New research provides insights from DC plan participants who had access to and invested in ESG funds—and demonstrates that how plan sponsors offer ESG matters in more ways than one.
On the whole, the research paints a “mixed picture” of the actual interest and drivers of demand for ESG funds in DC plans and suggests that plan sponsors should take a thoughtful approach when considering adding ESG funds to an existing core menu.
In ESG Fund Allocations Among New, Do-it-Yourself Defined Contribution Plan Participants by David Blanchett, Head of Retirement Research for PGIM DC Solutions, and Zhikun Lui, Senior Research Associate at EBRI, the researchers explore the allocation decisions of 9,324 new participants across 108 DC plans, who are self-directing their accounts and have at least one ESG fund available in their plan’s core menu.
Overall, the research found that allocations to ESG funds among do-it-yourself (DIY) investors were relatively low. Only 8.9% of new DC participants allocated to an ESG fund and the average allocation to ESG funds among those who held at least one ESG fund was 18.7% of their total balance. Moreover, the average allocation to ESG funds among all DIY participants included in the analysis was 1.7%.
One potential driver of the low allocation to ESG funds is the relative scarcity of ESG funds in DC core menus, Blanchett and Lui observe. For example, they found that among DC plans that offer ESG funds, 76% offered only one ESG fund, which was most commonly an equity fund (77% of funds), with Large Blend being the most common investment style (51% of all ESG funds available).
Not surprisingly, younger participants with higher deferral rates and higher incomes were more likely to allocate to an ESG fund. The research also found that the two largest factors related to participants having an ESG allocation were not related to participant demographics, but rather the number of funds in a participant’s portfolio and the percentage of participants in the respective DC plan allocating to an ESG fund.
“The notable increase in the probability of owning an ESG fund as the number of fund holdings increases, along with other core menu relationships, suggests naïve diversification is likely driving a significant amount of the ESG fund allocation decisions (i.e., the decision to allocate to the ESG fund is likely based on a weak preference, not conviction in ESG),” Blanchett and Lui write.
As such, despite relatively low usage today, the fact that ESG allocations increase as more participants in a plan allocate to ESG funds suggests plan-level interest effects could be a strong driver of future growth in ESG funds.
In fact, citing data from Cerulli, they note that while only 13% of plan sponsors currently offer an ESG fund, 29% of sponsors said they are likely to add at least one fund in the next 24 months.
Return Costs
There could be other potentially unintended consequences to adding ESG funds to a core menu, the paper emphasizes. The difficulty associated with building a diversified portfolio with only ESG funds has important implications on overall portfolio efficiency, Blanchett and Lui note. “If allocating to ESG funds requires participants to opt out of using a professionally managed portfolio option (e.g., target-date funds or retirement managed accounts), it may negatively impact future expected returns,” they write.
Participants who invest in ESG funds tend to invest more aggressively and have higher expected returns than the average DIY participant, although they have lower expected risk-adjusted returns, the researchers found. For instance, DIY participants in general have expected returns that are approximately 100 basis points lower than investors using professionally managed portfolios, such as target-date funds and managed accounts, ignoring any additional cost associated with the service.
Yet, with ESG investors having higher equity allocations and holding more funds in their portfolios, it also suggests that ESG investors on average are building less efficient portfolios. “These findings suggest that adding ESG funds to core menus may create additional implicit return ‘costs’ for participants to the extent the decision to allocate to an ESG fund drives participants away from professionally managed multi-asset options (e.g., target-date funds),” the researchers note.
As such, one important consideration for plan sponsors interested in adding ESG funds to a plan is that it may drive participants to opt out of the plan default investment (e.g., a target-date fund) and become a DIY investor, building portfolios that are less efficient than portfolios created by investment professionals, they further emphasize.
Investment Design Matters
Meanwhile, before assuming participants are not interested in ESG given low utilization in DC plans, consider the impact plan design may have on how participants invest, notes Mikaylee O’Connor, Vice President and Senior Defined Contribution Strategist at PGIM DC Solutions, in a summary of the report.
Citing Vanguard’s How America Saves study, O’Connor observes that 79% of participants remained 100% invested in the default option after three years and another 17% contributed to the default and other plan investment options, leaving only 5% of auto-enrolled participants who elected the DIY route.
This implies that plan design has a large influence on how contributions are invested, the PGIM strategist notes. As such, for plans considering ESG, O’Connor suggests that plans should know what their objectives are, as the answer should influence the approach and types of investment strategies to consider. “For some, there is a desire to screen out investments that don’t align with their organization’s beliefs or views; for others it may be a recognition that integrating ESG factors into the investment process will enhance risk-adjusted returns,” she says.
And while there are different ways plan sponsors can implement or integrate ESG into their DC plan, this new research underscores the potential challenges with adding an ESG fund to the core menu and supports a continued focus on professionally managed solutions for DC plan participants. “It doesn’t opine on the benefits of ESG, but instead reinforces that how you offer ESG to DC participants matters in more ways than one,” O’Connor emphasizes.
