Why Are Few Sustainable Investment Choices Available for 401(k) Investors?
Sustainable Investment Strategies Are Becoming Accepted
Sustainable or socially responsible investments – that is investments informed by environmental, social and governance (ESG) considerations as well as financial performance – are becoming an accepted, if not mainstream, investment approach for retirement savings. Secretary of Labor Thomas Perez recently issued guidance for retirement investment fiduciaries that expressly acknowledges that ESG-guided investment strategies can also promote strong investment performance and be consistent with investment managers’ fiduciary responsibilities. Institutions responsible for $59 trillion in assets around the globe have signed the UN Principles of Responsible Investment. Strategies informed by ESG principles are being adopted by some of the most influential US pension plans, such as the California Public Employee Retirement System (CalPERS) and the California State Teachers Retirement System (CalSTRS). Major European institutional investors have been leading in this area for more than a decade with nearly 60% of invested assets invested sustainably compared with approximately 18% in the US, according to the 2014 Global Sustainable Investment Review. At its most recent Convention in 2013, the AFL-CIO adopted Resolution 11 supporting responsible investment strategies for union retirement plans.
Few Defined Contribution Plans Offer Sustainable Options
In the world of retirement savings, most of the progress for ESG-guided investing has been with defined benefit pension plans. In contrast, opportunities to invest sustainably are few for US defined contribution investors, despite the fact that 401(k) plans now hold over $4.5 trillion of US retirement savings assets according to the Investment Company Institute.
Sustainable investment options are generally not included on the menu of investment options offered by large 401(k) plan record keepers. Frequently, the menu options offered are proprietary to the record keeper – that is they are investment products managed by the record keeper itself. And they generally include generic options – a limited menu of pooled funds for large cap stocks, small cap stocks, fixed income securities, international stocks, and possibly target date funds. While there are a number of excellent sustainably invested pooled funds on the market today, offering competitive performance at reasonable fees, defined contribution investors generally cannot include them in their retirement portfolios until they roll over their accounts on leaving their company. At that point, they are liberated from the limited menu of the original plan.
It is ironic that progress has been more rapid for sustainable investing with defined benefit pension plans than with defined contribution plans, like 401(k) plans. The argument has traditionally been made that defined benefit pension plans should be wary of values-driven investing because it is inherently political. One person’s values-based investment might focus on environmental issues, another on human rights issues, another on religious values, and so on. Since a pension plan may have thousands of beneficiaries, it would be unfair, the argument goes, for the plan trustees to impose their political views on diverse beneficiaries.
Many people, including this author, do not agree with this argument as it relates to ESG-guided investing. Pensions by their nature must invest for the long-term, meaning that issues of sustainability (or lack thereof) can directly affect their portfolios economically within the relevant time frame. And they invest in the whole economy, meaning that bad actor companies that externalize their costs, for example through environmental pollution or by mistreating workers, often burden other participants in the economy and therefore adversely affect a fully diversified investment portfolio over the long-term. Further, there is mounting empirical evidence that ESG strategies can, in fact, enhance short- and long-term financial performance. Maximizing retirement savings through strong investment performance is the shared goal of all beneficiaries. To the extent ESG investing advances that goal, there should be no concern about it from a fiduciary perspective, as DOL Secretary Perez has officially noted. These are not political considerations.
Nevertheless, it is important to recognize that defined contribution plans do not face this issue in the first place. Each investor owns his or her own account. If an investor wants to align his retirement investments with his or her values, who are plan trustees or record keepers to say otherwise? The essence of a fiduciary relationship is that the fiduciary must place the interests of the client first. The only reasons for a fiduciary standing in the way of an investor aligning investments with his or her values are either a determination that a particular investment or investment strategy is imprudent or a paternalistic posture that the client does not know what is in his or her best interest. While an investment fiduciary must be vigilant on behalf of clients regarding prudence – there are many traps in the investment world for the unwary and unsophisticated – it is simply false to say that sustainable investments managed on ESG principles, as a category, are not sound investment choices. As noted, the evidence strongly supports the opposite view.
Further, 401(k) investors, like pension trustees, can and should take a long-term perspective. They may be investing for retirement that is decades away and should care about the long-term consequences of their investments, not just near-term financial performance. In addition, their investments are, or should be, broadly diversified and, therefore, their portfolios may be adversely affected by bad-actor companies delivering near-term financial performance by externalizing costs that burden the economy as a whole. It is fair to ask: Are fiduciaries to 401(k) plan participants, including plan trustees and advisors, fulfilling their fiduciary obligations by not providing participants with access to sustainable investment alternatives?
Opening Doors to Sustainable Investments in 401(k) Plans
The real answer to why most defined contribution investors don’t see sustainable investment options on their 401(k) plan menus is, simply, inertia – and possibly resistance to sustainable investment from at least some of the institutions who dominate the 401(k) world. (And resistance to sustainable investment begins to look political in its own right.) In either case, the answer is the same – 401(k) plan participants and plan sponsors must demand that sustainable investment options be included on the menus of investment options for their plans. These demands must be addressed to the plan trustees who, in turn, can direct plan record keepers.
Recent developments suggest that plan trustees should get ahead of the curve and not wait for their beneficiaries to get mobilized. They should take note of the move to ESG-guided investment among the leaders of the defined-benefit investment world. They should require that sustainable choices be included on their plans’ menus now. There is little downside. Those plan participants who want to take advantage of them can do so. Those who prefer not to, can pass.
There may be additional benefits to be derived from plan trustees being pro-active on this issue. A survey conducted by Calvert Investments, a leader in socially responsible investing, suggests that the availability of investment options that align with participants’ values can increase interest in retirement saving – potentially increasing enrollment and encouraging long-term satisfaction with plan participation. Plan trustees can take note of the greater support for long-term retirement savings among investors who are able to invest in alignment with their values. This is another way in which trustees can place investor interests first.
The relentless shift of US retirement savings from defined benefit to defined contribution plans has clear downsides for participants that have received much attention. However, without minimizing these concerns, it is important to recognize that this shift also represents an historic opportunity for sustainable investment in the US. If sustainable investment choices become more widely available on 401(k) plan menus and if individual investors become more informed about ESG-guided investment, then individual investors can lead the way to a substantial increase in the share of US investment assets invested sustainably. There are reasons to be optimistic on the second “if.” A survey conducted for Morgan Stanley’s Sustainable Investment Institute found that over 70% of active individual investors are interested in sustainable investment. Further, the survey indicated that Millennial investors as well as female investors of all ages are nearly twice as likely to invest in companies that target specific social or environmental outcomes compared to the overall individual investor population. Fully 46% percent of Millennial 401(k) participants and eligible non-participants surveyed by Calvert indicated they would be likely to direct all of their plan contributions to responsible investments.
It is clear that the trend lines are pointing to greater investor choice and increased interest in sustainable investment. What is unclear is how quickly change will take place. Investors, plan sponsors, trustees and advisors can help accelerate the shift to sustainable investing by advocating and acting to include sustainable choices on 401(k) plan menus.
 Trustees and advisors serving 401(k) plans are ERISA fiduciaries under existing law. The US Department of Labor is now considering rules that would expand the reach of ERISA fiduciary duty to individuals providing financial advice to clients regarding other types of retirement savings accounts, such as individual retirement accounts (IRA’s). While this article is focused on 401(k) plans, the argument extends to all types of retirement investing.