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New research by PGIM DC Solutions paints a mixed picture about interest in and drivers of demand for Environmental, Social and Governance (ESG) funds in defined contribution plans. Many participants are opting into these funds out of a weak preference rather than a strong conviction, the report said.
The research explored the allocation decisions of 9,324 new DC plan participants across 108 DC plans who are self-directing their accounts. New participants were selected for the study because growth in ESG funds in DC plans is most likely to come from such participants rather than established participants who typically don't make many adjustments to their allocations.
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Among DIY investors, allocations to ESG funds were relatively modest when offered in the core menu, according to the ESG Fund Allocations Among New, Do-It-Yourself Defined Contribution Plan Participants report. Only 8.9% of participants had any allocation to an ESG fund and the average allocation to ESG funds among those who hold at least one ESG fund was 18.7% of the total balance. The average allocation to ESG funds among all the DIY participants included in the analysis was 1.7%.
The report, authored by David Blanchett, head of retirement research for DC Solutions, and Zhikun Lui, senior research associate at Employee Benefit Research Institute, theorized that a possible explanation for relatively weak ESG interest is the scarcity of ESG funds in core menus. Among plans that offer ESG funds, 76% only offered one ESG fund, which was most commonly an equity fund, with Large Blend being the most common investment style.
However, the report uncovered a correlation between interest in ESG options and the number of funds in the participant portfolio as well as the percentage of participants allocating to an ESG fund in a plan.
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"The notable increase in the probability of owning an ESG fund as the number of portfolio holdings increases, along with other core menu relationships, suggests naïve diversification is likely driving a significant amount of the ESG allocation decision (i.e., the decision to allocate to the ESG fund is likely based on a weak preference, not necessarily conviction in ESG)," said the report. "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)."
ESG funds are relatively rare in core menus today, with only 13% of plan sponsors currently offering an ESG fund, according to the report. However, one potential issue with simply adding ESG funds to the core menu is that it may entice some participants to opt out of professionally managed portfolio options – such as a target-date fund or retirement managed accounts – and self-direct their account. As a result, participants may end up building less efficient portfolios than those created by investment professionals, the report said.
Overall, while the future of ESG is unclear, it is important for plan sponsors interested in including the options in a plan to take a thoughtful approach to their inclusion, to ensure the outcome is really in the best interests of participants, the report said.
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