Sustainable investing is on a tear.

According to Morningstar research, sustainable investment funds, which the research firm defines as those that use environmental, social, and corporate governance (ESG) criteria as measurements for scoring the societal impact of investing in a public company, saw record flows of $5.5 billion in 2018.

Last year marked the third consecutive year of record flows to ESG-premised mutual funds, which increased 50 percent to 351 offerings in 2018. ESG funds held $161 billion in assets at the end of 2018, when 37 new funds were launched, and 67 existing funds added ESG criteria to their investment strategy.

But that momentum in the general mutual fund market has not yet translated to take-up in 401(k) plans, according to new analysis from Cerulli Associates, despite what the firm calls a noticeable uptick in ESG conversations in the retirement market.

The barrier to 401(k) plans is not due to sponsors' or participants' social indifference. A 2018 survey of 800 plan sponsors showed 46 percent of respondents believe ESG factors are “very important” when selecting a 401(k) plan investment.

Of 1,000 surveyed plan participants, more than half said they prefer to invest in “environmentally and socially responsible” companies. Younger participants and women were even more likely to prefer ESG options, Cerulli found.

But despite that appeal, adoption of ESG strategies in 401(k)s has been slack.

Callan data shows only 16 percent of defined contribution plans offer a dedicated ESG option. Moreover, take-up rates are low: The funds account for 2 percent of assets when they are offered.

Cerulli says Callan's numbers may paint an exaggerated picture of ESG's relevance in the 401(k) market, as Callan typically advises large and mega plans.

ESG last in sponsors' consideration of investment options

While nearly half of sponsors surveyed by Cerulli claimed to place a priority on ESG attributes, sustainability actually ranked last in the features that dictate how plan investments are selected.

Only 16 percent of sponsors said ESG was an important consideration to their selection process, compared to 45 percent that put investment performance as the top criterion, and 38 percent that said cost was the most influential determinate.

“Fee sensitivity and the notion that ESG investing entails a trade-off in performance are two broadly applicable headwinds to ESG adoption,” write analysts in the most recent edition of Cerulli Edge.

“Data shows that plan sponsors care about ESG factors, but they place a greater emphasis on performance and price,” said Dan Cook, a research analyst in the retirement practice at Cerulli, in a press release.

Regulatory crosscurrents: a tale of two Labor Departments

Further complicating the entrance of ESGs into 401(k) plans is the differing treatment the Obama and Trump Labor Departments have given to socially responsible investing.

Under the Obama administration, ESG investing in ERISA-covered retirement plans was given a nudge when regulators published a field assistance bulletin saying plan fiduciaries could choose an ESG option over a rank-and-file mutual fund when the risk and return prospects are equal among the two.

But last year, the Trump administration issued guidance with a “contrasting” tone, says Cerulli.

Addressing the specific use of choosing ESG investments as a qualified default investment alternative, the Trump administration said, “nothing in the QDIA regulation suggests that fiduciaries should choose QDIAs based on collateral public polity goals.”

Furthermore, sponsors and other plan fiduciaries that choose ESG investments based on their own policy and sustainability preferences without considering the “competing views” of other plan participants “would raise questions about the fiduciary's compliance with ERISA's duty of loyalty.”

In effect, ESG investments must be prudent of all plan participants, and not just a select group of participants, if it is to satisfy Labor's QDIA requirements, says Cerulli.

Enrolling participants in an ESG-based target-date fund should not be done “without sufficient due diligence conducted on non-ESG alternatives,” said Cerulli's Cook.

Who determines what's sustainable?

As ESG investing is making new inroads in capital markets, and more inquiries are made into its role in 401(k) plans, questions are emerging as to how different funds are benchmarked and how individual companies qualify as sustainable investments.

Facebook may be the most glaring example of the conundrum. Technology companies are often assumed sustainable based on low carbon footprints. According to analysis from Bloomberg in March of 2018, 80 ESG funds counted Facebook as a Top-10 holding.

But the Cambridge Analytics scandal called into question Facebook's corporate governance policies. Some ESG-centric fund managers reportedly responded by removing investments in Facebook. The recent massacre in New Zealand, which was live-streamed on Facebook, may raise more questions for ESG fund managers.

Fiduciaries are also raising concerns over inconsistent standards on how ESG funds are rated.

“We have a fiduciary obligation to our clients in almost all cases to outperform, and ESG's most important claim is that doing good will drive better returns,” writes Christopher Merker, a fiduciary advisor, in a blog post published on the CFA Institute's website. “That argument is weakened by inconsistent ratings.”

Merker notes that Berkshire Hathaway was ranked last on ESG measurements in the S&P 500 by one firm, while another ranked its sustainable value in the middle. “That's simply too much dispersion,” wrote Merker.

In the target-date space, Natixis was an early adopter of ESG investing. Its Sustainable Future 2050 Fund, rolled out two years ago, now holds $2.68 million in assets. Its net expense ratio is 65 basis points.

The actively managed fund holds hundreds of individual securities. Facebook Class A shares accounted for 0.39 percent of the fund as of January 31, 2019.

Shares of Alphabet account for nearly 1 percent, and shares of Amazon 0.62 percent. Both firms are under growing anti-trust scrutiny.

Meantime, the 2050 fund holds ConocoPhillips, which has a high sustainability rating in spite of being an oil company.

“To include or not to include? Are we avoiding the oil sector altogether or not,” asks Merker of the ConocoPhillips' role in ESG funds.

Natixis' 2050 fund also holds UnitedHealth Group, the country's largest health insurer, as more polls show millennials warming to government control of the health care system.

Dissenting views on defining ESG further complicates the role of sustainable investing in 401(k) plans, notes Cerulli's analysis.

“If asset managers grapple with the complexities of ESG benchmarking, one can assume that less sophisticated stakeholders–end-investors, plan sponsors, and, to an extent, advisors–have less knowledge in this area,” Cerulli's report says.

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