Investing September 22, 2022

DC Plans Slow to Adopt ESG Options

Many plan sponsors remain hesitant to implement environmental, social and governance investing until the Department of Labor rules on the subject.
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Art by Gizem Vural

Plan participants claim to want environmental, social and governance investment options in their defined contribution plan lineups. The Schroders 2022 U.S. Retirement Survey found that 87% of DC plan participants surveyed want their investments to be aligned with their personal values. It’s not just empty talk, according to the survey: Interested participants follow through with investments: “Of the 31% of 401(k) plan participants surveyed who knew their plan offered ESG options, nine out of ten invested in those options, and almost three-quarters (73%) estimate they allocate 50% or more of their assets to socially responsible choices.”

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The growth in the number of ESG funds and their assets supports the case for strong investor interest. Morningstar’s “Sustainable Funds U.S. Landscape Report” for 2021 found that sustainable funds attracted a “record $69.2 billion in net flows in 2021, a 35% increase over the previous record set in 2020. … Assets in sustainable funds landed at a record $357 billion at the end of 2021, more than 4 times the total three years ago.”

Slow Progress With DC Plans

Morningstar also reports that the number of sustainable open-end and exchange-traded funds available to U.S. investors increased to 534 in 2021, up 36% from 2020. Nonetheless, participants’ interest and the segment’s growth aren’t reflected in many retirement plans, and the availability of ESG options varies widely among plan types. Callan Institute’s 2021 ESG Survey contacted 114 U.S. institutional investors and found that 63% of public plans offered ESG options. Foundations (57%) and endowments (50%) followed closely, but only 20% of DC plans offered a dedicated ESG option. Vanguard’s recent “How America Saves” study found just 13% of the company’s DC plan clients offered socially responsible funds in 2021. Similarly, a Russell Investments survey from earlier this year of 28 of its U.S.-based defined benefit and DC clients found that only two of the plans offered an ESG investment option.

Unlike Schroders, Callan and Vanguard both reported participants’ use of the available ESG options in their plans was low. The Callan DC Survey reported a 1.2% participant average allocation of account balances to a plan’s dedicated ESG option. Vanguard found that just 6% of participants were using the available socially responsible funds.

Reasons for Slow Adoption

Most of the ESG implementation so far has occurred in plans at organizations whose purpose naturally aligns with ESG factors, says Jessica Sclafani, senior DC strategist for the Americas division with T. Rowe Price in Baltimore. “Think health care or religious organizations for the most part,” she says. Technology companies also tend to be more interested, she says, adding geographically, the interest has been concentrated in the Northeast and on the West Coast. “However, we are seeing many sponsors who continue to describe themselves as ‘sitting on the sidelines’ until we get a final ESG rule from the Department of Labor,” says Sclafani. She anticipates a final rule will be promulgated around the end of this year. “Until then, I think that we will continue to see education and interest in exploring ESG, but implementation is likely to stay on hold,” she adds.

Thomas Shingler, a senior vice president and Callan’s ESG practice leader in Summit, New Jersey, also points to regulatory-induced hesitation among sponsors. He notes that terms like “whiplash” or “ping-pong” are used to describe changes in DOL guidance and rulemaking under successive Republican and Democratic presidential administrations. The switches have made it difficult for plan fiduciaries, advisers and consultants like Callan to navigate ESG-related decisions, he says. Shingler anticipates that the DOL will issue its final rule this December; consequently, he expects more ESG adoption in 2023 and 2024.

Lack of Targets

Another factor hindering ESG’s adoption is the lack of ESG-focused target-date funds. TDFs, fueled by automatic plan enrollment and their status as many plans’ qualified default investment alternative, capture a large share of participants’ investments. According to Vanguard, by year-end 2021, 64% of all Vanguard participants were solely invested in an automatic investment program and 56% of all participants were invested in a single TDF.

The dominance of TDFs creates a problem for ESG funds looking to get into DC plan lineups. Greg Wait, partner with ESG advisory firm Riverwater Partners in Milwaukee, says there is only one ESG target-date series available with a five-year performance record—the Natixis Sustainable Future Funds. “There’s almost nothing to choose from for a plan sponsor to add an ESG target-date fund when there’s only one on the marketplace,” says Wait. “And I think the fact that there’s only one in the marketplace also makes some plan committees and fiduciaries nervous, because while they can compare it to other target-date funds, they can’t compare it to other ESG target-date funds.”

Several companies are developing ESG TDFs. BlackRock launched its LifePath ESG Index series in 2020 and in May, Putnam Investments announced it will reposition its Putnam RetirementReady Funds target-date series as the Putnam Sustainable Retirement Funds. In October 2021, Morningstar announced that it was working with Plan Administrators Inc. to launch a pooled employer plan “intentionally designed to limit exposure to material environmental, social and governance risks.” Morningstar Investment Management will also create a custom ESG TDF portfolio for the PEP that is specifically designed as a QDIA option. In March, Transamerica, Future Plan by Ascensus and Natixis Investment Managers announced joint plans to introduce an ESG TDF series.

Zach Stein, co-founder of climate-focused robo-adviser Carbon Collective in Albany, California, also sees a shortage of ESG TDFs in the market. He says that some of his firm’s clients opt to use the firm’s climate-focused target-date portfolios as their QDIA, but these are balanced portfolios—rather than funds—that follow the firm’s investment strategy. “We have not been able to find an ESG or sustainability-focused retirement (target) date fund we feel comfortable ethically recommending to our clients,” he explained by email. “The closest is from Natixis, but they are quite expensive and hold companies like Exxon that don’t make sense to us in a sustainably-focused portfolio.” 

TDF Alternatives

Another approach to getting ESG funds into a plan lineup that Wait has used with clients involves the creation of three “tracks” for the DC plan. One track is a standard target-date fund. The second track includes multiple funds with different investment objectives, such as U.S. large cap, U.S. small cap, international equity and a fixed-income option. The third track mirrors the multifund second track but uses ESG funds. “I think it’s a really prudent approach because then you’re offering your participants a choice of having ESG funds in the same manner as you’ve got non-ESG funds,” Wait says. “You’re allowing those participants, if they choose, to build for themselves a fully diversified account of ESG funds.”

Brokerage windows are another option. Alan Hess, associate vice president for U.S. Fund Research at ISS Market Intelligence in Boston, says brokerage windows fit with how ESG funds are sold within the broader market. “The ability to incorporate ESG factors within strategies that can normally appear on investment lineups means that pursuing them through a brokerage window is a less high-risk strategy on the part of an interested investor,” says Hess. “Plan sponsors still weighing regulatory uncertainty from shifting administrations may find an incentive to point investors more toward these windows than revamping their current lineups.”

ESG investing is likely more widespread among DC plans’ investments than recognized, however. Kerry Galvin, a New York City-based senior consultant with Russell Investments, says the lack of a distinct ESG option or investment manager doesn’t mean that a plan’s lineup isn’t using ESG in some format. Managers are “using E, S and G factors in their underlying stock analysis to better inform their stock-selection decisions,” Galvin says. “I think that’s an important distinction to make. That is what our corporate plan sponsors are offering, but that’s also what’s going on with the managers they’re utilizing.”

In a May blog post, Galvin noted that Russell Investments’ 2021 Annual ESG Manager Survey found that “82% of U.S.-based investment managers reported using explicit ESG factor assessments in their investment decisions. Governance remains the ESG factor which impacts investment decisions the most. However, the usage of environmental factors is increasing.”

Benefits September 22, 2022

Investors’ ESG Demands: Will More Plan Sponsors Be Forced to Act?

Studies about the concerns of Generation Z and Millennial investors indicate that they’re worried about retirement and care deeply about how they are investing.
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Art by Gizem Vural

On May 4, the Securities and exchange commission publicized two denials it made to companies that had requested the right to block a proxy vote that would require them to evaluate commitments in their retirement plans for investing based on environmental, social and governance principles.

According to two attorneys at the law firm Seyfarth, a shareholder requested that the board of a company review the company’s retirement plan investment options and assess how those options align with the company’s climate action goals. The shareholder said every investment on the plan menu, including the default, contained companies in businesses related to fossil fuels or deforestation. The shareholder also said there were limited numbers of funds to choose from that were screened for environmental and social impact, according to the attorneys.

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It’s unclear who is behind the request to the companies for a proxy vote that was upheld by the SEC. But the move does raise a question: Will retirement plans increasingly become a battleground for socially conscious investing efforts?

Recent studies about the concerns of Generation Z and Millennial investors indicate that they’re worried about retirement and care deeply about investing their money according to ESG principles. Given that these cohorts will eventually hold vast amounts of investable assets, much of it inherited from Baby Boomers, their attitudes are likely to have considerable influence. Meanwhile, anecdotal evidence suggests members of these generations are becoming more vocal about having the option to make ESG investments inside their retirement plans, with the tax advantages those plans offer.

In Nuveen’s 6th Annual Responsible Investing Survey, published in 2021, 96% of Millennial investors said it is important that their asset managers are knowledgeable about responsible investing. Additionally, 94% said they would be more comfortable working with an asset manager that had experience in responsible investing. Among all investors, not just Millennials, 63% agreed that their financial adviser could do much more to help them see the specific societal or environmental benefits of responsible investing.

Queries on the Rise

“I increasingly hear directly from individual investors who are trying to have more access to credible ESG funds within their retirement plans,” says Amy O’Brien, global head of responsible investing at Nuveen. “It’s related to their retirement savings plans and their employer’s behavior overall. Companies are starting to realize that their employees are scrutinizing their stated sustainability commitments and are connecting that to the availability of investment options.”  

O’Brien says plan sponsors should consider adding more options for values-based investing to their menus and understand what’s important to younger investors, who are coming out of college well-versed in the ideas behind sustainable investing.

 “Plan sponsors need to take a second look,” she says. “In the past, we’ve seen them add options, but in some cases if they did not commit to educating employees, they didn’t do the education, and then they didn’t see the fund flow they had hoped for. This is a way for companies to attract and retain younger workers.”

Similarly, Brendan McCarthy, head of retirement investing at Nuveen, says plan consultants have been reaching out to Nuveen looking for ESG options because sponsors, prompted by employee interest, are asking for them. “It’s a regular thing,” he says.  

In some cases, the option is already available but not widely known about among participants. To address the problem, companies can fold communications about ESG options in their plans into other sustainability communications, McCarthy says. One company he works with did this recently with its communication on Earth Day.   

Consistency in Word and Deed

“Millennials and Gen Z employees are particularly concerned about working for employers who act in line with their values,” says McCarthy. “If employees are raising this demand, it’s very important for companies to communicate back and let them know that the company appreciates and is considering their values.”

Lazaro Tiant, sustainability investment director in North America at Schroders, echoes that sentiment. “Plan participants in this group want to align their investments with their values, particularly those within companies that have made commitments to sustainability-related initiatives,” he says. “Companies that have set sustainability goals may continue to see a rise in demand from employees who want to see consistency between those commitments and their retirement options.”  Research published earlier this year by Schroders showed participation would likely increase if sustainable investments were offered. 

What the Data Say

Azish Filabi, professor and executive director at the American College of Financial Services Cary M. Maguire Center for Ethics in Financial Services, studies trust and ethics in financial services. Recent data she collected show that Millennials and Generation X, which comprises people age 26 to 55, are most concerned about their finances and worry that they won’t have enough money to last them in retirement. Data from Gen Z show low trust in financial services, with the younger generation having a bleaker outlook on their finances.   

She notes that when the younger generation begins to trust a company, one of the things they look for is that it supports the community. For Filabi, there’s a link to ESG themes: Values drive the decisions and engagement with financial services of the younger generation.

Making Values Actionable

Filabi says if companies want to reach these cohorts, authenticity matters. “Make sure your actions match your words,” she says. “If you are articulating certain kinds of values to live by, then you need to make sure you’re living by them.”

She adds that concepts related to ESG and stakeholder capitalism are not new, and companies need to have an opinion on them. “Reputation risk really matters in the ESG environment, and it could be of material value,” she says.

Similarly, many companies don’t actually know what their employees think about important issues, or if they perceive gaps between what a company says and does. Filabi says a five-question annual survey of employees’ views won’t cut it. “Do a deeper-dive analysis on what employee perspectives are on key topics,” she says.

Finally, keep in mind that investors are looking to make nuanced societal challenges more actionable. For the younger generation, this might mean support for the local community. And for many, it might mean making investment choices in line with values.

Who Is Calling the Shots on Plan Menus?

But how do you make your values actionable if the options in your plan just aren’t there?

Stefania Di Bartolomeo, founder and CEO of Physis Investment, an impact investment data platform, has observed that, in general, decisionmakers at investment companies and for 401(k)s “are part of the old generations, and do not see the need for ESG unless it is for regulatory compliance,” while Millennials are exercising their influence with their spending habits.

But it won’t be long before this starts to shift, says O’Brien.

The Boiling Pot

Pressure groups are targeting retirement plans for changes, and others, like the The Forum for Sustainable and Responsible Investment and the Intentional Endowments Network, have put together resources for more people to do so.

“I’d like to see more campaigns about generating end investor demand for plans,” says O’Brien. “That will demonstrate the interest in these options for decisionmakers and lead to outcomes. But often, it takes more, such as an internal ‘champion’ for employees who are asking for more options, or someone who really wants to see the company’s actions in line with its identity.”

She continues: “The reality is that a lot of sustainability and ESG investing has been done at a high level by sophisticated institutional investors. But now, gradually, I would say it’s being democratized. Average individual investors are learning about it and really demanding to have these options in their plans.”  

Dave Nadig, a financial futurist at VettaFi, a financial services firm, says companies should ensure that Gen Z and Millennials are represented on committees that advise the retirement plan. This can boost participation and helps companies understand what the cohorts want.

If a company is only now starting to pay attention to ESG, it’s about “15 years too late,” he says. “ESG is real. It’s ‘realer’ the younger your employee base. I don’t care what survey you look at. Boomers care. Gen X cares, Millennials care a lot, and it’s the only thing Gen Z cares about. If it’s not in their 401(k) plan, it’s just because they haven’t yelled loud enough.”

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