Environment, Social, and Governance Investing in 401k plans

Want to see corporations change? Become an activist investor. This means swaying votes and influencing business practices using your share of ownership in publicly traded companies.

If you don’t have millions to invest, that’s okay. There are investment options out there that are screening for companies that take the environment into consideration as well as good social and governance practices. That’s an easy way to reward companies that do good and align with your values.

Can you be an activist investor with your retirement plan dollars? After all, that account is often the largest pot of money the average employee has for investing.

Back in January, an interesting article in the NY Times outlined how to get socially conscious funds added to your employer’s retirement plan. Good advice on the ecosystem of how the decisions are made, but first we have to ask if it’s even allowed by law.

Recently, DOL released guidance on the subject, attempting to clarify retirement plan sponsor duties as they relate to selecting and monitoring investments and specifically ESG investments, and have only created more questions.

This is murky water. Let’s dive in. (Also recognize that we’re not lawyers and do not provide legal advice. This is meant to be an educational overview of some of the issues!)

Issue 1: First, let’s talk about “exclusive benefit.”

When you’re managing dollars under ERISA for other people, you’re held to the (higher) fiduciary standard. As DOL’s position has been, this means you should be “focused solely on the plan’s financial risks and returns, and the interests of plan participants and beneficiaries in their plan benefits must be paramount.” Stated differently, the fiduciaries “must never sacrifice investment returns, take on additional investment risk, or pay higher fees to promote non-pecuniary benefits or goals.”

Time travel back to the 1970s with the apartheid in South Africa. People were calling on corporations not to do business with South Africa as part of larger political pressure. By searching for and investing in companies that were specifically abiding by this, one could argue that the investment was no longer for the sole benefit of plan participants, but now dual focused, with the second focus being pressuring South Africa to fix their government and policies. That violates the exclusive benefit rule.

Issue 2: Where do you draw the line?

Negative screening practices have historically been prominent, meaning that socially conscious investing usually involved starting with a list of companies and then eliminating any that didn’t meet criteria. What do you do in a situation where the same parent company owns Philip Morris and Cheerios (which was the case until 2007)? Most often, they get screened out for being associated with tobacco products. So as an investor, you no longer get the benefit of whether Kraft Macaroni and Cheese, Post Cereal, Maxwell House, or Kool-Aid takes larger market share. Is that really in the best interest of the investor by avoiding giving dollars to the tobacco industry, or are they giving up potential returns of affiliated companies and thus retirement money?

Take that one step further - let’s look at environmental, social, and governance screening and let’s use Amazon as our example. They’ve pledged commitment to environmental sustainability, but let’s be real about the current carbon footprint and number of cardboard boxes. Where do they fall on the ESG spectrum, and do they make the cut for inclusion within an ESG fund? We’ve actually seen arguments both ways for this company.

Issue 3: Maybe the better question is, what’s the definition that is being used for ESG investing?

If a company has only old, white men on their board, but they excel in their field, company culture and DEI practices are good, and they have little environmental impact, do you say 2 out of 3 is good enough and put dollars there? Or should certain factors be favored more than others? If a fracking company has managed to pioneer a new process with much less environmental impact than their competitors, are they automatically a no-go simply because they’re a fracking company?

This seems filled with landmines, which is why many investment firms have used ESG in their investment screening as another data point by which to decide whether to invest or not. The majority of the investment partners we’ve asked about this have said sure, if several companies are being considered and all have similar balance sheets and growth prospects, of course they’re going to choose the one with better labor practices, a more diverse board/leadership, or the one with the sustainability edge for inclusion in the portfolio. Anyone who wouldn’t is foolish. They also recognize that any of those factors could change (for better or worse) at any time.

Issue 4: Monitoring investments is just as important as selecting them in an employer-sponsored retirement plan.

How do you monitor an investment against an appropriate measuring stick if the measuring stick isn’t easily identified or available? If using an ESG benchmark, you’d have to ensure that the definitions of the benchmark and the fund being measured are identical. Or, if you used traditional benchmarks, you may come into question if the ESG funds are consistently underperforming the benchmark for an extended period of time, violating an investment policy statement or calling the exclusive benefit rule into question.

In conclusion, it is possible, with a lot of effort, a properly written investment policy statement and monitoring guidelines, alignment with the employee values (and attorney blessing) to put ESG funds into a retirement plan. It’s a great idea to encourage companies to “do the right thing,” but the inclusion of these investments in employer-sponsored plans like 401k and 403b is difficult and you shouldn’t attempt to go it alone.

Are ESG funds right for your employees and your plan? How do you navigate these landmines? Book a call with us for help.