Climate funds hold less than 1% of 401(k) money. Here’s why

Investors are pouring money into funds that aim to do environmental and social good. But one of America’s biggest pots of wealth — 401(k) plans — are stunting their growth.

The popular savings plans and similar workplace retirement plans held $9 trillion as of last year — almost a third of all U.S. retirement assets, according to the Investment Company Institute.

But retirement investment trends and the threat of lawsuits are deterring uptake of environmental, social, and corporate governance funds, according to experts.

Additionally, recent Trump administration rules offer another road block, discouraging a 401(k) plan from including ESG investment options, they said.

“There has been steady and impressive growth [in ESG funds] over the last 10 years,” said Bryan McGannon, the director of policy and programs at the Forum for Sustainable and Responsible Investment. “And that growth has not reached the 401(k) space.”

Yet investor demand is accelerating such that it may outstrip inhibiting forces in coming years, experts said.

U.S. investors — both individuals and institutions like pensions and endowments — hold $17 trillion in assets managed using “environmental, social and governance” factors, according to the Forum.

These funds may, for example, invest in energy firms that aren’t reliant on fossil fuels or in companies that promote racial and gender diversity.

About 33% of all professionally managed assets are managed using ESG investment rules, the Forum said. Climate change is the most important specific issue money managers are considering, in terms of total assets.  

Investment growth has picked up in recent years, even before Joe Biden’s presidential-election win promised to bring a stronger national stance on environmental issues and the Black Lives Matter movement renewed focus on issues like systemic racial inequality.

Last year, ESG mutual funds and exchange-traded funds took in a net $21 billion, four times higher than the prior record, according to Morningstar, which tracks investment data.

The funds are on pace to more than double last year’s haul, according to Jon Hale, Morningstar’s director of ESG research for the Americas.

That growth has come despite meager uptake in 401(k) plans.

Just 3% of plans offer an ESG fund as an investment option for employees, according to the Plan Sponsor Council of America, a group that represents companies offering workplace retirement plans.

A fraction of all 401(k) assets — about a tenth of 1% — are held in such socially responsible funds, the group said.

“It’s kind of amazing ESG assets have grown so much when they’re basically limited to [being] outside of 401(k) plans,” Hale said.

There are many road blocks to adoption, experts said.

For one, target-date funds have become a powerhouse in workplace retirement plans, leaving increasingly little room for other investments to flourish.

These are all-in-one funds that shift from stocks to bonds as investors approach retirement age. Companies often choose them as a default investment for employees automatically enrolled in a 401(k) plan.

These funds hold 1 in every 5 dollars invested in 401(k) plans, double their share a decade ago, according to the Plan Sponsor group.

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Only a few money managers — including Natixis and BlackRock — offer an ESG-focused target-date fund. BlackRock’s debuted a few months ago.  

Employers are also afraid of being sued by employees for offering ESG investments, experts said.

The number of lawsuits involving 401(k) investments — often over allegedly high cost or underperformance — has ballooned in the past decade.

Companies that perceive ESG funds as a litigation risk tend not to offer them, according to Philip Chao, principal and chief investment officer at Experiential Wealth, which serves as a 401(k) investment advisor.

Inconsistent federal rules — such as Department of Labor guidance and regulation around ESG-fund use, which tend to change with each new administration — have also stymied uptake. Trump administration rules issued in October will put cold water on ESG funds’ already limited uptake, Chao said.

The Labor Department regulation requires employers to only consider investment factors like risk and return — and not characteristics like social or environmental good — when choosing 401(k) funds, according to Morningstar’s Hale. Otherwise, employers expose themselves to extra regulatory scrutiny, he said.

The federal agency also explicitly disallows employers from automatically enrolling workers into an ESG-focused fund, Hale said.

However, some ESG proponents remain optimistic about future 401(k) growth.

For one, investor demand is “getting to the point where [employers] could say, we need to do this anyway,” Hale said. President-elect Biden, who has called climate change “the number one issue facing humanity,” may issue favorable 401(k) rules or guidance, he added.

Further, some investors believe ESG funds offer a financial benefit to stakeholders, in addition to social impact.

All but one ESG-focused index fund had higher net investment returns this year relative to conventional index funds, according to Morningstar. Some of that is due to conventional funds’ larger exposure to the energy sector, which has underperformed this year.

The University of California sold all fossil-fuel holdings in its pension and endowment, and invested more than $1 billion in clean-energy projects, the institution announced earlier this year. It did so based on a favorable outlook for renewable energy investments, and an unfavorable one for oil and gas companies, officials said.

“Today we remain convinced that continuing to invest in fossil fuels poses an unacceptable financial risk to UC’s portfolios and therefore to the students, faculty, staff and retirees of the University of California,” Jagdeep Singh Bachher, the university’s chief investment officer, said.