3 Steps to Integrating ESG Into 401(k) Plans

The U.S. Department of Labor has just made it easier for American workers to invest in sustainable funds in their 401(k) plans. The new rule, finalized in November, makes clear that those who run 401(k) plans can consider environmental, social, and corporate governance factors and approaches, including climate-related risks. Employers who sponsor 401(k) plans need to start thinking about how ESG figures into their plan menu construction and how to address requests from participants interested in sustainable investing.

Surveys suggest that retirement plan participants want sustainable fund options included on their 401(k) menus and would increase their contribution rates if they had such options.

In Schroders 2022 US Retirement Survey, for example, 87% of plan participants said they want their investments to be aligned with their values, 78% said they believe companies that are ESG-focused will have better results over time than those that are not, and 74% said they would or might increase their overall 401(k) contribution rate if offered ESG options. These results suggest that having ESG options on a plan menu can improve retirement readiness for many participants.

The new rule says 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 can require the funds in their lineup to consider climate risk and other material ESG issues as part of their regular investment process.

Beyond that, the Labor Department rule makes clear that plan administrators may select sustainable funds that seek to deliver impact benefits beyond financial returns, either by avoiding investments in companies that produce negative outcomes or by emphasizing investments in those that produce positive outcomes for people and planet. Such funds may be selected so long as their risk-adjusted return profile is in line with those of other funds investing in the same asset or subasset class. For example, a core large-cap ESG fund would need to have a competitive performance profile compared with core large-cap funds overall. That being the case, a plan can choose the ESG fund. The rule also allows plans to designate ESG funds as the default option for participants who don’t want to select funds on their own.

Even though the Labor Department has removed the regulatory obstacles to putting sustainable funds on 401(k) menus, it will take time for many 401(k) plans to add sustainable funds to their lineups. And we’re starting from a low base: Vanguard estimates only 13% of plans for which it serves as plan administrator currently offer sustainable options.

What to Think About When Adding ESG to Your 401(k) Plan

If you are a plan administrator who makes decisions about the investment menu and default option, consider these three steps to integrate ESG considerations into your 401(k) plan:

1. Require all funds on the menu to consider climate and other ESG-related risks

A plan may now require all funds on its menu to at least consider climate and other ESG-related risks, even those that are not explicitly marketed as ESG or sustainable funds. To do this, plans should evaluate every fund on their menus by asking these three questions:

• Is the fund company/asset manager that runs the fund a signatory to the Principles for Responsible Investment? Signing on to the six principles is an indication of a firm’s commitment to integrating ESG analysis into its overall investment process. As of November, 4,000 asset managers globally and nearly 1,000 based in the United States are PRI signatories, so there are plenty of funds from these asset managers for plans to consider.
• Can the fund itself explain and demonstrate how ESG analysis is considered in its investment process? ESG need not be required to be a central feature of the fund, but funds on the menu should consider ESG factors and explain how they do so.
• Does the fund have a Morningstar Sustainability Rating of 3 globes or higher? The “globe” rating is a measure of the ESG risks in a fund’s portfolio relative to the fund’s peer group. Requiring a Sustainability Rating of 3 or higher excludes the bottom third of funds in a category—those with the highest level of ESG risk.

These are reasonable requirements for plans that want to implement minimum ESG standards for funds on their menu. They are intended to exclude funds that are making little-to-no effort to address ESG issues. Even if plans wish to continue offering funds that don’t consider ESG, they should be willing to inform their participants about how each fund on the menu has answered these three basic questions.

2. Consider ESG for the Default Option

When participants do not wish to make their fund-allocation decisions themselves, their contributions are defaulted into a designated “default option.” Most default options are target-date funds, which are a collection of funds (called “funds of funds”) that base their asset allocation on the participant’s time to retirement and make adjustments as retirement draws nearer. Target-date funds may be mutual funds or collective investment trusts put together specifically for the plan.

Target-date funds are attractive choices for many plan participants, as they do not have to make decisions regarding stock/bond allocations and fund selection about which they may have little interest or expertise. Participants don’t have to worry about making adjustments to more conservative stock/bond allocations as they near retirement because the target-date fund does so automatically.

Balanced funds, which have a static asset allocation that is typically 60% stocks and 40% bonds, can also be default options. And some plans offer professional management as the default, in which a third party constructs, in effect, 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 type of default option, plans can apply the same three basic requirements outlined above—PRI signatory, show how ESG is part of the investment process, and minimum Sustainability Rating—to their default option.

Or a plan can designate a sustainable fund as a default option. This can be done by using existing sustainable target-date funds, by creating a collective investment trust, or by designating a traditional sustainable balanced fund as the plan’s default option.

3. Add Sustainable Funds to the Menu

The new rule allows the addition of sustainable funds that seek to deliver impact benefits beyond financial returns, either by avoiding investments in companies that produce negative outcomes or by emphasizing investments in those that produce positive outcomes for people and planet. In selecting such funds, a plan must first make sure they meet the same financial criteria as it requires for any similar fund.

Many sustainable funds will likely make the cut. Through November, 54% of sustainable funds have three-year trailing annualized returns that rank in the top half of their Morningstar Category, despite many of these funds having underperformed so far in 2022. Over the trailing five years, 62% of sustainable funds have annualized returns that place in the top half of their category. And though only 143 sustainable funds have 10-year records, 55% of them have annualized returns over the past decade that rank in the top half of their category. In general, it should not be difficult to find appropriate candidates for inclusion in plans.

Most 401(k) plans that currently have an ESG fund on their menu offer only one fund, typically a large-blend equity fund. If you have such a fund in your plan and want to allocate to it, be sure to lower your exposure to other large-blend equity options, lest you inadvertently overweight that portion of the market.

Best practice for plans should be to allow participants to meet their desired stock/bond asset allocation using ESG funds. That means, at minimum, plans should offer a sustainable balanced fund or should pair a sustainable equity fund with a sustainable bond fund.

The better course of action would be to add sustainable target-date funds. For some plans, especially those just getting started, the sustainable target-date series could serve as the default option. For plans that already have a target-date series as their default option, the target-date fund could sit alongside as a participant-selected option. This would require participants to make an affirmative decision for the sustainable target-date fund, but they would then receive the same allocation benefits over time as they would in a conventional target-date fund.

Currently, only two target-date fund series exist, Natixis Sustainable Future and BlackRock LifePath ESG Index. Natixis Sustainable Future funds typically place in the top half of their categories over three years and top quartile over five years, so they have performed well. They earn a Morningstar Analyst Rating of Neutral, largely because they rely on a smaller asset-allocation team than do most target-date series, and not all of their underlying funds are ESG-focused.

The BlackRock LifePath ESG Index target-date series of funds lacks a three-year record or Morningstar analyst coverage, but it shares a team and asset-allocation glide path with the conventional BlackRock LifePath Index series, which earns a Morningstar Analyst Rating of Gold based on its innovative team and topnotch resources. Its underlying components, however, are not all sustainable funds and the ones that are take a light-touch, passive “ESG-aware” approach.

In February 2023, Putnam Investments will reposition its Putnam RetirementReady Funds target-date series as the Putnam Sustainable Retirement Funds, employing sustainability-focused or ESG principles and strategies.

As demand grows, expect more sustainable target-date series to be launched or repurposed from existing series.

In sum, if you are an employer and plan sponsor, now is the time to be thinking of how you are going to address ESG factors in your plan, particularly if you are likely to get specific requests to do so from plan participants. In addition to ESG being a catalyst for participants to save more for retirement, the Schroders survey reported that a significant number of respondents (40%) said that having ESG options available in their plans “would improve how they view their employer.” This suggests that many plans should be proactive rather than wait for participant requests.