Editorial Note: Forbes Advisor may earn a commission on sales made from partner links on this page, but that doesn’t affect our editors’ opinions or evaluations.
The Biden administration has proposed a rule that would make it easier for employer-sponsored retirement plans to offer funds that adhere to so-called environmental, social and governance (ESG) metrics.
The proposal is a departure from Trump administration policy, which blocked employers from considering social or environmental impact when selecting funds or auto-enrolling employees in retirement plans. The Biden administration’s move was cheered both by environmental activists who hope ESG funds can help curb carbon emissions (among other goals) and Wall Street firms that reap higher fees on ESG products than plain old index funds.
The policy proposal, announced on Oct. 13 by the Department of Labor (DOL), isn’t much of a surprise. Given that the Biden administration favors the ESG approach, plus the onslaught of inflows to ESG funds in recent years, the proposal almost seemed inevitable.
Nearly $18 billion streamed into ESG funds in the second quarter of 2021, according to Morningstar, following almost $21.5 billion in the first three months of the year, an all-time record.
“I’ve been shocked at the level of interest,” said Robert Gilliland of Houston-based Concenture Wealth Management, who estimated that 95% of prospective clients said that exposure to ESG funds is something they’d want or is at least nice to have.
With so much investor interest, it was only a matter of time before ESG investing took a more prominent position in the vast retirement space. A 2019 Plan Sponsor Council of America report found less than 3% of 401(k) plans provided an ESG fund.
Whether you should pin your retirement hopes on the promise of ESG, though, is a separate question.
The Case for ESG in Your 401(k)
There are two main arguments for ESG investing—and similar models like sustainable investing and impact investing. The first is that investors want to put their money into companies that do business in a way that improves the health of the planet and the welfare of the people on it. The second is that such practices will improve returns.
Rather than simply shunning sin stocks or avoiding certain types of business, for instance—an approach favored by socially responsible investing (SRI)—practitioners of ESG investing say that using environmental, social and governance metrics should lead investors to companies that perform well over time.
“A principal idea underlying the proposal is that climate change and other ESG factors can be financially material and when they are, considering them will inevitably lead to better long-term risk-adjusted returns, protecting the retirement savings of America’s workers,” said Acting Assistant Secretary for the Employee Benefits Security Administration Ali Khawar.
Jon Hale, a director on Morningstar’s ESG strategy team, agrees. In a recent article, he notes that this is about “investing in high-quality companies that understand the importance of incorporating greater focus on the material ESG issues facing their business and embedding sustainability in their long-term strategy.”
This framework can be boiled down to the very American axiom of “doing well by doing good.” Investors should reward companies who will lead to reduce carbon emissions, exhibit good corporate behavior and promote a diverse workforce, among other goals.
By doing so, the theory goes, they’ll be able to reap higher returns over time.
The Case Against ESG in Your 401(k)
There are a few problems with these arguments, however. First off, there’s mixed evidence that ESG or sustainable funds deliver outsized returns compared to the indexes whose performances are tracked in low-cost exchange-traded funds (ETFs) or mutual funds.
A recent paper by professors from NYU, Johns Hopkins University and The Wharton School analyzed roughly 1,400 studies published between 2015 and 2020 and found that “the financial performance of ESG investing has on average been indistinguishable from conventional investing.”
This isn’t terribly surprising. Studies show that it’s incredibly difficult to reliably pick stocks that outperform over time, which is why so many investing dollars go into funds that track a diversified index.
Between 2011 and 2020, according to Morningstar data, just 42% of the biggest 5,000 stocks ended up higher than they began, with another 36% down. The other fifth or so were either swallowed up by another company or are no longer in existence.
Moreover, ESG funds charge much higher fees than other passively traded index funds. For instance, the popular iShares ESG Aware MSCI USA (ESGU) has a 0.15% expense ratio, compared to the 0.03% for the iShares Core S&P 500 (IVV).
Sustainability proponents may counter that while some ESG funds are pretty expensive or don’t outperform, that isn’t true of all ESG funds. After all, it’s not as if every fund manager who purports to invest in undervalued companies does equally well or charges the same amount for their efforts.
That’s a fair point, but it doesn’t change the problem from the investor’s perspective. How are they to know which analysis is the right one?
Should You Invest in ESG Funds for Retirement?
While overall market demand for ESG assets has been strong in taxable investing, there’s been less for retirement dollars. For instance, the Employee Benefit Research Institute (EBRI) found in a 2020 survey that just 14% of participants said the most valuable improvement to their retirement savings plan would be the inclusion of ESG funds, trailing six other options.
It may be the case that investors are interested in ESG in their taxable brokerage accounts but aren’t particularly keen on upsetting the apple cart that will need to hold enough apples to get them through 30 years of retirement.
But attitudes can change. It wouldn’t be surprising if younger retirement savers who use robo-advisors felt perfectly fine putting their dollars into ESG funds, even if there’s a risk of underperformance or higher fees.
Here are three things to watch out for if you’re considering investing in ESG funds in your workplace retirement fund:
- Know Thyself. As Morningstar’s Hale alluded to, there’s no definitive ESG or sustainability metric. Environmental, social and governance are broad categories that mean different things to different people. For some it’s a short-hand for companies with low carbon footprints. But you’ll find Facebook in some big ESG funds, even after its problems with “corporate behavior.” Ask yourself if that’s something you’re comfortable with.
- Do Your Research. Given the rise of ESG investing, there are a plethora of options available to judge just how well a particular company or fund is holding to an ESG standard. For instance, MSCI has an easy-to-use tool that shows how well a particular company is doing on various ESG metrics, including climate. On a fund level, Morningstar offers sustainability ratings, with more globes equaling a better score. Make sure you do your research instead of blindly picking whatever ESG fund is offered by your retirement plan.
- Don’t Double Dip. It’s easy to imagine, said Gilliland, that someone might want to put a little bit of their retirement savings into an ESG fund and the rest in a S&P 500 ETF. The problem with that approach is that you may be compromising your diversification since there’s such a large overlap in funds. To help avoid that, you may want to employ a service like Blooom that will help you make sure you have an appropriate asset allocation for your age and risk tolerance.
Use Personal Capital’s Retirement Planner to calculate how much you would need to save for your retirement