The US Department of Labor has made it easier for American workers to invest in permanent funds in their 401(k) plans. The new law, which was finalized in November, makes it clear that those who manage 401(k) plans can take into account environmental, social and corporate governance factors and approaches, including climate-related risks. Employers sponsoring 401(k) plans should start thinking about how ESG can be addressed in their plan menu construction and how to address participants’ questions about sustainable investing.
Research shows that retirement plan participants are looking for permanent fund options included in their 401(k) menu and will increase their contribution rates if they have such options.
In the Schroders 2022 US Retirement Survey, for example, 87% of plan participants want their investments to match their value, and 78% believe that ESG-focused companies will perform better over time than others. And 74% said they would raise or increase their overall 401(k) contribution rate if ESG options were offered. These results suggest that having ESG options on the plan menu improves retirement preparedness for many participants.
The new rule states that those responsible for administering 401(k) plans may consider ESG factors as part of their fiduciary responsibility to plan participants. That means, for example, they may want funds in the lineup to consider climate risk and other ESG issues as part of their regular investment process.
Furthermore, the Labor Department rule makes clear that plan managers can choose sustainable funds that seek to provide impact benefits beyond financial returns by avoiding investments in companies that produce negative results or focusing on investments that produce positive results for people and the planet. . These funds may be selected as long as their risk-adjusted return profile is comparable to other funds investing in the same asset or sub-asset class. For example, a core large-cap ESG fund should have a competitive performance profile compared to core large-cap funds. In that case, a plan can choose an ESG fund. The regulation allows plans to allocate ESG funds as a default option for participants who do not want to choose their own funds.
Although the Department of Labor has removed regulatory barriers to putting permanent funds on 401(k) menus, it will take time for many 401(k) plans to add permanent funds to their lineups. And we’re starting at the low end: Only 13 percent of plans for which Vanguard serves as a plan administrator currently offer sustainable options.
What to think about when adding ESG to your 401(k) plan
If you’re a plan administrator making investment menu and default selection decisions, consider these three steps to integrating ESG issues into your 401(k) plan:
1. Require all funds on the menu to consider climate and other ESG-related risks
A scheme may now require all funds in its portfolio to at least consider climate and ESG-related risks, even those that do not sell as ESG or sustainable funds. To do this, plans should evaluate each fund on their menu by asking these three questions:
- Is the fund company/asset manager that manages the fund a signatory to the Principles of Responsible Investment? Signing up to the six principles is an indication of a firm’s commitment to integrating ESG analysis into its overall investment process. In the year As of November, there are 4,000 asset managers worldwide and nearly 1,000 based in the United States who are PRI signatories, so there is plenty of money for plans from these asset managers.
- Can the fund itself explain and demonstrate how ESG analysis is considered in the investment process? ESG need not be a central feature of the fund, but the funds on the menu should consider ESG factors and explain how they do so.
- Does the currency have a durability rating of 3 Globes or more? The “Globe” rating is a measure of the ESG risks in the fund’s portfolio relative to the fund’s peer group. A sustainability rating of 3 or higher excludes the third category of funds – those with high ESG risk.
These are reasonable requirements for plans that want to apply minimum ESG standards to funds on their menu. They are intended to exclude funds that make little to no effort to address ESG issues. Even if plans want to continue offering funds that don’t consider ESG, they should be willing to inform their participants how each fund in the menu answers these three basic questions.
2. Consider ESG as a default option
When participants don’t want to make their own funding decisions, their contributions are cut to a designated “default option.” Most default options are target-date funds, which are mutual funds (called “funds of funds”) that allocate assets based on when the participant will retire and make adjustments as retirement approaches. Target date funds may be mutual funds or mutual investment trusts put together specifically for the plan.
Target-date funds are an attractive choice for many plan participants, as they don’t need to make decisions about stock/bond allocations and fund choices, so they may have little interest or knowledge. When a target-date fund approaches retirement, participants don’t have to worry about making adjustments to a more conservative stock/bond allocation because the target-date fund does it automatically.
Balanced funds, typically with a real estate allocation of 60% stocks and 40% bonds, can also be default options. And some plans offer professional management as default, where a third party builds a personalized target-date portfolio for participants from the funds on the menu. (Morningstar has such a service called 401(k) Retirement Manager.)
Regardless of the specific default option, plans can apply the same three basic requirements listed above—PRI signatory, how ESG is part of the investment process, and a minimum level of sustainability—in their default option.
Or a plan may designate a permanent fund as a default option. This can be done by using existing sustainable target date funds, creating a mutual investment trust or designating a traditional sustainable balanced fund as the plan’s default option.
3. Add permanent funds to the menu
The new law allows for the addition of sustainable funds that seek to provide impact benefits beyond financial returns, either by avoiding investments in companies that create negative results or by focusing on investments that bring positive results to people and the planet. When choosing such funds, a scheme must first ensure that it meets the same financial criteria as required for any similar fund.
Many sustainable funds can make the cut. As of November, 54% of sustainable funds had three-year consecutive annualized returns in the top half of the Morning Star category, although most of these funds had a 2010 loss. Annual returns in the top half of their respective categories. Although only 143 sustainable funds have a 10-year track record, 55% have annualized returns over the past decade, ranking in the top half of their category. In general, it should not be difficult to find suitable candidates for inclusion in the plans.
Most 401(k) plans currently offer only one ESG fund on their menu, typically a large-cap equity fund. If you have such a fund in your plan and want to allocate to it, make sure you lower your exposure to other large-mix equity options so you don’t inadvertently add to that market segment.
Best practice for schemes should be to allow participants to meet their desired stock/bond asset allocation using ESG funds. This means that at least schemes must offer a sustainable balanced fund or combine a sustainable equity fund with a sustainable bond fund.
A better course of action is to add sustainable target-date funds. For some plans, especially those that are just getting started, the perpetual target date series can be used as a default option. For plans that already have target-date series as a default option, target-date funds can be placed alongside it as a participant’s preferred option. This requires participants to make a positive decision for the perpetual target-date fund, but they will receive the same allocation benefits over time as they would in a conventional target-date fund.
Currently, there are only two target-date fund series: Natixis Sustainable Futures and BlackRock LifePath ESG Index. Natixis’ sustainable futures funds rank in the top half of their categories over three years and in the top quarter over five years, so they’ve performed well. Morningstar Analysts achieve independent status, primarily because they rely on a small asset allocation team that works on most target series dates and not all of their underlying funds are ESG-focused.
The BlackRock LifePath ESG Index Target Date Series of funds does not have a three-year track record or Morningstar analyst coverage, but shares a group and asset allocation slide path with the traditional BlackRock LifePath index series, which earns a Morningstar analyst gold rating. On top of its creative team and top-notch resources. The underlying components, however, are not all sustainable funds and take a light-touch, passive “ESG-aware” approach.
In February 2023, Putnam Investments will rebrand its Putnam Retirement Target Date Series as Putnam Sustainable Retirement Funds, focusing on sustainability or employing ESG principles and strategies.
As demand grows, expect more ongoing Target Day series to be launched or renewed from existing series.
In general, if you are an employer and a plan sponsor, now is the time to think about how you will address ESG factors in your plan, especially if you are likely to receive specific questions from plan participants. In addition to ESG encouraging participants to save more for retirement, the Schroders survey reported that a large number of respondents (40%) said that having ESG options in their plans “improves their perception of their employers”. This suggests that many plans should be proactive rather than waiting for participant requests.