ABCs of ESG in 403(b)s
April 9, 2024
By Barbara O'Neill, CFP®, AFC®
Retirement planning is replete with acronyms. Take COLA, DB (pension), ERISA, IRA, RMD, and TSA, for example. Then there are “acronym cousins” like 403(b) and 457(b) which are also part of the “alphabet soup” faced by investors. At the risk of inducing “acronym overload,” I will add another one to your vocabulary: ESG, short for environmental, social, and governance, a form of values-based investing.
ESG investing is not new. Rather, it is a rebranding of SRI, an acronym for socially responsible investing. I recall teaching about SRI mutual funds that excluded companies related to alcohol, cigarettes, gambling, guns, etc. (i.e., so-called “sin stocks”) as far back as the 1980s. Fun fact: Then- and now- there are also mutual funds that specifically pack their portfolios with “sin stock” companies. One so-called “anti-ESG fund” even has the provocative ticker symbol VICEX.
But I digress.
This post is about an investment product that people purchase to make the world a better place. It will discuss what the letters ESG stand for, advantages and disadvantages of ESG investing, and the availability of ESG mutual funds in 403(b) plans. It also summarizes research about investors’ ESG investing knowledge and attitudes and concludes with three “need to know” facts and six take-away action steps.
ESG Background
In their previous life under the SRI moniker, socially conscious mutual funds often employed “negative screening.” In other words, they focused on excluding certain companies or industries from their portfolio (e.g., fossil fuels, pornography, and casinos).
ESG funds, on the other hand, commonly use “positive screening” methods to seek out companies that employ best practices in making, as Wall Street Journal Columnist Jason Zwieg notes, “the world Environmentally cleaner, Socially fairer, and Governed better.”
Other words that are often used interchangeably with ESG to describe socially conscious investments include “green,” “sustainable,” “social impact,” or, simply, “impact” investing.
An AAII Journal article noted that there were 1,048 mutual funds classified as socially responsible by Morningstar in early 2022 with about $790 billion in assets. Nearly 40% were launched within the previous five years. Fisher Investments noted in a 2024 report that “U.S. investments in ESG funds have increased 10x since 2018” and that “nearly 40% of 403(b) plans include an ESG option in their lineup.” Included in the mix are ESG index funds that typically have lower expense ratios than actively-managed ESG funds.
Below is a brief description of what each of the words in the ESG acronym refer to:
Environmental
The Wall Street Journal noted that environmental concerns rooted in a growing concern about climate change are “a key magnet” for ESG investors and that environment and climate-focused funds dominate the ESG investment market.
Key factors considered in environmental screening include: air quality, carbon “footprint” (i.e., amount of carbon dioxide and other harmful greenhouse gases), energy conservation measures, hazardous materials use, land use practices, natural resources use, renewable resources use (e.g., solar and wind), waste management practices, and water management practices.
Social
Compared to environmentally focused ESG mutual funds, there is less interest in funds focused on social issues and fewer funds available.
Social screening metrics include companies’ relationships with their employees, customers, and communities. Within a company, it includes diversity, equity, and inclusion (DEI) programs and policies, employee engagement with management, equal employment opportunities, workplace safety, and gender and racial diversity in hiring and promotions. With respect to external relationships, social screens include community impact in places where a company is located and the impact of a company’s products (e.g., tobacco and firearms) on the world.
Governance
Governance refers to how a company is managed including its leadership (CEO, executive officers, and board members) and internal risk controls to prevent loss or mismanagement.
Key factors considered in governance screening include: board diversity, board independence from management, ethical standards and practices, financial risk reduction practices (e.g., debt reduction, diversified products/services, employee training, and insurance), the gap between executive pay and employee pay, and voting rights for shareholders.
Advantages of ESG Investing
An advantage of ESG investing is the positive feeling investors get by aligning investments with their values and concerns (e.g., gun violence and global warming). A second advantage is mitigation of investment risks associated with environmental damage, social controversies, and lack of regulatory compliance. A third advantage is the positive impact ESG investments could have on society by openly addressing issues such inequality and human rights abuses. A study by Morningstar found a performance advantage versus mainstream mutual funds. In other words, investors can do well by doing good. Other studies, not so much.
Disadvantages of ESG Investing
There is a lack of standardization in ESG funds, which makes them difficult and time-consuming to compare. Some are very niche and focus on E, S, or G. Also, some funds exaggerate their ESG efforts, a practice known as “greenwashing.” In addition, by definition, ESG funds are less diversified than traditional funds because they exclude certain industry sectors. This can lead to underperformance and higher volatility. ESG funds experienced net outflows in 2023 and lagged behind non-ESG peers.
ESG Investments in 403(b) Plans
Now that I’ve covered ESG basics, lets discuss the question you are probably asking yourself: are ESG investments available in 403(b) plans? The short answer is “it depends.” ESG access depends on the vendors that are available to plan participants and the specific investments that those vendors offer.
Let’s start with the two 403bwise Green+ vendors: Fidelity and Vanguard. Fidelity packages its ESG funds under the umbrella term Fidelity Sustainable Investing and offers a number of ESG funds. Some Fidelity ESG funds reflect a broad range of ESG selection criteria while others are more narrowly focused around environmental, social, and governance “themes.” There are two funds on the list of investment choices for Fidelity non-profit organization plans for the E part of ESG: Environment and Alternative Energy Fund (FSLEX) and International Sustainability Index Fund (FNIDX). Other Fidelity ESG investments that 403(b) plan participants could include in their IRAs or taxable accounts include Fidelity® Climate Action Fund (FCAEX), Fidelity® Water Sustainability Fund (FLOWX), Fidelity® Women’s Leadership Fund (FWOMX), and the new Fidelity® Sustainable Target Date Funds with dates ranging from 2010 to 2065.
The Vanguard ESG Investing website lists a lineup of seven ESG investment products: four mutual funds and three exchange-traded funds. However, only their FTSE Social Index fund (VFTAX), with a razor thin 0.14% expense ratio, is on the list of investment choices for 403(b) plan participants with access to Vanguard (or Aspire to indirectly invest in Vanguard). Other Vanguard ESG investments that 403(b) plan participants could include in their IRAs or taxable accounts include three actively-managed funds: Baillie Gifford Global Positive Impact Stock Fund (VBPIX), Global Environmental Opportunities Stock Fund (VEOIX), and Global ESG Select Stock Fund (VEIGX).
The 403bwise Yellow vendor, TIAA, also deserves mention. Its TIAA-CREF Social Choice Equity Fund (TISCX), currently with a 0.27% expense ratio, has been around longer than many ESG mutual funds. However, changes are underway. As noted on the fund website “Effective May 1, 2024, the Fund's name will change from TIAA-CREF Social Choice Equity Fund to Nuveen Large Cap Responsible Equity Fund. In addition, the Fund's Institutional, Advisor and Retail share classes will be renamed, and an up-front sales charge will be applied to certain purchases of Class A shares (formerly Retail Class shares).”
Research Results
The FINRA Investor Education Foundation and NORC conducted a study to understand investor perceptions and preferences related to ESG investing. They found that 57% of 1,228 respondents strongly or somewhat agreed that investing can be a way to make positive change in the world. However, only 28% were familiar with ESG investing and only 21% knew what the letters ESG stand for. Self-reported familiarity was highest among investors under age 30, with incomes under $30,000, and African-American investors. The study also found that respondents did not appear to consider ESG values in other financial transactions like shopping.
Three (More) Things
- Investors in ESG mutual funds, even ESG index funds, typically pay more than non-ESG peers because there is a cost to obtaining social responsibility data and vetting companies.
- In some locations, ESG investing is viewed as part of a “woke” political agenda, which has resulted in new state laws and plan sponsors removing ESG investments from retirement plan investment offerings.
- A Harvard study found that ESG funds have 68% of their assets invested in the same exact assets as non-ESG funds. Thus, only about a third of average ESG fund assets are distinctly different.
Six Smart Strategies
No. 1: Read ESG Fund Prospectuses — Pay attention to an ESG fund’s objective, performance history, expense ratio, and time since fund inception, just as you would with any mutual fund. Select a fund that performs best on your search criteria.
No. 2: Do a “Rule of Three” Comparison — Use this worksheet to compare characteristics of three mutual funds that you are considering (e.g., three ESG funds or an ESG fund vs. non-ESG funds). Use data from fund prospectuses to complete the form.
No. 3: Monitor ESG Fund Performance — Don’t make the mistake of sticking with a poorly performing ESG fund simply because you think it will “help save the world.” Treat ESG funds just like any other investment.
No. 4: Expect Different Points of View — Be aware that others may not have the same enthusiasm for ESG investing as you do. Unfortunately, as noted above, this investment style has gotten caught up in “culture wars.”
No. 5: Use ESG Rating Resources — Use search tools like Morningstar Sustainability Rating to evaluate ESG characteristics of mutual funds and avoid greenwashing. Morningstar ratings are provided using a one (lowest) to five (highest) globe system.
No. 6: Do More Than Invest — Consider ways, beyond ESG fund investing, to make an environmental, social, or governance statement. Examples include advocating for public policy changes and boycotting products from concerning companies.
In Summary
403(b) plan investors may have an opportunity to invest in ESG funds but, like any other plan investment option, it is important to “look before you leap.” As noted above, performance results vs. non-ESG funds are mixed and expenses will always be more than the 0.04% charged by Vanguard’s Total Stock Market Index Fund (VTSAX). It is up to individual investors to decide if the higher fees and questionable superior performance of ESG funds are worth it.
This post provides general personal finance information and does not address all the variables that apply to an individual’s unique situation. It should not be construed as legal or financial advice. If professional assistance is required, the services of a competent professional should be sought.
...
Dr. O'Neill is the owner/CEO of Money Talk: Financial Planning Seminars and Publications where she writes, speaks, and reviews content about personal finance. She is a Distinguished Professor Emeritus at Rutgers University and a long-time 403(b) plan participant.