Could ESG Options Undermine Participant Outcomes?

Despite surveys to the contrary, a new study finds that overall interest in ESG strategies by participants is “relatively weak” and “driven by naïve diversification.”

The difference may, of course, be attributed to the difference between what individuals say—and what they actually do. Unlike surveys that purport to capture participant (and plan sponsor) sentiments, the research by David Blanchett of PGIM and Zhikun Liu of the Employee Benefit Research Institute (EBRI) looks at the actual allocation decisions of 9,324[i] newly enrolled DC participants who are self-directing their accounts in a DC plan that offers at least one ESG fund. 

‘Weak Preferences’

They do so in a paper titled “ESG Fund Allocations Among New, Do-It-Yourself Defined Contribution Plan Participants,” they claim to find that overall interest in ESG strategies among these participants is “relatively weak,” with only 8.9% of participants having any allocation to an ESG fund and average allocations to ESG strategies of just 18.7% among those holding any ESG funds.[ii] Indeed, while they note “some clear demographic preferences for ESG funds (e.g., among younger participants with higher incomes),” they find that ESG allocations appear to be “primarily a function of weak preferences, driven by naïve diversification.”

Now, that hardly sounds like the heightened interest and engagement with those options that some participant surveys have captured (well, aside from that by younger participants with higher deferral rates and higher incomes). However, the research claims that the two factors which appeared to drive the largest allocations to ESG funds were not related to participant demographics, but rather the number of funds in the participant portfolio and the percentage of participants in the respective DC plan allocating to an ESG fund. 

If that seems a confusing descriptor, they found a “notable increase” in the probability of owning an ESG fund as the number of portfolio holdings increases—basically, the more funds the individual holds, the more likely he or she is to have an ESG offering among them. This tendency they characterized as attributable to “naïve diversification”—again, basically, if you’re simply picking a larger number of funds overall, then they concluded that the decision to allocate to the ESG fund is “likely based on a weak preference, not necessarily conviction in ESG.” Said another way, if you’re picking a lot of different funds, the more you pick, the better the odds that an ESG fund will (randomly) be among them.

On the other hand, those looking for a more optimistic future for ESG might take heart from their conclusion that “the fact ESG allocations increase as more participants in a plan allocate to ESG funds suggests plan interest effects could be an especially strong driver of future growth in ESG funds (despite relatively low usage today).” In fact, they noted a “notable plan interest effect, whereby ESG allocations are significantly higher in plans where general ESG usage is higher.”

Plan Sponsor Cautions

That said, the current decision-making by those participants appears to be “sub-optimal” (worse than you might expect) from a return standpoint—with the researchers here basically finding that participants who self-direct their portfolios have significantly lower expected returns than those using professionally managed investment options, such as target-date funds—something that proponents of professionally managed asset allocation solutions shouldn’t find surprising. To put it another way, those more likely to pick ESG funds are more likely to be the “do it yourself” (DIY) types—and those don’t do as well as those professionally managed solutions. This, as the researchers point out, can be an “important consideration for plan sponsors when adding ESG funds to the core menu to the extent they entice participants to self-direct their accounts.” So, adding an ESG fund might encourage more DIY investing by those interested in ESG—and that interest pulls them away from the professionally managed, higher-returning alternatives.   

In fact, an additional analysis suggests that those DIY participants have expected returns that are approximately 100 basis points lower than investors using professionally managed portfolios, such as target-date funds and managed accounts. And this, the researchers comment, suggests that adding ESG funds to core menus may create additional implicit return “costs” for participants—by adding those options that encourage participants to make choices other than professionally managed multi-asset options (e.g., target-date funds).[iii]

Overall, the researchers comment that their analysis paints a “mixed picture about the actual participant interest, and drivers of demand, for ESG funds in DC plans and suggests that plan sponsors should take a thoughtful approach when considering adding ESG funds to an existing core menu.”

Or—it seems fair to say—when adding (or subtracting) any funds at all.

- Nevin E. Adams, JD

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[i] Of the 9,324 participants included in the dataset, only 833 had some allocation to an ESG fund, which is 8.9% of the total.

[ii] Among participants with an allocation to an ESG fund, the average allocation was 18.7%, with a standard deviation of 19.0%. The total average balance allocation to ESG funds is 1.7% (including all participants). There are only 56 participants (0.6% of the total) with ESG allocations greater than 50% of their balance and only 19 participants (0.2% of the total) with 100% of their balance in ESG funds. “In other words, even among participants who select the ESG funds, they almost always play a relatively supporting role as part of the overall portfolio.”

[iii] Some of the issues here are no doubt a consequence of current menu constructions. In the sampling studied, no plan offered more than five ESG funds, and the vast majority (approximately 76%) offered only one ESG fund. “This suggests it would be relatively difficult to build a diversified portfolio using only the ESG funds in DC plans currently,” the authors note. Moreover—and adding to the reality that it is “relatively difficult to build a truly diversified portfolio using only ESG funds”—they explain that roughly half of all ESG funds available are large blend funds. Only 13 of the funds (8.7% of the identifiable category total) are fixed income funds, and only 12 (8.1% of the identifiable total) are balanced funds. “The difficulty associated with building a diversified portfolio with only ESG funds has important implications on overall portfolio efficiency. If allocating to ESG funds requires participants to opt out of using a professionally managed portfolio option (e.g., target-date funds or retirement managed accounts), it may negatively impact future expected returns”—a cost the authors say they plan to quantify in a future work.

Are SDBAs the Next Litigation Target?

Back in the 1990s, the ability to support a self-directed brokerage account (SDBA) capability was a widely utilized means of winnowing the field in a 401(k) search, and more recently, the option seemed to hold promise as a foil for excess fee litigation charges. But that could be changing.

The SDBA option allowed participants to make investment choices outside the standard retirement plan menu – a big deal at a time when you could count the number of choices on two hands. Vanguard’s 2017 “How America Saves” report notes that one in six (17%) plans offer the SDBA option, though nearly a third (30%) of plans with more than 5,000 participants do. And while this amounts to nearly 3 in 10 Vanguard participants having access to the option, only 1% of these participants used the feature in 2016, and in those plans, only about 2% of plan assets were invested in the SDBA feature that year. PLANSPONSOR’s 2017 DC Survey pretty well mirrors those findings: 18.7% of plan sponsor respondents have the option, with nearly half of plans with more than $1 billion in assets choosing to do so.

Of course, with SDBAs, it has never been about how many used the option, but who – and for the very most part, the option has its greatest appeal among those whose balances (or financial acumen, real or perceived) calls for it, particularly among closely held small businesses and professional practices, such as lawyers and doctors.

Fee Litigation

In the early days of the so-called excessive fee litigation, at least one court (the 7th Circuit, in Hecker v. Deere) found compelling the notion that the existence of the SDBA gave participants access to a sufficient variety of reasonably priced funds to refute excessive fee claims against a plan that had a “regular” fund menu comprised of nothing by the proprietary funds of its recordkeeper.

However, and while it hasn’t been a primary focus of recent litigation, several of the more recent suits do raise concerns with the existence of the SDBA, but more importantly, how it was managed.

About a year ago, in a suit brought by American Century participants against their own plan, the plaintiffs took issue with how the SDBA was administered, and while they acknowledged that usage of the SDBA is higher within than industry statistics would suggest, they went on to state that that result was “no doubt due to Defendants’ imprudence and self-dealing” (less than 7% of the plan’s assets are held in SDBAs).

In a 2015 suit involving PIMCO, the plaintiffs argued that “…those who choose to utilize an SDBA are typically assessed an account fee and a fee for each trade” — fees that they said “often make an SDBA a much more expensive option compared to investing in the core options available within the Plan.” Additionally, they claimed that because “employees investing in mutual funds within an SDBA must invest in retail mutual funds, rather than the lower-cost institutional shares typically available as core investment options,” those who do use the option again pay higher fees.

And then, just this year, in a suit brought against Schwab, the participant-plaintiffs charged that not only that Schwab received revenue sharing payments from third-party ETF and mutual fund providers whose funds were made available to via the platform, but that the SDBA’s “byzantine complexity and confusing schedule of fees alone make it inadvisable for all but the most sophisticated of investors.” The plaintiffs framed the availability of the option to all participants (rather than just more sophisticated participants) as an issue, and charged that Schwab made no effort to determine: (a) if the SDBA was a prudent option at all, or (b) if another provider’s SDBA might have been better.

All of which should remind us that plan fiduciaries have a responsibility to carefully select and monitor their SDBA provider and these services. That could include:

• the qualifications and qualify of the provider;
• the reasonableness of the fees; and
• the security of the account and stability of the provider.

And just like any provider of services to a qualified plan, if the brokerage window can’t be prudently selected, the plan should not offer that window.

Something on which the plaintiffs’ bar now seems to be focusing.

- Nevin E. Adams, JD