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The ESG Fight in a Big Retirement Plan

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The government’s Thrift Savings Plan has a new feature that allows investors to choose ESG funds. It’s controversial.

Illustration by Ana Yael for Studio Pi

The Thrift Savings Plan may be the most important investor you’ve never heard of. The retirement plan, which serves 6.5 million federal employees, including civil servants and the military, had $762 billion in assets as of March 31.

It’s little wonder, then, that the Department of Labor—which wants private-sector retirement plan sponsors to consider climate and other environmental, social, and governance, or ESG, risks in their fund selections—wants the TSP to consider them, too. Yet because the TSP is under a different regulatory regime, political friction has emerged around the issue.

In February, the DOL’s Employee Benefits Security Administration published a request for public feedback on “Possible Agency Actions to Protect Life Savings and Pensions from Threats of Climate-Related Financial Risk.” In it, the DOL asks some pointed questions about the TSP’s investment options and its governing board, the Federal Retirement Thrift Investment Board, or FRTIB, including: “The TSP’s fund offerings rely on passive index investing.…What analysis could FRTIB undertake to inform whether other possible indexes may better take into account the risks posed by climate change?”

Meanwhile, eight Republican members of Congress—all of whom have received campaign contributions from the fossil-fuel industry in the past—introduced the No ESG at TSP Act in May. They’re opposed to the TSP’s new “mutual fund window,” similar to a brokerage option, which allows participants to invest in some 5,000 different funds outside the plan, including some ESG funds. Rep. Chip Roy (R., Texas) claims that ESG “undermines U.S. energy freedom to the benefit of our enemies,” and wants to prohibit ESG funds in the window.

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The window isn’t an attractive option for most investors, including ESG ones. It charges an annual $55 administrative fee, an annual $95 maintenance fee, and a per-trade fee of $28.75. Moreover, it is only accessible to participants with balances over $40,000, and they can’t contribute more than 25% of their TSP balance to it.

Unlike with private-sector retirement plans, the DOL doesn’t have the regulatory authority to make rules for the TSP; only Congress can. Yet the DOL is supposed to audit the TSP to see that it behaves as a fiduciary for participants. Fiduciaries must consider the potential risks to plan participants of various investment options and try to minimize those risks. The question then becomes whether the existing plan options adequately address climate-change risk. If they don’t, should the FRTIB tweak them or add a new ESG-friendly investment option?

The TSP currently offers five main plan options: a Treasury bond fund (G Fund), a bond index fund (F Fund), a large-cap stock index fund (C Fund); a small-cap index fund (S Fund), and an international index fund (I Fund). Participants can allocate to these funds at their own discretion or choose from 10 target-date “life cycle” funds (L Funds) consisting of combinations of the main funds.

Though any changes would affect millions of participants, the DOL has received only 139 letters in response to its information request. (The comment period ended May 16.) One of those letters, though, was from the FRTIB, which is pushing back against any suggested changes. First, it states that its role as a fiduciary is different from a private-sector one: “Most retirement plan fiduciaries have the discretionary authority to determine the number and type of investment funds that are available to their participants. The FRTIB, on the other hand, has no such authority. The number and types of investment options available to TSP participants are dictated by federal statute.”

It’s true that Congress approved the options currently in the TSP, and the TSP can’t add a new ESG option without congressional approval. But could the FRTIB recommend changing the existing index funds’ strategies to make them ESG-friendly?

According to the rules governing the TSP, the current funds in the plan must track indexes that are “commonly recognized” and a “reasonably complete representation” of the market. The FRTIB states: “While there are clearly ESG indexes, to date none of them rise to the level of a ‘commonly recognized’ index.”

Yet how widely recognized are the TSP’s existing indexes? The C Fund and the F Fund track the most popular indexes—the S&P 500 and the Bloomberg U.S. Aggregate Bond Index, respectively. But the S Fund tracks the Dow Jones U.S. Completion Total Stock Market Index for small-caps. That isn’t a commonly recognized index. One of the only funds to track it, Fidelity Extended Market Index (ticker: FSMAX), was downgraded by Morningstar from a Silver to a Bronze rating in August because: “The fund’s quirky index has a persistent growth tilt that has recently moved it into the mid-cap growth category.” That’s because the index holds stocks that the S&P 500 excludes, including some midsize-to-large tech ones.

“The statute [governing the TSP] says that we have to choose a widely recognized fund that is as representative of the market as possible,” says Kim Weaver, the FRTIB’s director of external affairs. “There, at the moment, is not any one widely recognized ESG fund because there are differing different views of what ESG is.”

Yet there are also different views as to what small-caps are—see the popular Russell 2000 and S&P SmallCap 600 indexes. There are also different definitions of international stocks, yet the TSP’s I Fund tracks an index that leaves out emerging markets such as India and China as well as small-to-midsize international stocks.

If the lack of completeness of market coverage is the argument against an ESG index, it’s worth noting that the S&P 500 has always left out certain large, important companies. For 45 years, the S&P 500 left out Berkshire Hathaway (BRK.B), which only joined the index after a 50-to-1 stock split in 2010. The index also waited years to include tech giants such as Tesla (TSLA), (AMZN), and Alphabet (GOOGL).

It’s worth noting that the S&P 500 and the MSCI USA Extended ESG Focus Index, which the $23 billion iShares ESG Aware MSCI USA (ESGU) tracks, have had virtually identical returns in the past five years—13.6% and 13.7% annualized, respectively.

One question that arises: If climate change is a financial risk, will returns be identical in the next 20 years?