The Evolution of Fiduciary Responsibilities in 401(k)s

The new DOL rule, Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights, comes after President Biden’s executive order in May 2021, directing federal agencies to consider policies to protect against the threat of climate-related financial risk. Recently, the agency also released a factsheet explaining the proposal.

The DOL emphasized that ESG is not a mandate. Instead, the agency views ESG components as economically significant factors when evaluating risk and return. The rule gives fiduciaries options that take the physical and transitional risks of climate change into account when selecting mutual funds, stocks, or other plan investments.

“We’re heartened to see the DOL’s ruling on ESG in defined contribution plans as multiple plan consultants we’ve spoken with said they didn’t feel comfortable suggesting any non-traditional options until they had a clearer signal from Washington,” says Zach Stein, Chief Investment Officer of Carbon Collective, a climate-focused advisor.

The move also follows the introduction of ESG options across many IRA-focused robo-advisors, including Betterment’s and Wealthfront’s SRI portfolios. Other online advisors, like Carbon Collective and NewDay Impact, provide climate and sustainability-focused portfolios. Now, these types of investment options may be available in 401(k) accounts.

The U.S. has about $7 trillion spread across 600,000 401(k) plans for about 60 million active participants and millions more former employees and retirees. In addition to de-risking these portfolios, impact-driven climate investments could pour billions of dollars into industries that could help turn the tide of climate change.

In addition to adding ESG options to 401(k) plans, the new rule reverses the prior rule’s prohibition on using ESG funds as qualified default investment alternatives (QDIAs). As a result, ESG-aligned funds could become the default option in an automatic enrollment 401(k) defined contribution plan (e.g., target-date retirement funds).

The impact on climate change risk, however, depends on the efficacy of these investments. According to an analysis by the Economist, the world’s 20 largest ESG funds hold an average of 17 fossil-fuel producers. Six own Exxon Mobil, two own Saudi Aramco, and one holds a Chinese coal mining company, not to mention gambling, tobacco, and alcohol companies.

“Now the real work begins to make sure there are actually sustainable, cost-effective, impact-driven TDFs (target-date retirement funds) for plan sponsors to choose from,” says Stein. “The current ones are expensive, have no clear voting strategy, and still have plenty of fossil fuel companies in them.”

The Department of Labor’s new rules could open the door to more ESG options (or even defaults) in 401(k) plans. By providing clarity to plan sponsors, it goes beyond the promise not to enforce the prior rule. But despite these gains, many existing ESG funds fail to deliver on their goals, meaning more work needs to be done to truly mitigate climate and ESG risk.

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