ESG getting nods from institutions. Why does it lag in 403(b)s?

ESG investing has barely made inroads in nonprofit and government defined-contribution plans, despite the wider enthusiasm those institutions have for it in their endowments and pension funds.

Much as in the 401(k) world, 403(b) plans have very little explicit consideration of environmental, social and governance criteria. For example, data from the Intentional Endowments Network and the Plan Sponsor Council of America show about 3% of colleges and universities offer ESG funds on their DC plan menus, and only about 1% of total plan assets are invested in those funds. Those figures are similar to those on ESG use in the 401(k) world.

“We’re seeing a lot more [ESG] growth among endowments than around 403(b)s,” said Georges Dyer, executive director of the Intentional Endowments Network. The group this month noted the discrepancy and offered an ESG guide for colleges considering such options for their retirement plans.

There are now more than 200 endowments that include ESG factors in their investment policy statements, up from a little more than 100 that the group was aware of a year ago, Dyer said.

“On the 403(b) side, there are many that use TIAA and have the Social Choice [Equity Fund] in their plan, but beyond that, there are very few ESG options offered,” he said. “That is in part due to some of the regulatory guidance from the DOL.”

Regulatory and potential litigation concerns have all but kept ESG-specific investments out of DC plans. The Department of Labor under the Biden administration has shifted its stance from that of the Trump administration, but employers might be unlikely to change their plans unless they have a high degree of certainty that ESG investments meet the letter of the law.

Congress is also considering bills that would encourage the use of ESG in retirement plans, which could also help.

Nineteen percent of endowments incorporated responsible investing criteria into their portfolios in 2020, according to figures from the National Association of College and University Business Officers and TIAA. About 16% applied that criteria to the global equities portion of their portfolios, and 15% did so for emerging markets.

In DC plans, “you’re kind of relying on the individual to make the [allocation] decision, whereas with pensions, you have a professional manager,” said Matthew Petersen, executive director of the National Association of Government Defined Contribution Administrators.

This week, Maine became the first state to mandate that its pension plan fully divest from fossil-fuel-linked funds, with Gov. Janet Mills signing new legislation. The state is now required to divest from those assets in its $17.6 billion plan by 2026.

The decision followed a similar move in December by New York State, which is shedding many of the fossil-fuel investment assets in its $226 billion plan.

The country’s largest public pension fund, CalPERS, at $455 billion, does not have a divestment strategy but states that it seeks to engage with companies as part of its sustainability objective.

Increasingly, colleges and universities have faced pressure to reduce the carbon footprints of their endowments.

Unlike 401(k) plans, public-sector DC plans and some 403(b)s are not subject to the Employee Retirement Income Security Act.

“Tax-exempt entities which sponsor 403(b) plans are more often ‘mission driven’ than their 401(a) sponsor counterparts. I would expect to see a greater interest in ESG investments, but I have not personally seen that movement,” ERISA lawyer Robert Toth said in an email. “[T]he exception seems to be church-related 403(b) plans, where there remains a strong interest in ESG funds. However, with these plans generally qualifying as churches they are exempt from the DOL’s ESG rules.”

Without that Department of Labor oversight, the plans could arguably have an easier time adding ESG investment options. But that isn’t the case, Petersen said.

Plan administrators “often use ERISA principles … they’ll try to incorporate good practices,” he said. “The ESG guidance has really been sit and watch, and see how it plays out.”

And there are different forces that shape 457 and 403(b) plans. Historically, those plan types had overwhelming choices for their participants, who had to select one of numerous record keepers and choose from hundreds of different investment options.

For 457 plans in particular, that has changed. And adding more options — ESG or not — isn’t something many sponsors appear to be considering.

“There’s a trade-off between adding these options and creating a bigger menu for your participants to have to choose from, and the benefits you see from those offerings,” Petersen said. “In the 457 world especially, there has been a very concerted effort to pare everything back. We advocate for that specifically.”

Many ERISA 403(b) plans have similarly trimmed their menus, but information about non-ERISA 403(b) plans is lacking, and those sponsors have not faced the same regulatory pressure to overhaul their plans.

Plan sponsors also have not necessarily seen demand from their participants, Petersen said. But that could be because people are not vocal. Several recent surveys have found that the majority of participants are interested in ESG, and many indicated that such options would make them more engaged with their plans.

“People want to invest in things they believe in,” Petersen said. “It’s a trend that isn’t a fad — it’s likely to stick around.”

More data that show ESG funds perform as well as traditional funds could also help encourage sponsors to add them, Dyer said. That has also helped incorporation on the institutional side, he said.

“We see that changing with the financial performance case becoming clearer for ESG strategies and the financial risks for not including [them],” he said. “The baseline, core factors never change. Plans should look at the best financial options for their participants.”