An increasing number of investors want their portfolios not only to do well but also to do good. But, at least according to the U.S. Labor Department, retirement investors with such goals need to be saved from themselves.
“Environmental, social and governance” criteria, usually abbreviated ESG, represent a set of standards rapidly gaining acceptance by investors as a tool for screening potential investments. Environmental standards relate to a company’s track record as a steward of the natural world and its resources, Social criteria deal with a company’s actions toward its employees, suppliers, customers and community. Governance concerns the company’s leadership, executive pay and internal structure.
I occasionally use ESG funds in client portfolios if clients request it. However, we typically recommend that clients who are interested in supporting conservation or social change instead invest in a diversified portfolio and direct a portion of the returns to supporting organizations working toward the goals they value.
In April, the Labor Department issued a notice warning that companies “must not too readily treat ESG factors as economically relevant” when choosing which investments to offer in a retirement plan. The department added that it cannot be assumed if “an investment promotes ESG factors, or that it arguably promotes positive general market trends or industry growth, that the investment is a prudent choice for retirement or other investors.”
In other words, employers who offer ESG funds in their retirement plans may be violating their fiduciary responsibility to their employees. Under ERISA employers that offer retirement plans such as 401(k)s must act in the best interests of plan participants.
The Labor Department notice does not forbid companies from including any ESG fund in their retirement plan’s investment menu. However, based on this notice, if such a fund doesn’t perform well, employers might be exposed to compliance complications. If the Labor Department aggressively pursues such cases, it may well discourage employers from offering such funds in the first place. At a minimum, plan administrators may feel that they need to more thoroughly document the financial reasons for offering such a fund, and as a result they may find it easier not to bother.
The Labor Department’s stance strikes me as troublesome. If an employer offered ESG funds exclusively, I could view it as a problem. But it is hard to see how including one or two in a wider menu of investments violates an employer’s fiduciary responsibility.
If employees want an ESG fund, it is hard to argue that providing one would violate the employer’s fiduciary duty. The Labor Department cites ESG funds’ poor returns, but this reasoning fails the smell test. Some ESG fund advocates argue their returns are as good as comparable funds or, in some cases, better. A 2015 study in the Journal of Sustainable Finance & Investment examined about 2,200 studies and found that in 90 percent of cases, there was no negative correlation between concern for social factors and financial performance.
The Wall Street Journal recently reported that ESG ETFs outperformed the broader market in the 12 months ending in March 2018. That doesn’t mean that’s funds as a group will consistently outperform more diversified strategies over the long term. ESG strategies are still relatively new, and it is not proven that ESG fund returns are better or worse across the board.
The Labor Department may be attempting to fix a problem that largely does not exist. According to surveys, only a small percentage of employer plans offers an ESG fund option.
The restriction on ESG funds seems more like retaliation than a sincere effort to protect investors. If nothing else, adding additional restrictions on retirement plans is not a very consistent move from an administration that has vowed to ax as many regulations as possible.
It is important to make sure that employers are offering reasonable menus of investment choices to their employees, but the entire point of self-directed retirement accounts is to give individual investors a level of control over their portfolios. Even though I do not recommend ESG funds for my own clients, I don’t think they are so dangerous employers should be barred from offering them at all.
Paul Jacobs, Certified Financial Planner (CFP) is the chief investment officer of Palisades Hudson Financial Group, based in its Atlanta office.
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