How to Get Sustainable Investment Options in Non Profit Retirement Plans

One of the main motivations for most who choose to work at a nonprofit is to spend their day to day lives driving change and making a positive impact on the world.

Values are important in any organization. They are especially important at a nonprofit. And that’s where we see a lot of nonprofit orgs get into trouble. It can be hard, scary, and even intimidating to try and align a nonprofit’s retirement plan options with the values of the nonprofit itself.

That’s what we spend our day to day lives doing at Carbon Collective and if you work at a nonprofit, this article is for you.

Because yes, it is possible to include sustainable options in your nonprofit’s retirement plan in a manner that is fiduciarily responsible and simple to administer.

So let’s start with the objections, or maybe why you’ve been told this is hard:

Why You’ve Been Told No

If you’re an employee or an HR manager talking to your 401(k) advisor and you’ve asked this very question, you’ve probably heard a response like this:

“Sorry we can’t. We have a fiduciary responsibility.”

What’s that actually mean?

According to the Department of Labor (DOL), a plan sponsor (that’s what a company/org is called in 401(k)-language), has a fiduciary responsibility to diversify the plans offerings to reduce the risk of large losses, regularly monitor the service providers and plan itself, and operate the plan in such a way that is solely in the interests of the employees. Here’s a link to the DOL’s exact language.

Plan sponsors are more cautious than most other types of investment managers because the stakes are higher for them. They can get sued much more easily. And if they lose, they will need to pay out the difference in claimed losses… So the hesitancy you’re seeing is very understandable given the litigious risk.

But here’s the rub: the DOL does not say anything about what types of investments are allowed and which are not. If a company wants to add a fund, it simply will need to document that they did it to: “diversify the plan’s offerings to reduce the risk of large losses” and that they believed it was in the best interests of the participants of the plan.

Sounds simple right?

We believe it is actually that simple (which we’ll talk more about below), but before we do, we should fill you in on the back and forth that’s made a lot of plan sponsors and advisors over-complicate it:

Trump vs. Biden era DOL rules on ESG

Let’s catch you up on a little 401(k) history.

The Trump administration in 2019 filed a proposal that plan sponsors could only consider “pecuniary” factors when considering what funds to include in their investment lineup.

Pecuniary means “of and related to money.”

This was a pretty clear move to block any consideration of other reasons someone might choose an investment lineup that took other considerations into account like environmental or social impact.

The Trump ruling never got fully implemented but it set the stage.

The Biden administration first came on strong, saying that concerns like climate risk had to be considered by fiduciaries. But after a long commentary period, this got watered down to a landing place where the DOL has ruled explicitly that Environmental, Social, and Governance factors may be considered when choosing an investment lineup, but only as a “tiebreaker” between two funds that have similar performance or other pecuniary measure.

Thus, both in fear of a change of policies under a new Trump administration and feeling uncomfortable defining when a “tiebreaker” is appropriate for ESG considerations, many 401(k) investment advisors and consultants have avoided any inclusion of ESG or sustainable funds in 401(k)’s.

ESG Is a Different Investment Philosophy than Passive Investing

But it’s not like that results in a de-facto scenario where low-fee passive funds track whole generic indices are the only option that can be included in a 401(k) plan.

To us, it just means that a plan sponsor cannot include an ESG or a sustainable fund in a 401(k) because they believe it will be more impactful or values-aligned than the alternative.

This is where we see so many nonprofits and investment committees get stuck.

They assume that in order to be included, a fund that applies an ESG screen or includes sustainability factors in its holdings selection should have the same performance and follow the exact same trends as a fund that does not include such factors.

But that’s not a fair comparison. An investment portfolio that fully excludes oil companies can and should perform differently than one that includes them. They are two different investment philosophies and their ongoing performance should not reasonably be expected to match.

Let’s make it a little more concrete:

• 2020: A fossil fuel free portfolio would have outperformed one with fossil fuels after oil stocks collapsed in response to the pandemic.
• 2022: A fossil fuel free portfolio would have underperformed one with fossil fuels after oil stocks had a major rally in response to Russia’s invasion of Ukraine.

Now here in 2024, which portfolio will make more money for a 30 year old retiring in 30 years? Nobody knows for sure. One can make credible arguments either way. It is really up to the individual on what investment philosophy they believe will perform the best.

This holds for ESG investing and climate-focused investing. They are both unique, coherent investment philosophies that have a clear rationale for why one could expect outperformance vs. the overall stock market over their career.

For ESG it’s that the overall stock market does not adequately account and price in environmental, social, and governance-related risks. A portfolio that excludes companies with low ESG scores could be argued to outperform over the long term by reducing these risks.

For Climate it’s that the overall stock market is neither adequately pricing in climate risk or climate opportunity. A portfolio that takes those two factors into account could be argued to outperform over the long term by taking these factors into account.

It’s not about which strategy will outperform. Or which did better last year. It’s that they each have a coherent philosophy on why they could outperform in the long run. 

So that might sound rational, but what do the courts say about it?

The Case Law is Clear: A 401(k) Can Have Multiple Investment Philosophies

While we have not yet seen major litigation around ESG in particular, we have seen a number of trials come to court around an arguably similar issue: active vs. passive management.

There’s been a number, but they all come down to the same framework: a company opted to use an actively managed fund series for the default investment option in their 401(k). Due to the difficulties of ongoing active outperformance and/or the higher fees for active funds, those funds underperformed a lower-fee passive target date option. So, a participant sues the company saying they are owed for the difference in potential gains.

A bunch of major companies that use a Blackrock actively managed target date fund were targeted with such a lawsuit recently (including Cisco, Microsoft, Capital One, and others).

What happened? In each case, the courts sided with the company, dismissing the charge.

Why?

Let’s use an example from another nonprofit.

In 2021, a federal judge dismissed a case against Catholic Health Initiatives and their $3.2 billion 401(k) plan that argued that using Fidelity’s actively managed target date funds instead of their passive ones cost the plan participants in higher fees and underperformance.

This is from the ruling:

“[A]ctively managed funds and passively managed index funds are not ideal comparators: ‘they have different aims, different risks and different potential rewards that cater to different investors.”

“In fact, a fiduciary is required to offer a diverse array of investment choices to plan participants. Offering funds with different management approaches and varying levels of risk is one way to diversity the portfolio of available investments”

“Viewed in this context, a plan fiduciary does not necessarily act unreasonably merely by including an actively managed fund that happens to perform worse or cost more than any given passively managed fund. Any other conclusion would in effect prohibit plan managers from offering investment options a plaintiff views as inferior, something which courts have repeatedly held is not the law under ERISA.”

Re-read that first paragraph again. The two types of investment philosophies have “different aims, different risks, and different potential rewards that cater to different investors.”

ESG and climate investing definitely check all of those boxes.

Our (Not-Secret) Method: Add, Don’t Subtract Options. Document Thoroughly

So how do you get sustainable, ESG, and/or climate options added to your nonprofit’s retirement plan?

Let’s break it down:

1. You explicitly choose to add new investment philosophies to the plan
2. Document that decision process and why each investment philosophy could lead to long-term outperformance.
3. Research and choose the best performing funds within each investment philosophy
4. Document that decision process.
5. Re-run this process regularly.

Oh, and make sure you always keep a full series of low-fee passively managed options in the plan. From target date funds to the S&P 500. This was one of the main factors that helped Catholic Health Initiative’s case:

“However, the plan did include some index funds, so participants were not necessarily forced to invest in the higher-cost active funds if they did not wish to, according to the court.“

Nobody should ever be forced away from investing with the total stock and bond market. But they should not necessarily be forced into doing it either.