Investment funds tailored to meet social or environmental goals have been growing in popularity, and many have been outperforming more traditional funds, but now the federal government proposes to restrict such choices in retirement and pension plans.
The language is complex, but the takeaway is that if a pension or 401k plan wanted to include investment funds that, for example, exclude coal stocks, that might not be allowed under proposed regulations.
The Department of Labor says the changes would prevent pension managers from choosing investments that "subordinate return or increase risk for the purpose of non-financial objectives."
If teachers did not want their pension fund to invest in companies that make guns, for example, the proposed rule could block such a decision.
The Labor Department says that protects the financial interests of retirees, but the American Retirement Association and many leading financial firms that manage retirement accounts disagree and have submitted comments opposing the proposed change.
The Department of Labor's plan could lead to pension plans investing more in guns, coal, and other businesses some retirement savers would prefer to avoid, by having to eschew funds that avoid such investments. Meanwhile, the hottest investment sectors this year include solar energy funds (the exchange-traded fund TAN, for example).
A typical index fund — a staple of retirement accounts — buys proportionate shares of all the stocks in a given index, such at the S&P 500 or Russell 2000. They naturally do not exclude any companies in that index.
Environmental, social and governance, or ESG, funds take a different approach. Some exclude certain types of investments, while others research corporate hiring practices and sustainability goals, or hand-pick companies for their leadership in different metrics.
Years ago, these were considered niche investments, and had a reputation for high fees and returns that lagged the broader market.
Recently, some ESG funds have been outperforming the market substantially. Why? One simple reason is that they tend to be more heavily concentrated in technology businesses and alternative energy companies, both of which have been doing quite well.
Consider two funds offered by Vanguard, one of the largest financial firms in the world:
- Vanguard's (S&P) 500 Index fund buys proportionate shares in all 500 of the largest U.S. companies. The fund was up 3.47 percent this year through Aug. 4, and boasts a super-low expense ratio of 0.04 percent.
- The Vanguard FTSE Social Index Fund is "screened for certain environmental, social, and corporate governance" criteria and "specifically excludes stocks of certain companies in the following industries: adult entertainment, alcohol, tobacco, weapons, fossil fuels, gambling, and nuclear power." That fund was up 6.28 percent through Aug. 4 and has a very low expense ratio of 0.14 percent
For both funds the five largest holdings are Microsoft, Apple, Amazon, Alphabet and Facebook. The difference in performance comes from the investments the Social Index Fund excludes.
Fidelity, also one of the world's largest investment companies, offers a half-dozen ESG funds. Some are broadly focused and some are more targeted, such as a fund that "invests in companies that prioritize and advance women’s leadership and development."
Do investors want such options? Fidelity says it's research has shown that "two-thirds of retail customers say social impact is key to their investing decisions."
The Labor Department, however, has interpreted the Employee Retirement Income Security Act of 1974 to require that retirement plan fiduciaries — pension and 401k plan managers — "may not invest in ESG vehicles" if they understand that the investments' non-financial objectives could reduce returns or increase risk.
Are there options? Investors and retirement savers can put their money wherever they like, in IRAs or personal investments, but if the Labor Department rule takes effect, pension and 401k plans would be restricted from ESG investments.
The comment period on the proposed policy has ended, and the agency has not yet announced how it will proceed.