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ESG Investments in 401(k) Plans: The DOL Final Rule

Final Rule shifts focus to accommodate growing participant interest in ESG investing.

Articles by Megan Fitzgerald
By Megan Fitzgerald Legal Counsel, Betterment Published Jan. 07, 2021
Published Jan. 07, 2021
6 min read

As investors show increased interest in environmental, social and governance (ESG) investing, the government has taken notice. In June, 2020, the Department of Labor (DOL) issued a proposed rule focused on the use of ESG options within retirement plans (such as 401(k)s), citing concerns that investment options were being evaluated using non-financial factors. The DOL softened its stance in its Final Rule, “Financial Factors in Selecting Plan Investments,” released on October 30, 2020, by shifting its regulatory focus away from specifically ESG criteria to the use of broadly defined “pecuniary factors,” or financial considerations, and permitting additional flexibility to consider ESG factors in a financial analysis of investment options.

So what exactly is the Final Rule and how do Betterment’s socially responsible investing (SRI) portfolio strategies comply with it?

Back to Basics: 401(k) Fiduciary Responsibilities

As an employer sponsoring your company’s 401(k) retirement plan, you take on important fiduciary responsibilities under ERISA (Employee Retirement Income Security Act of 1974), including a duty of loyalty and a duty of prudence:

  • The duty of loyalty requires plan sponsors act in the best interests of their plan participants at all times.
  • The duty of prudence requires plan sponsors to be knowledgeable about their plan’s investment options and, if they lack investment expertise, to hire and monitor a service provider like Betterment to manage their plan’s investments for them.

While plan sponsors cannot fully transfer all of their fiduciary responsibilities to a service provider, Betterment helps with many of these obligations, serving as both a 3(16) administrative fiduciary and a 3(38) investment fiduciary for 401(k) plans. Betterment as a 3(16) administrative fiduciary handles certain day-to-day administrative responsibilities, such as recordkeeping and filing reports. Betterment as a 3(38) investment fiduciary assumes responsibility for selecting, managing and overseeing a plan’s investment options, relieving plan sponsors of their investment fiduciary responsibility.

As a 3(38) investment manager, Betterment is directly responsible for ensuring that our investment options comply with the Final Rule. Having an understanding of the Final Rule and Betterment’s compliance with it will help plan sponsors to ensure that Betterment is choosing investments appropriately for their plans.

Changes Resulting from the DOL Final Rule

Long-standing DOL guidance, called the “investment duties regulation,” previously focused on how an investment fiduciary could satisfy the duty of prudence in selecting and managing investment options available to participants. The Final Rule makes several key changes to the investment duties regulation and goes into effect on January 12, 2021.

“Pecuniary” Factors and the Tie-Breaker Test

The Final Rule requires that plan fiduciaries evaluate investments based solely on pecuniary factors (financial criteria), which, consistent with past regulation, include time horizon, diversification, risk, and return.

The Final Rule’s definition of pecuniary factors provides additional flexibility for fiduciaries to select an investment option (such as an ESG option) if it has a return and risk profile equivalent to or better than alternative options. Investment fiduciaries, like Betterment, can evaluate whether certain factors (such as brand, corporate reputation, or sustainability) would affect the risk return calculus of an investment, and thus constitute pecuniary or financial factors.

The Final Rule also allows an investment fiduciary who is unable to make an investment decision on the basis of financial factors alone to include non-financial factors. To rely on this tie-breaker test, the investment fiduciary must document the decision in detail.

Acting in Participants’ Best Financial Interests

The Final Rule sets forth that investment fiduciaries may not prioritize other objectives over the interest that participants and beneficiaries have in returns generated from their retirement investments (i.e. their future retirement income), such as sacrificing return or taking additional risk to promote non-pecuniary goals. In other words, the duty of loyalty requires fiduciaries to act in the best financial interests of participants.

In addition, fiduciaries must also consider reasonably available alternatives, but not every possible alternative in the market.

Application to Qualified Default Investment Alternatives (QDIAs)

Lastly, the Final Rule prohibits an investment alternative from being used as a QDIA if it has investment objectives or strategies that consider one or more non-pecuniary factors. Consequently, plan fiduciaries should be careful when choosing a QDIA investment strategy to ensure that it does not identify non-financial performance metrics (such as ESG) as an investment goal or a principal investment strategy.

Betterment’s Investment Options

Betterment Core as QDIA

As a 3(38) investment fiduciary to 401(k) plans, Betterment uses its core (Core) portfolio strategy as the QDIA. If plan participants do not select an investment strategy to be used for their 401(k) account, all of their contributions will be invested pursuant to the Core portfolio strategy.

The Core portfolio strategy is a globally diversified portfolio of low-fee stock and bond Exchange Traded Funds (ETFs) that includes stock investments in developed and emerging markets and bond investments in governments, agencies and corporations around the world. It considers diversification, liquidity, and current and future return as primary performance metrics in line with the DOL’s guidance and takes into account an appropriate level of risk based on the participant’s age and expected retirement age.  Notably for purposes of the Final Rule, the Core portfolio strategy does not name ESG factors as investment goals and does not consider ESG factors in the selection of investment funds to include in the portfolio strategy. To learn more, the Betterment Core portfolio strategy white paper describes the Core portfolio’s construction and methodology.

That being said, Betterment does provide a broad range of other investment strategies for participants who do not want to invest in the Core portfolio. Betterment evaluates and monitors all investment portfolio strategies available to participants and beneficiaries.

Betterment SRI Portfolios

Plan participants with a Betterment 401(k) account may elect, if they choose, to invest their contributions in one of Betterment’s Socially Responsible Investing (SRI) Portfolios, which were recently upgraded to include Broad Impact, Climate Impact and Social Impact portfolio strategies.

Betterment’s SRI portfolio strategies aim to maintain the diversified, low-fee approach of Betterment’s Core portfolio while increasing investments in companies that meet SRI criteria. Betterment’s three SRI portfolios each have a different focus within the realm of Environmental, Social, and Governance (ESG) investing. Betterment’s Broad Impact portfolio offers increased exposure to companies that rank highly on all ESG criteria equally, while Betterment’s Climate and Social Impact portfolios focus on increasing exposure to companies with positive impact on a specific subset of ESG criteria.

In constructing and testing our SRI Portfolios, we evaluated whether the portfolio or selected investment fund is in the best interests of our clients, including plan participants. To satisfy our duty of loyalty and duty of prudence, we consider here the pecuniary metrics of the SRI Portfolios relative to the Betterment Core portfolio, a reasonably available alternative.

Betterment SRI Portfolios are Diversified and Low-Cost

The Final Rule reiterates that plan fiduciaries must consider diversification and the reasonable expenses of administering the plan. At Betterment, diversification and low-cost are key tenets of our investment philosophy and were applied to the development of the SRI portfolios.

We analyzed all liquid ETFs available which aligned with the SRI mandate of each SRI portfolio that could replace components of the Core portfolio strategy without disrupting the diversification or cost of the overall portfolio. You can read more about the ETFs that are included in each of the SRI portfolios in our SRI Portfolios white paper.

While funds that meet ESG criteria are often more expensive, we sought to ensure that the SRI portfolios remained consistent with our low-fee mandate and are not meaningfully higher than those of the Betterment Core portfolio. Expense ratios vary depending on the specific asset mix. Compare our portfolio expense ratio ranges:

Betterment SRI Portfolios Are Performance Tested

Stressing that plan fiduciaries must evaluate investments based on pecuniary factors alone, with the Final Rule the DOL sought to address concerns that a socially responsible investment could lead to lower returns in the long term compared to another similar portfolio.

To determine if there were in fact any financial tradeoffs associated with an SRI portfolio strategy relative to the Betterment Core, we examined evidence based on both historical and forward-looking returns. When adjusting for the stock allocation level and Betterment fees, we found that:

  1. There were no material performance differences
  2. The portfolios were highly correlated overall
  3. Over certain time horizons the SRI portfolios actually outperformed the Betterment Core portfolio

Our forward-looking analysis does not provide any basis for concluding that, over the long term, there will be a meaningful difference in performance between our SRI and Betterment Core portfolios. You can read about our full methodology and performance testing in our SRI Portfolios white paper.

Our findings are consistent with broader testing of sustainable funds by third-party sources. A white paper by the Morgan Stanley Institute for Sustainable Investing summarized the results from a study that analyzed the performance of nearly 11,000 funds from 2004 to 2018 and compared traditional funds to sustainable funds. The primary takeaway of the study revealed that there was no trade-off in performance when comparing sustainable to traditional funds.

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Summary

While the Final Rule does place some limitations on ESG investing within retirement plans, it is flexible enough to permit investment fiduciaries like Betterment to include ESG factors as part of its financial evaluation of an investment option or strategy.

Betterment complies with the Final Rule by offering the Betterment Core portfolio strategy as its QDIA and by carefully evaluating the other available portfolio strategies to ensure they do not sacrifice return or take additional risk to promote non-pecuniary goals. Our extensive work to construct diversified low-cost SRI portfolios is in line with the DOL’s guidance, and our historical and forward-looking performance did not provide any basis to conclude that the Betterment SRI portfolios entail a tradeoff returns for sustainability. Because of this measured approach to portfolio construction and performance testing, we are able to offer plan participants the opportunity to invest in SRI portfolios that are in their economic best interest and align with their values.

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