The topic of adding ESG investments inside of a 401k plans has been a popular topic as of late.
On March 10, 2021, the U.S. Department of Labor announced its endorsement of two rules which had been on hold under the Trump administration. The first rule that will not be administered by EBSA is restricting investors from relying on Environmental, Social, and Governance (ESG) criteria to evaluate the majority of retirement investing that could potentially lock out some ESG investments. The second rule being put off is not allowing voting for ESG criteria.
Despite the U.S. Government’s efforts to push ESG investing and more investors joining the bandwagon, it is slowly catching on mainly due to political and regulatory factors. From this outlook, the Biden administration is encouraging employers and employees to invest ESG funds in 401k plans.
As a consequence, it is also prompting companies to care more about climate change and other issues to draw in more investors who care about such values. As retirement plans consider ESG funds, it is important to understand what they are all about.
What Is an ESG Fund?
It is a kind of portfolio constituting bonds and equities which incorporates environmental, social, and governance factors.
For an organization or company to engage in ESG investing, they are evaluated by potential investors on environmental, social, and governance standards. How does the company manage environmental issues such as conservation, animal testing, and the use of energy? Does the firm have a value system for how it relates to its stakeholders and the surrounding community? And, how does it deal with corporate governance issues, transparency, and accountability in their financial reporting, participation of stakeholders, and voting rights?
Before an investor chooses to work with any company, they need to be assured of their values.
ESG, however, is not a new phenomenon, as it caught on in the mid-2000s when it was highlighted during the 2006 United Nation’s Principles for Responsible Investment (PRI ) report. The idea was to use ESG as a metric for measuring the financial performance of firms to grow sustainable investments.
How ESG Funds Work
They apply both passive and active investing. Active ESG funds involve investors actively engaging companies to improve their ESG practices. They choose funds that fit their set criteria. As for passive ESG funds, companies rely on index providers such as MSCI. The indexes point out the companies with high-level ESG scores.
Types of ESG Investments
These are the leading options:
- Environmental ESG investments: These are available to firms promoting renewable energy resources.
- Social ESG investments: It is limited to companies that have a good reputation for upholding labor and human rights.
- Corporate governance ESG investments: Every investment is evaluated under corporate governance standards.
Why Are They Becoming More Popular?
According to the American Retirement Association, a survey revealed that 72 % of Americans were considering ESG funds. This means firms and organizations have to start streamlining their operations and culture to apply the growing trend of sustainability investing. A company is now more than a profit-making machine but one that creates a positive impact on its partners, employees, the environment, and the community.
In 2020, there was an upsurge in ESG funds accounting for $51.1 billion from investors, double the previous year. Last year was a pivoting period for the whole of America dealing with significant social justice and environmental issues. In particular, investors were and are still keen on matters of climate change and racial and gender equality and put their money in institutions that applied ESG standards.
Overall, two reasons sum up why ESG funds are being taken up by more investors:
1. They promote common good
They focus on the commitment of a company to vital issues such as the environment and social justice. Companies are now rating themselves on how much they can impact communities by giving back. This draws in the majority of people, especially when matching values. Its main attractive quality is doing well while making profits.
2. They generate large ROIs
ESG funds tend to perform well because the leadership performs according to its corporate governance rules, which safeguard the interest of investors. Even with the pandemic ravaging investments, ESG funds have outperformed most in the market.
Is It a Good Idea to Add to Your Lineup?
There has been a positive reception by employers towards the adoption of ESG options. However, the uptake is still very slow. But why is this? Before considering integrating ESG into a 401k plan, there are a few considerations.
Similar to the management of 401k plans, ESG funds have regulations that make investors shy off. Previously, President Trump had set up rules preventing 401k plans from including ESG funds. So far, only 3% of plans offer ESG funds for investing, according to the Plan Sponsor Council of America. Even though the current government waylaid these rules, 401k fiduciaries want a stable legal foundation to include these funds.
Another concern among employers is potential lawsuits by employees adding to the bag of other 401k lawsuits. Adding ESG options to the 401k plan will demand the plan advisors ensure the good performance of investments. Employers have to stay on top of effective asset allocation and diversification.
On the other hand, ESG 401ks promise exponential performance for an organization. More and more investors want to link their portfolios to sustainable investing. A good example of successful companies that have ESG funds in their retirement plans is Google Inc. and Amazon Inc. This is evident it can work. As more investors are getting into the trend, it is likely more employees will want to invest if these funds are included in their 401k plan. As time progresses, it may require more awareness and education of employees on ESG funds, which is initiated by the plan sponsors.
While there is a growing interest in channeling money into ESG funds, 401k plans are still lagging. It is expected for employers to be overly cautious about providing ESG fund options to employees due to the regulatory environment and risk of being sued.
Even as advisors and administrators of the plan caution employers, more employees are showing interest in ESG 401k funds. Deciding if ESG funds are right for your company depends on how you can circumvent the barriers to their adoption, and if you can structure your 401k plan to adopt and set them up for success.
If you need help finding which plan makes sense for your company, schedule a plan discussion with us or take 30 seconds to find which plan is best for your company with The Retirement Plan Evaluator.