Keeping ESG out of 401(k) Plans Hurts Participants and Produces Worse Outcomes

Last month, the Department of Labor (DOL) proposed a new investment duties rule that would essentially keep ESG funds out of retirement accounts and kill ESG momentum if enacted. Everything I’ve seen throughout my career shows that such a move would hurt investors. The comment period closes this Thursday.

While the DOL states “the rule is intended to provide clear regulatory guideposts for plan fiduciaries in light of recent trends involving environmental, social and governance (ESG) investing,” the context they provide shows a lack of understanding of ESG. This will affect everyday American’s access to modern day investment strategies, which take into account the way businesses treat stakeholders. With the update, the DOL seeks to clarify requirements for plan fiduciaries, stating that ERISA plan fiduciaries cannot invest in ESG vehicles when they “understand an underlying investment strategy of the vehicle is to subordinate return or increase risk for the purpose of non-financial objectives.” 

The crux of the problem with the proposed rule is that it rests on the outdated belief that ESG funds subordinate financial objectives to environmental, social or governance objectives, and will therefore underperform. In fact, just the opposite is true. JUST Capital launched the JUST US Large Cap Diversified Index (JULCD) on November 30, 2016, the index underpins the Goldman Sachs JUST U.S. Large Cap Equity ETF (JUST ETF), which launched in 2018. At 2Q 2020 the JULCD represented 447 of the top companies in the Russell 1000, by industry, according to our rankings. The Index provides broad exposure to companies that do right by their stakeholders: workers, customers, communities, the environment, and shareholders. Since inception through 2Q 2020, the index returned 13.73%, outperforming both the Russell 1000 and the S&P 500, which returned 12.43% and 12.53% over the same period.  

External studies have also shown that ESG funds generally outperform conventional peers. An April Morningstar report by Jon Hale, PhD, CFA found that from 2014 through 2019, sustainable funds showed strong performance in both up and down markets relative to conventional peers. Per Hale, “when markets were flat (2015) or down (2018), the returns of 57% and 63% of sustainable funds placed in the top half of their categories. When markets were up in 2016, 2017, and 2019, the returns of 55%, 54%, and 65% of sustainable funds placed in the top half of their categories.” 

Our work at JUST Capital over the last six years centers on elevating the voice of the public to align their priorities for just business behaviors with corporate action. Coupled with that, we seek to highlight the relationship between the financial outperformance of just companies and how well they serve all stakeholders – the results show a clear connection between the two, debunking the myth that ESG investments are doomed to underperform. 

Amidst the COVID-19 pandemic, JUST Capital has doubled efforts to look under the hood to evaluate how companies are treating their stakeholders during the crisis and highlight the outperformance of just companies. What we’ve found is that companies with strong corporate governance lead the market in a downturn. We did this analysis on Russell 1000 companies by looking at the data points related to corporate governance within the JUST Capital rankings model. 

In this exercise, we noted that top quintile companies have significantly outperformed the market in the past year by 3.0% relative to the fifth quintile performance during the past year. With regard to social issues, we found in particular that companies that have prioritized their workers during the pandemic have continued to outperform. Looking at the performance of each quintile year-to-date as of 5/31, we see the top quintile (Q1) outperforming by 6.26% relative to the bottom quintile. 

Earlier in my career, I worked as an ETF product manager for private wealth clients. A critical part of my role was evaluating the holdings, investment strategies, and performance of ETFs and determining whether they were acceptable offerings for our clients. This meant I needed to take the time to carefully evaluate the funds. What was driving performance? Did the holdings match the fund’s stated investment objective? How did the fund compare with peers in its asset class?  

That experience leaves me confident that the DOL proposal would do a disservice to all investors, but particularly millennials, who are overwhelmingly inclined towards making ESG investments and whose 401 (k) plans represent a large portion of their savings. In the most recent “Better Money Habits® Millennial Report” Bank of America found that “of millennials with savings, three-quarters are saving for retirement.” And a recent Morgan Stanley report found enthusiasm for sustainable investing at an all-time high, with 52% of the general population and 67% of millennials taking part in at least one sustainable investing activity, such as investing in companies or funds that target specific environmental or social outcomes. The report goes on to state that “investors want products that match their interests; 84% want the ability to tailor their investments to their impact goals, 90% among millennials.” 

To be clear, the work we do at JUST is in complete harmony with the stated mission of the DOL, which is “to foster, promote, and develop the welfare of the wage earners, job seekers, and retirees of the United States; improve working conditions; advance opportunities for profitable employment; and assure work-related benefits and rights.” With institutional investors increasingly investing in ESG leaders and moving away from ESG-risky companies, our concern is that the general public will be left owning companies in their 401 (k) plans that face high downside risks as a result of poor environmental, social, and governance performance. 

Adding hurdles such as documentation requirements for fiduciaries choosing between “truly economically ‘indistinguishable’ investments” could work to disincentivize plan sponsors from adding ESG investment options, which many end investors are interested in, and eventually make 401(k) plans a haven for companies rated as ESG laggards.

We hope to see more firms add their voice to the discussion so that investors can choose from best in class companies in their retirement plans, companies who look after their stakeholders, ensuring a better future for all. 


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