If you have been wishing you had choices for socially responsible investing in your company’s 401(k) plan, you’re not alone. A recent Allianz Life study showed that more than half of respondents want socially conscious investment options. When it comes to 401(k) plans, though, an employee’s options are limited to the funds selected by their employer. Since Aquent’s employees have increasingly been asking for these types of funds, we began investigating how to add them to our plan.
We quickly discovered how uncommon these types of funds are in employer-based retirement plans. For example, less than 3% of 401(k) plans even offer a single ESG fund. As we found throughout the process, the complexity of selecting and introducing this new type of fund may explain their slow adoption. But we firmly believe that the time and effort we spent to expand our investment options was worth it because we’ve responded to the needs of our employees.
So how did we navigate the world of ESG funds while maintaining our fiduciary responsibility as the plan sponsor?
One name, many meanings — the varied definition of an ESG fund.
We work with some great partners to administer our 401(k) plan — among the best in the country. The first thing we did was to ask them for a list of Environmental, Social, and Governance (ESG) funds to choose from, and we encountered our first problem. There is no agreed-upon definition of which funds qualify as ESG funds. Various indexes include different funds, and they all have different criteria.
One initial piece of information we received from our advisors was a list of our existing funds, put through some ESG screening criteria, which showed that they all scored very high. That was great, but it wasn’t what we were looking for. We wanted to add some targeted ESG funds to our lineup, not just get validation that our existing group of funds, many of which are extremely large, are broadly consistent with ESG criteria.
Mitigating risk but with socially responsible options.
It became obvious that ESG funds aren’t viewed as a separate asset class. They aren’t one of the traditional boxes that might be included in a 401(k) plan: stock vs. bond, growth vs. value, large-cap vs. mid-cap, etc. That itself didn’t strike me as a huge problem, but I started to realize that one major hurdle in convincing a company to add targeted ESG funds to a plan is that they don’t want to get sued. Some may ask, why would adding socially responsible funds get them sued?
Companies have a basic fiduciary responsibility to the employees enrolled in their retirement plans. The Department of Labor states that those offering the plan have to do so in the best interest of the participants. One aspect of this fiduciary responsibility is in the selection of funds offered under the plan and the screening criteria that are applied to select those funds. By adding ESG funds that may not pass their normal screening process, companies are concerned about being accused of shirking their fiduciary responsibilities. That is where those feared lawsuits can happen.
However, we are not doing that. Each of the funds we are adding went through the same process that all the other funds in our lineup have gone through. They all have at least a three-year track record (this alone eliminated from consideration many of the newest ESG funds that have sprouted up recently). They all will be evaluated quarterly for performance and adherence to our plan design just like the rest of our funds.
What’s really in an ESG?
Once I had a list of funds that passed our initial screening, I had to dig into each of their holdings. This is where there were some surprises. Let’s take a look at what I found off the bat:
The first fund listed its largest holdings as:
The second fund listed its largest holdings as:
The third fund listed its largest holdings as:
At this point I was confused. Those are all great companies. I have the highest respect for them, and they are valued partners of Aquent. I just wasn’t expecting to see them as the largest holdings of targeted ESG funds. After all, if you look at the top four holdings of the largest index fund in our lineup, they are:
So what are you getting in an ESG fund that is different? My preconception was that a targeted ESG fund would concentrate its holdings in areas like renewable energy, but that just wasn’t an option from the large funds that satisfied our screening criteria. So, what exactly makes these companies socially responsible then? Well, ESG funds are not so much about what they include, but rather what they exclude from their holdings.
Funds that work for us and our employees.
Many ESG funds are defined by the companies that they exclude. For example, the FTSE4Good US Select Index, which many funds use as a guideline, excludes companies that engage in industries like the manufacture of weapons or vice products (gambling, adult entertainment, and alcohol). In addition, companies were excluded if they were fraught with a lack of diversity, corrupt company conduct, or violations of human, labor, or environmental rights.
This process ends up creating a list of very recognizable companies that pass the screening process but also excludes many others that might be in large, diverse funds.
So what did we end up choosing to offer our employees? In addition to our existing funds (none of which were removed or replaced), later this summer we will be adding three ESG funds:
- The Vanguard FTSE Social Index Admiral Fund, an ESG Index fund, since we feel strongly that it is important to offer index funds with very low expense ratios as options.
- The Calvert Green Bond Fund, an ESG bond fund, which invests almost all of its assets in municipal green bonds that support projects with minimal environmental impacts. (Finding a targeted ESG bond fund was actually harder than finding a stock fund.)
- The Pioneer Balanced ESG Fund, a blended fund, which has a modest expense ratio and is actively managed for employees who prefer that someone has more freedom to add or subtract holdings in the fund.
Don’t stop, persist. ESG funds are worth the work.
Social responsibility is a popular issue not only in consumer spending but also in consumer investing. As the demand for these types of funds increases, the number of funds available will increase as well. However, as I found looking for funds that passed Aquent’s criteria and fiduciary responsibility, not all funds are created equally. ESG funds may not be right for every organization, but they will likely become a larger part of most companies’ portfolios in the future as employees continue to ask for these types of funds as options in 401(k) plans.
If you wish to add socially responsible funds to your company’s lineup, be persistent. I can almost guarantee you that if enough people ask enough times, change will eventually happen.
As a plan sponsor, it’s challenging to navigate the world of ESGs, but it’s worth the time and effort to provide these options for your employees’ retirement.