Unless you’ve been living under a rock, you must have heard about ESG Investing. The concept of investing while assessing the Environmental, Social and Governance aspects of underlying companies has become a major focus of the SEC, Department of Labor and Investment Advisors recently. The concept is now working its way into the investment portfolios of America’s most common retirement program: the 401(k) Plan.
The ESG concept, also known as Corporate Socially Responsible Investing takes action to protect the environment as well as promote human rights and equal employment opportunities. It has long been established that businesses and corporations should act responsibly in the communities and environments they operate in. These actions essentially established Socially Responsible Investing (SRI) screens, but it was not until the 1960s that SRI vaulted forward as an investment discipline in the United States.
- 1960s – Protests of the Vietnam War led to boycotts of companies that provided weapons used in the war. Community development banks were established in low-income communities to provide financing opportunities that were otherwise not available.
- 1970s – Social activism spread to labor-management issues at many corporations, while the protection of the environment also became a consideration for many investors.
- 1980s – While Jesse Owens was imprinted on and made advertisements for the South African Krugerrand, many churches, universities, and organizations protested to force US Companies to divest themselves from operations in South Africa due to apartheid. Some of the first SRI mutual funds were marketed as investments. The Calvert Social Investment Fund not only restricted investment away from weapons, alcohol, tobacco, and gambling, but also examined more modern issues including nuclear energy, environmental pollution, and the treatment of workers.
- 1990s – Sufficient proliferation of SRI mutual funds and growth in popularity as an investment approach led to the creation of an index to measure performance. The Domini Social Index, made up of 400 primarily large cap US Corporations launched in 1990 and over time, helped to disprove the argument that investors were settling for lower returns by limiting the companies they included in their portfolios.
So, how do these SRI practices relate to a 401(k) Plan? In November 2020, the Department of Labor published regulations billed as the final rule on “Financial Factors in Selecting Plan Investments”. This rule amended the investment duties under Title I of ERISA requiring Plan Fiduciaries to select investments and investment courses of action solely on “pecuniary factors”, which were defined as factors a fiduciary prudently determines are expected to have a material effect on risk and/or return of an investment based on appropriate investment horizons consistent with the plan’s investment objectives and funding policy. In other words, the amended rules would require plan fiduciaries to select investments based solely on financial considerations of the investment. The DOL specifically indicated this was an effort to set limits on SRI investing (or as they referenced it, ESG Investing), stating that the only factors in fund selection should be three ERISA duties – prudence, diversification, and loyalty. The DOL felt that if decisions were made based on other factors, the Plan Fiduciaries may be in breach of their fiduciary duties. But is ESG Investing a breach of fiduciary duty?
When selecting investments in a qualified plan, ERISA dictates that a Plan Fiduciary must act rationally for the exclusive benefit of all participants and must ensure diversification among asset classes. The rule of loyalty requires that securities be purchased at a fair market value, not just what they are willing to pay for the security but ensuring they are paying the value of the security. This is especially true when preparing a menu of funds for participants to direct their investments. The initial DOL regulation assumed that socially responsible investing is somehow less prudent, less diversified or has less value. However, in March of 2021. the DOL released an enforcement policy statement that they will not enforce the recently published final rules and would be investigating the matter further. It may have been due to the public comments, it may have been due to the change in leadership, but the DOL is discussing the future consideration of these funds and their ability to be part of a prudent investment line-up.
New surveys suggest that many workers are not aware of ESG options but would likely invest in them if offered the choice. The success of companies such as Bombas, Toms and DIFF, who donate socks, shoes, or glasses to under-served communities with each purchase, proves there is a strong desire and market for this type of investing. If a fund menu provides acceptable ESG investing options as well as sufficient non-ESG alternatives, and the participant can construct a well-diversified portfolio either way, there is no problem under ERISA. There is no requirement to offer these funds, but if participants want to invest this way, the plan may find increased participation, greater participant engagement and more successful retirement outcomes. Ultimately, isn’t this why a company establishes a retirement plan to begin with?