “a fiduciary may not subordinate the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to other objectives, and may not sacrifice investment return or take on additional investment risk to promote benefits or goals unrelated to interests of the participants and beneficiaries in their retirement income or financial benefits under the plan.” However, the DOL further states that a plan fiduciary can consider ESG factors in selecting an investment when such factors are material to the risk-return analysis. ESG factors can be considered alongside other material factors and should be given appropriate weight. The DOL points to carbon emissions as a case in point, suggesting that investors should be looking at emissions from a financial risk perspective.
So, the key takeaway is that ESG factors can be relevant to risk/return. But, will risk/return actually be the driving factor behind most fiduciary decisions involving ESG? Generally, 401(k) participants who ask about ESG fund alternatives want the freedom to choose to be socially responsible. Thus, the starting point in any conversation about ESG is often framed in terms of choice, which inevitably results in the addition of a new “choice” – a fund with an ESG label. However, if we conceptualize ESG as connected to risk/return, why would we stop at one choice? Why isn’t the responsible fiduciary assessing ESG factors across the 401(k)’s investment platform as a whole? Is it really wise to add a single ESG choice that could conceivably encourage participants to put all their eggs into one basket (usually, a large cap equity fund with an ESG label) because it makes them feel socially responsible? Therein lies the problem. ESG is not a fund category within the risk/return spectrum. It is not specific to equities or bonds or large/mid/small cap stocks or growth or value stocks. Rather, ESG attributes can exist broadly across all investments along the spectrum.
There are many more questions here than answers. What is an ESG rating, anyway? Is there a distinct weighting given to E vs. S vs. G or are they all the same weighting? If a fund invests in emerging markets and get high marks for choosing mining companies that have good underlying corporate governance, does that mean anything to the average 401(k) participant who may be interested in climate change? We don’t have answers to any of these questions, but these are the questions fiduciaries need to be asking as they start to incorporate ESG into their investment decisions.