ESG could thrive in 401(k) plans, despite DOL rule

Even as the regulator moves to stem the funds in retirement plans, there are ample opportunities, according to speakers at the NAPA 401(k) Summit.

The Department of Labor’s stance on the use of ESG funds in 401(k)s has long made the investments a non-starter with plan sponsors — and the regulator’s recently proposed rule isn’t helping.

That also means there isn’t anything to lose, one investment manager said.

“There’s nothing but upside here, as far as I can see,” said Neal Weaver, CEO of LeafHouse Financial, speaking Friday at the virtual NAPA 401(k) Summit. “If this was a $20 trillion market, we wouldn’t be having this conversation.”

More plan sponsors and financial advisers are asking, unsolicited, about environmental, social and governance investment strategies than ever before, Weaver said. The timing of that demand couldn’t have come at a worse time, given that the DOL is preparing to release a final rule that will almost certainly restrict the use of ESG funds in employer-sponsored retirement plans.

But given the small size of the current market and increasing interest for investments that are more socially and environmentally friendly and can outperform conventional funds, there is opportunity, panelists at the event said.

“This isn’t just for hippies. This is for everyone,” said Bonnie Treichel, chief operating and compliance officer at custom benefits firm Zuna. ESG considerations represent “a new way of thinking about the extra layer of qualitative due diligence.”

The interest from individual investors is apparent, as net inflows to those products roughly quadrupled between 2018 and 2019, Treichel said.

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The DOL’s proposed rule for ESG investments would limit plan fiduciaries from considering non-pecuniary factors when selecting funds, and it would prohibit the use of ESG-specific funds as the qualified default investment options, or the funds into which participants are automatically enrolled.

Those restrictions don’t prevent plans for using ESG investments, Treichel said. But it would be helpful for the DOL to more clearly define what it considers ESG investments, as the proposed rule leaves much up to interpretation, she said.

Fund providers and investment managers have raced to the market with new products marketed as ESG investments, and many more explicitly make ESG considerations in their investment process, even if those products are not packaged as such.

“There is all of a sudden this wealth of data that is available,” Treichel said. Advisers and plan sponsors can benefit from understanding investment managers’ ESG scoring systems and knowing what questions to ask portfolio managers when vetting investments, she said.

For plan sponsors, it can be practical to include ESG considerations in investment policy statements, “as long as it’s not that in nature,” Weaver said. His firm provides scoring systems for investments, the first of which is based on performance and other general factors. Investments are graded on a scale of 1 to 4 and receive academic-style letter grades. If an investment passes the first round of evaluation, meaning it has a 2.5 or higher overall, it can then go on to be vetted separately as an ESG investment, Weaver said.

LeafHouse designed that ESG-scoring system with the DOL’s 2018 guidance in mind, as the regulator at the time made clear that plan fiduciaries must consider performance first when opting for ESG funds.

The use of that kind of ratings system can yield unexpected results, Weaver said. For example, an oil company would tank in the environmental category, but the same company might score very well on social and governance issues, he said.

“What if they’ve got diversity and inclusion policies?” he said. “They might actually check more boxes than you would have thought.”

One strategy that retirement plan advisers will likely be taking is to use a third-party fiduciary to evaluate ESG funds for plan menus, which could potentially shield advisers from some liability, Weaver said. Plan advisers should be asking themselves whether ESG could benefit their practices, and if so, they need to establish how plans will document everything in the investment policy statement and selection process to ensure DOL compliance, he said.

The DOL has recently been sending letters to advisers and consultants about their recommendations of ESG investments to plans, Treichel said.

LeafHouse was one of those firms, Weaver said.

“We thought of it in a very positive light,” he said, of the regulator’s examination of how fiduciaries are evaluating ESG. “This allows us to show the regulators what can be done within a system.”