Key Takeaways
ESG investing involves incorporating environmental, social, and governance factors into the decision-making process
Some advocates argue that ESG factors may help build resilient companies that produce better long-term financial gains
If you select ESG investments, we think it’s important to consider factors like your investment objectives, risk tolerance, diversification, and fees
In recent years, environmental, social, and governance (ESG) investing has gained notoriety as debate over its efficacy has heated up. Proponents hail ESG investing as both a financial boon and a moral imperative, while its opponents suggest it is an unproven strategy with potential pitfalls that misplace priorities.
This trend has extended to retirement plans, where ESG considerations are becoming more prevalent among retirement plans and investors alike. This article examines ESG investing in retirement plans and more.
Understanding ESG Investing
As its name suggests, ESG investing involves incorporating environmental, social, and governance factors into the investment decision-making process.
Advocates for ESG investing argue that considering environmental, social, and governance factors helps build stronger, more resilient companies, leading to better long-term financial gains. These factors are considered alongside traditional financial metrics, such as earnings and revenue, to provide a more comprehensive assessment of a company's overall value and potential long-term risks and opportunities.
Environmental factors focus on a company's environmental impact, such as resource usage, pollution emissions, energy consumption, waste management, and climate change mitigation strategies.
Social factors consider a company's relationships with its employees, customers, and communities, including labor relations, employee engagement and development, human rights compliance, consumer protection, and product safety.
Governance factors assess a company's corporate governance practices, such as management structure, board composition, board accountability and independence, executive compensation, audits and internal controls, and shareholder rights.
ESG investing in retirement plans
As ESG investing gains popularity, it is becoming increasingly accessible within certain retirement plans. Many 401(k) and other defined contribution plans now offer a variety of ESG investment options, as either standalone funds or incorporated into target-date funds.
Fiduciaries of retirement plans are responsible for acting in the best financial interests of plan participants. The Department of Labor (DOL) has clarified that fiduciaries can consider ESG factors when making investment decisions, as long as they do so prudently and in accordance with their fiduciary duty.
This means that ESG investment options can be made available to participants, but they must go through the same prudent decision-making process as any other investment offered to participants, and a determination must be made that those options are in the best interest of participants.
Types of ESG investment options
There are a number of different approaches that investment managers can take when managing ESG investment options. Broadly speaking, they can include:
Negative screening: These funds seek to exclude investments based on certain criteria; common filters include environmental harm, alcohol, tobacco, gambling, or firearms.
ESG integration: These funds seek to include ESG factors within the investment process as an additional perspective in an effort to enhance potential long-term performance and manage risks for investors.
Impact: These funds intentionally seek positive environmental and/or social outcomes alongside financial returns through their investment decision-making processes.
Thematic: These funds aim to invest in companies that emphasize specific issues or outcomes like climate change or women-owned businesses.
Considerations for ESG investing in retirement plans
If you decide to select ESG investments for your portfolio, we believe it's important to consider the following factors:
Investment objectives and risk tolerance: ESG investments should align with the overall investment objectives and risk tolerance of your personal circ*mstances. Given the proliferation of ESG investment options, understanding the nuances and focuses of each, and how they may fit into your overall portfolio is important. Some ESG options offer broad exposure to ESG factors across asset classes (i.e. a multi-asset or balanced portfolio), while some options focus on specific factors (i.e. clean energy). Understand the focus of each option and how it may fit into your overall portfolio.
Diversification: As with any investing strategy, we believe your portfolio should be diversified across different asset classes and industries to help mitigate risk.* Keep that in mind as ESG investment options can sometimes be highly concentrated, particularly if they are focusing on a particular factor (clean air, women or minority-owned firms, etc.). Concentrating on a particular factor may increase the overall risk in your portfolio, so make sure your asset allocation aligns with your risk tolerance and time horizon.
Fees: Keep in mind the fees you are paying to invest in particular ESG investment strategies. Fees may vary widely depending on the type of ESG approach the investment manager takes. Broad ESG strategies may have lower fees relative to focused or niche strategies.
*Diversification does not ensure a profit or protect against loss.
Align retirement savings and values
ESG investing has grown in the retirement plan industry in recent years. ESG investing often involves investing in new and emerging industries that can experience meaningful swings in volatility. By incorporating ESG factors into investment decisions, individuals may align their retirement savings with their values.
Investing in ESG investments is not without risk, so it is important to understand the investment objectives and fees of the ESG options you’re considering and understand how those investments fit into your current portfolio, from both a diversification and asset allocation perspective.
