Politics Have Put the Brakes on ESG in Workplace Retirement Plans

If you predicted that the first veto issued by President Joe Biden would address legislation on socially-conscious investing in 401(k) plans, congratulations. I certainly didn’t see that one coming.

President Biden vetoed legislation in March that would have rescinded a Department of Labor rule paving the way for workplace retirement plans to take environmental, social and governance factors into account when they evaluate investment offerings. It’s a good bet most Americans, including retirement savers, have no idea what ESG is and probably didn’t have a view one way or the other about whether it should be in their 401(k) plan.

But the veto is significant, because it will put the brakes on adoption of ESG options in workplace plans, a trend that already was moving slowly.

ESG investing is different from the socially responsible investing offerings that started to crop up during the 1960s era of shareholder activism. The early fund offerings often focused either on a single, narrow area of investments or only on exclusion of specific investment categories, such as fossil fuels.

Most ESG mutual funds use ratings systems to score securities for their exposure to indirect financial factors, including environmental impact and internal governance. The funds either underweight or eliminate securities that fund managers expect to have high risk associated with those factors or tilt toward those that an investor believes will have a positive impact.

Surveys of plan participants show a high degree of interest in sustainable investing options, but sponsors always move cautiously when it comes to making changes in their plans. The DOL rule provides important clarification on how sponsors can adopt ESG without violating their fiduciary duties. But the bill that passed both the House and Senate sent the message that the rule could be undone by a future administration less sympathetic to social investing.

The final DOL rule represented a consensus view in the industry aimed at providing stable regulatory guidance, says Mikaylee O’Connor, a principal and senior defined contribution strategist at PGIM DC Solutions. Under ERISA, plan fiduciaries are required to make decisions based on factors that are financially relevant to their investments. Under the new rule, those factors can include climate change and other ESG issues. The rule does not require them to do that, but sponsors now can do so without concern that they are violating their fiduciary responsibilities.

“It’s not a must, but you can do this knowing that you’re not in violation of your fiduciary duty,” says O’Connor. “The hope was that it would eliminate this ping-pong effect on ESG policy between administrations,” she adds. “Now, unfortunately, the political environment has really dampened or at least delayed progress. People have to wonder if the rule could be repealed down the road – that’s the hesitation that plan sponsors have now.”

Sustainable investing has taken off in Europe and among retail investors in the U.S., but in the 401(k) world, things move slowly. PGIM’s 2023 DC plan landscape study found that one out of four DC plan sponsors offer an ESG option, with most offering a single US equity or balanced fund.  For 36% of plans, ESG is not a topic of interest; 14% plan to add ESG options to their investment menus over the next 12 months. Most others indicate that they are evaluating or studying ESG options to at least some degree.

One driver of that activity likely is high interest among plan participants. A survey of DC plan participants earlier this year by Natixis Investment Managers found that nearly three-quarters of individuals eligible for plan participation say they would be more likely to participate in a plan or increase their contributions if they could make ESG investment choices.

The highest degree of interest comes from younger workers, but they aren’t alone. Eighty-eight percent of millennials view ESG investments as an incentive to save, but so do 72% of Generation Xers and 49% of baby boomers. Notably, 83% of survey respondents think companies that focus on sustainable business practices represent attractive investment opportunities.

That view runs counter to the critique of ESG as “woke capitalism,” along with mounting evidence that ESG does allow retirement investors to choose socially-responsible investments and still enjoy healthy returns.

Morningstar maintains a number of sustainability indexes designed to measure the performance of sustainable investing solutions. In 2022, a tough year for markets all around, only 27% of the indexes outperformed their non-ESG equivalents, down from 57% in 2021 and 75% in 2020.

But the case for ESG looks stronger if you expand the scope to the past five years. From 2018 to 2022, 78% of the ESG indexes beat their non-ESG equivalents. And the ESG funds also outperformed on risk: 70% of the indexes that have five-year histories lost less than their non-ESG equivalents during down periods between 2018 and 2022.

Still, the political circus has taken on dimensions few expected to see just a few years ago.

Along with the DoL dustup, an analysis by PGIM found dozens of ESG-related bills that have been introduced in 35 states, with a very wide array of intents and purposes – some conservative, and some progressive. Many deal with investments and business relationships entered into by public entities; some direct state officials to divest from investment options that use ESG scoring. Others require the use of ESG factors in investment choices.

O’Connor has begun to wonder if it’s time to retire the term ESG.

“I think we should actually retire the term ESG. I don’t I don’t think it’s, I think there’s too much confusion and misinformation out there. And it’s doing more harm than good. ​​If you think about the components of ESG, you have to wonder- why are these elements lumped together? Over the next five to ten years, we’re going to be graduating from this kind of basic ESG nomenclature to one that describes what we’re actually trying to solve. I think that’s where these funds will end up.”

Mark Miller is a journalist and author who writes about trends in retirement and aging. He is a columnist for Reuters and also contributes to Morningstar and the AARP magazine.

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