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What’s Holding ESG Adoption Back in the 401(k) Market?

Industry Trends and Research

Environmental, social and governance-oriented investment options continue to “face headwinds” to widespread adoption in the defined contribution market, new research shows. 

Plan participants and plan sponsors are generally supportive of ESG-oriented investments in concept. In a 2018 survey of 1,000 active 401(k) plan participants, more than half (56%) of participants agree with the statement, “I prefer to invest in companies that are environmentally and socially responsible,” according to Cerulli Associates’ first quarter 2019 issue of The Cerulli Edge—U.S. Retirement Edition

Participants under age 40 display an even stronger preference for investing in environmentally and socially responsible companies than their older counterparts, registering at 63% for that age cohort, compared with only 37% for those ages 60-69. Additionally, the firm notes that 46% of 401(k) plan sponsors describe ESG factors as a “very important” consideration when selecting 401(k) plan investments. 

Interest But No Action

However, plan sponsor perspectives on ESG factors differ when contextualized with other investment attributes. Among these were fee sensitivity, the notion that ESG investing entails a tradeoff in performance and the regulatory environment in the DC market. 

When Cerulli asked plan sponsors to identify the three most important attributes when selecting 401(k) plan investments, “environmental and social responsibility” ranked last with 16% of responses. Not surprisingly, long-term investment performance and cost of investments were the top-ranked attributes, collecting 45% and 38% of responses, respectively, the firm notes. “Data shows that plan sponsors care about ESG factors, but they place a greater emphasis on performance and price,” explains Dan Cook, a research analyst in Cerulli’s retirement practice. 

Moreover, Cerulli notes that Labor Department guidance issued in 2015 and 2016 was viewed as being largely supportive of increased ESG adoption in the DC market, but guidance issued by DOL in 2018 took a “contrasting tone and explicitly scrutinizes” the use of ESG-themed investments as a plan’s qualified default investment alternative (QDIA). 

Cook suggests that the best path for ESG-oriented funds to gather assets in the DC market is in a QDIA role, but adds that the recent guidance and the “idiosyncratic nature of ESG investing create significant hurdles.” As such, Cerulli emphasizes that this guidance raises an important point related to ESG investing in a DC plan context, given that ESG investments must be prudent options for all plan participants, not a select group or sub-segment.  

For example, the report observes that a small business owner may have strong convictions regarding environmental and social issues and prefer to personally invest in accordance with these views. “This does not mean that participants in the business owner’s 401(k) plan should be automatically enrolled into an ESG-oriented target-date fund without sufficient due diligence conducted on non-ESG alternatives,” Cook explains.  

Benchmarking Challenges

Effectively benchmarking ESG funds also continues to be a challenge. “Inherent in this challenge is the variety of approaches managers take in addressing each individual factor: E, S, and G,” the report explains. For example, it notes that two funds may be classified as ESG, but one may focus on low carbon emissions (E-factor) and the other on corporate diversity (G-factor), which could lead to investors comparing two funds that are materially different. 

“If asset managers grapple with the complexities of ESG benchmarking, one can assume that less sophisticated stakeholders (i.e., end-investors, plan sponsors, and, to an extent, advisors) have less knowledge in this area,” the report states. 

Cerulli suggest that this example underscores the importance of educational efforts in spurring greater ESG adoption in not only the DC market, but the asset management industry as a whole.