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What is Environmental, Social, Governance (ESG) investing?

What is Environmental, Social, Governance (ESG) investing?

Jeff Rosenberger, PhD

There’s more to your investment portfolio than just dollar signs. With ESG investing, you may just be able to put money aside for retirement and contribute to the greater good.

Environmental, social, and governance (ESG) investing is a socially responsible investment management approach that takes into account companies’ impact on their communities and the planet at large. While nearly a quarter of all U.S. professional investments today fall into this category, hardly any of that comes from company-sponsored retirement plans. Less than 13 percent of 401(k) providers offer an ESG option, according to a 2019 survey.

So what gives? We’ll dive into how ESG investing works and how this socially-conscious approach interplays with saving for retirement.

How ESG Investing works

Socially-conscious investors have turned to ESG investing as a means of both making money and a difference. According to one report, 60 percent of investors today seek out investments that align with their personal values. And it turns out that doing so may have more tangible benefits than just feeling better: Early evidence suggests a correlation between a company’s adherence to ESG values and its financial success.

But what actually constitutes an ESG investment? To qualify, companies need to meet a set of generally agreed-upon criteria. Below are some of the characteristics and activities associated ESG status.

Category Characteristics
  • Preventing pollution
  • Reducing carbon emissions
  • Transparency around energy usage and sources
  • Using alternative, renewable energy sources
  • Recycling and proper disposal of byproducts and waste
  • Environmental reporting
  • Cooperation with the U.S. Environmental Protection Agency (EPA)
  • Social
  • Positive labor relations
  • Promoting workplace health and safety
  • Anti-harassment training
  • Workplace diversity and inclusion initiatives
  • Progressive stance on socio-political issues
  • Government
  • CEO-to-worker pay ratio
  • Voting structure for the board of directors (majorities vs. pluralities)
  • Absence of “golden parachutes” for departing executives
  • Transparency with shareholders
  • Maintaining a diverse board of directors
  • Reasonable perks and bonuses for executives
  • It’s important to note that companies don’t have to score well in all three of these categories to be considered an ESG investment. In fact, the kinds of businesses that qualify might surprise you. Oil and gas companies, for example, have increasingly appeared in ESG funds because they might check the boxes elsewhere—like corporate governance or labor relations. To get around this, some funds screen out certain sectors, like the tobacco or firearms industries.

    As the U.S. Chamber of Commerce has noted, there’s no agreed-upon standard for determining what qualifies as an ESG company. As a result, third-party evaluators have emerged to fill that void—most recently, S&P.

    Retirement and ESG investing

    While demand for more socially-minded investments exists, is that the same dynamic reflected in Americans’ 401(k) investment strategies? According to  a study by Natixis, 60 percent of plan participants would like to see more ESG options available—but as stated earlier, less than 13 percent report that their 401(k) providers offer them.

    Employers might be partly responsible. In one survey of plan sponsors, respondents ranked “environmental and social responsibility” as the least important investment attribute.

    In addition, ESG funds can have higher expense ratios than regular funds. With more interest in ESG investing, the gap has narrowed in recent years. As an example, VFTAX (Vanguard FTSE Social Index Admiral Shares), an ESG index fund fund, has an expense ratio of 0.14% ($14 annually for every $10,000 invested). By comparison, VTSAX (Vanguard Total Stock Market Index), a non-ESG fund, has an expense ratio of 0.04%.

    But there’s a more complex reason behind why some are slow on the uptake. Plan sponsors are required by federal law to put the financial interests of 401(k) participants first. This is referred to as their fiduciary responsibility. Under the Obama administration, ESG investments were considered compliant when they had a comparable risk/return to more conventional mutual funds.

    But under the Trump administration, the Department of Labor—the agency tasked with enforcing fiduciary responsibility—has taken a different stance. In a 2018 publication, the agency opined that employer-sponsored retirement plans designed to advance “public policy goals” might violate federal law if they somehow overlook financial gain.

    Breaking through

    Employees, especially millennials, want access to ESG retirement options. And there’s mounting evidence that when introduced, ESG investment options boost participation. One company reportedly saw 401(k) enrollment go from 14 to 95 percent two years after implementing ESG options.

    Bolstered by numbers like those, plan sponsors and 401(k) providers are making headway. Increasingly, plans are adding ESG considerations to their fund menu—while still optimizing returns and mitigating risk.

    Guideline offers 401(k) plan participants who self direct their investments the option to allocate a portion of their savings into two ESG funds: VFTAX and TRPSX. VFTAX tracks the performance of the FTSE4Good US Select Index, an index of companies that excludes investment sectors such as tobacco, weapons, coal, and more. TRPSX attempts to achieve the returns of the US stock market, while only investing in companies that meet its ESG criteria.

    ESG investing is built around the idea that it’s possible to do good while doing well. While once amorphous, the process of determining which companies count as socially or environmentally-conscious has improved. This trend, coupled with growing demand from employees across all generations, has spurred retirement plan sponsors and administrators alike to reevaluate their attitudes toward ESG investing.

    Guideline believes that the impact of saving for retirement extends beyond just the traditional beneficiary. Take a tour of our easy-to-use product and learn how our 401(k) plans are different.