Investing for Values, Value, or Both?

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Fiduciaries should account for participant preferences in designing ESG-friendly 401(k) retirement plans.

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Socially responsible investing. Sustainable investing. Environmental, social, and governance (ESG) investing.

The terms have changed over time. What has not changed in nearly 30 years is the regulatory controversy over the extent to which retirement plans should consider ESG-related factors when making investment-related decisions.

Surveys show that most participants in 401(k) and similar plans want access to sustainable investments. Some subgroups, such as young employees and women, are particularly enthusiastic and indicate they may save more if only they had access to those types of investments. Most of them do not have that option because fewer than 10 percent of plans offer sustainable investments.

Whether or not it is the primary cause, there is little question that regulatory instability has chilled the inclusion of sustainable options on plan menus. Decisions on composition of plan investment options are fiduciary decisions governed by the duties of loyalty and prudence. It makes sense that if regulation burdens the use of sustainable options or indicates the options may not be in the best interest of participants, then risk-averse fiduciaries will avoid them. And it seems they do exactly that.

In late 2022, the U.S. Department of Labor issued a regulation providing an avenue for fiduciaries to add sustainable investment options while mitigating the fiduciary risk. It clarifies that the preferences of a retirement plan’s participants can matter. If a fiduciary prudently believes that adding an investment option would lead to increased savings, the addition furthers the plan’s purpose of providing retirement benefits. The motivation of increasing benefits fulfills the classic loyalty obligation to prioritize retirement income and financial benefits under the plan.

The regulation leaves open many questions about how to consider participant preferences. The most fundamental question is whether the regulation will finally stabilize the general guidance on consideration of ESG factors in retirement plans. The 2022 regulation substantially amended a regulation issued in late 2020 near the end of President Donald Trump’s Administration.

Everything associated with ESG, though, seems to be a political hot potato. A group of state attorneys general and others filed a court challenge before the Labor Department’s regulation even became effective. And in early March 2023, Congress passed a resolution seeking to nullify the regulation. President Biden then issued the first veto of his term to quash that legislative resolution.

Although the Labor Department’s 2022 regulation is the latest in a long line of guidance on ESG and retirement plans, it is the most neutral approach to date. Its overarching direction simply reinforces the traditional legal principle governing plan investments—plans cannot prioritize anything other than retirement income and financial benefits under the plan.

Everyone who has the best interests of U.S. workers should support the 2022 regulation. It is time for both sides of the political ESG battle to leave workers’ retirement assets out of their political fight.

The Labor Department elected not to provide specific advice for fiduciaries on how to take account of participant preferences when building and monitoring plan menus. The relevant prudence standards are almost entirely procedural. A conservative fiduciary should assume that it needs to meet that duty when surveying participant preferences. This should not be overly burdensome. European Union requirements that financial advisers determine clients’ views on sustainability as part of the standard suitability determination may provide a model for participant surveys.

One would expect that surveys would show that participants have a variety of investing preferences. Fiduciaries will need to decide how many investment options to add and which preferences to prioritize.

In making this decision, fiduciaries face a tension. More options may mean that more participants save more in the plan. But, because fiduciaries must monitor all the options for prudence, an increased number of options will increase monitoring costs and litigation risk. Even from the overall perspective of participants, adding more options will not be necessarily better. Research in the field of behavioral economics shows that too much choice can cause people to make no choice or to spread their contributions over an irrational set of choices.

Fiduciaries that decide to add one or more investment options in response to participant interest will need to take care in their communications with participants. The goal of adding an option should be to increase savings. Encouragement to invest in the new option, though, could be treated as investment advice and, as such, it could subject the fiduciaries to potential liability for the advice.

In short, responding to participant interest in sustainable investments will not be without risk. It has the potential, though, to increase retirement savings particularly by younger employees and women. If young people can be encouraged to save early in their careers, they can benefit from the power of compound interest in tax-favored accounts. Women have lower account balances than men but need more retirement savings because they have longer life expectancies. Increased savings by women would help offset this pension gap.

These advances in retirement security provide good reasons for plan fiduciaries at least to consider the potential importance of participant preferences when developing 401(k) plan menus. The new Labor Department regulation now makes it possible for plan fiduciaries to give participants’ preferences their due consideration.

Dana M. Muir is the Robert L. Dixon Collegiate Professor of Business at the Stephen M. Ross School of Business at the University of Michigan.

This essay is part of a five-part series entitled, ESG and Retirement Plan Investing.

Further discussion of these issues can be found in the author’s forthcoming article, Matching Preferences and Access: Sustainable Investing in 401(k) Plans.