By Mike Sebastian. Mike has served as chief investment officer at Aon, and at fintech firm NextCapital.
Defined contribution plan participants say overwhelmingly that they want sustainable investment options, and that they would participate and contribute more if they had them. But in practice, few self-directors actually allocate to such options when offered them, and most participants stick with the default, likely a target date fund that doesn’t explicitly employ an ESG approach.
Participants in plans for which the population in aggregate favors sustainable investments would be better served by default (target date fund, managed account, or hybrid) investments that integrate ESG factors into their active investment processes with a risk/return objective, and/or low-cost, rules-based strategies that align with as universal of a set of values as possible.
Participant communication and education about sustainability and values in investments should be improved, making clear how ESG factors and values are addressed in the default option (including getting credit with participants for ESG integration), focusing on the most widely agreed-upon values (such as overall employee welfare and positive long-term trends such as clean energy), and avoiding the term “ESG”.
A recent survey of DC plan participants finds, maybe not surprisingly, that 92% of Millennials (and 65% of Boomers) want more sustainable investments in their plan. Most importantly, a majority (and 88% of Millennials) say they would be more likely to begin contributing/increase contributions if they could invest in companies with good ESG records.[i]
A second major survey of participants similarly finds that 74% of those who don't have ESG options (or don't know if they do) would or might increase their contributions if they did. And 40% say access to ESG options would improve their view of their employer.
Sounds like a real opportunity! We can debate ESG, but rules-based ESG-tilted investments probably perform similarly to the regular versions (before costs at least) and integrating relevant ESG data into active processes makes a lot of sense. So, let's nudge participants to save more.
However, the second survey noted above also finds that 90% say that, when offered ESG options, they invest in them. Almost three-quarters say they invest 50% or more. The problem is, it's probably not true.
A study of a large sample of newly enrolled self-directing DC participants in plans with at least one ESG option finds that under 10% actually have any allocation, at an average of less than 20% of assets among those that do allocate.[ii] And these are self-directors—most participants will stick with the default, likely a target date fund that doesn’t explicitly target ESG.[iii]
Participants say they want ESG, but don't invest in it when they can, and say they already invest in it, when they don't. Where's the disconnect?
Participants could be saying (in an anonymous survey) that they want ESG when they really don't—maybe, but why?
Participants might not understand ESG well enough to know if they want or have it, and that's a strong contender for an explanation. (A third survey of participants that finds a plurality think it's "Economic Stock Growth".[iv] Blame politicians and the industry for this often-deliberate ambiguity.)
But the real issue is that participants, on average, are ill-equipped for understanding options and constructing portfolios when left to their own devices. They don't know if they have access to ESG options, how to use them, or even if they already do.
And they’ll construct bad portfolios. Blanchett and Liu  express concern that adding ESG options will encourage participants to become self-directors to take advantage of them, thus worsening their outcomes.
What should plan sponsors and service providers do?
- Plan sponsors should first strive (through surveys, etc.) to understand the level of ESG/value alignment interest on the part of their specific participant base, and take into account possible net impact on participant and contribution rates and investment implications. ESG will likely not be effective at improving participant engagement in every plan.
- Participant access to anything ESG is ideally through the default—a TDF, managed account or hybrid that integrates ESG in an appropriate way—to avoid encouraging self-direction.
- The starting point for ESG in defaults should be ensuring integration of ESG factors and data in any underlying active investment processes, with a risk/return objective. If a TDF, MA or hybrid solution uses active management, it should integrate relevant ESG data. Service providers should do this (80-100% of active managers say they already do) and plan sponsors should understand what the manager is doing and get "ESG credit" for it with participants.
- The next stop on the ESG-in-defaults road should be low-cost, controlled-tracking-error rules-based approaches centered around as universal a set of values as possible (overall employee welfare and positive long-term trends such as clean energy.) Interestingly, the Schroders survey found that participants favored investments that benefited from long-term trends (48%) over excluding those that harm the environment (29%) – 56/33 for Millennials.
- Participant education should improve, seeking a better understanding of how and why portfolios might be aligned to a set of values, how ESG data could be used to improve returns, how the default might be in line with participant values, and the over-arching importance of participation and savings. Avoid the term “ESG” itself, which, as noted above, few understand, and some will oppose.
Plan sponsors will no doubt harbor concerns about practical aspects of the Department of Labor’s final rule on ESG, and litigation risk. While adaptation to the final rule in a work in progress, and plan sponsors should seek legal counsel on any actions, here are two things on which to reflect.
First, a starting point for ESG in defaults could be, as described above, integration of ESG factors and data into any active investment management processes, with a risk/return objective. Properly done, the goals of this (alpha) are fully pecuniary (but may well result in portfolios that don’t align with any set of values.)
Second, it is notable that more target date funds with consideration of sustainability/ESG characteristics are being launched by major providers post-final rule—so there is some industry momentum toward this being a viable solution for plan sponsors.[v]
Finally, it is important that communication and education about ESG in DC investments be clear(er) about why it is being pursued and what participants should reasonably expect.
Alignment of investments with a set of values is a reasonable and achievable goal. Impact may be challenging to achieve in public secondary market investments. Signaling through investment choices, especially the stigmatization of companies that do not reflect a particular set of values (which is potentially an effective impact tactic for institutional investors), may not work well with DC participants, who may be more oriented toward positive trends. The potential effect on investment performance and likelihood of achieving retirement goals depends on the approach taken (ESG integration, rules-based tilts, etc.) and may be uncertain.
A direction for future research is exploring the actual, not survey-based, connection between ESG in DC investments and participation and contribution rates.
The potential connection between value alignment and participant engagement is an opportunity for plan sponsors and service providers to close the gap between aspiration and reality, through improved defaults and education.
See my piece on setting clear and achievable ESG goals here: Doing as Much Good as You Can: A Realistic Mini-Guide to ESG Investing
 See Natixis .
 See Blanchett and Liu .
 See Sphere 
 See, for example, industry press coverage in NAPA .
Blanchett, David and Liu, Zhikun, ESG Fund Allocations Among New, Do-it-Yourself Defined Contribution Plan Participants (June 29, 2022). Available at SSRN: https://ssrn.com/abstract=4149885 or http://dx.doi.org/10.2139/ssrn.4149885
National Association of Plan Advisors, Major Players Offer New Sustainable ESG Target Date Funds, 2023.
Sebastian, Mike. ESG: Complex in a Vague Sort of Way, Environmental Finance, 2023.
About the Author:
Mike Sebastian has over 20 years of experience in investment management and consulting, working with a wide variety of investors globally, leading large teams, and driving forward innovation in investment strategies and processes. Mike has served as chief investment officer for Aon and at fintech firm NextCapital. Mike has authored notable practitioner research in investment topics, developed innovative methods of analyzing and constructing investment programs at large scale, and is active in his community.