Political Football: Inclusion of ESG Funds in 401(k)s

In nation accustomed to litigation, availability of funds has varied by U.S. Circuit Court boundary

About three in four 401(k) participants surveyed said they would save more if offered an ESG (environmental, social, governance) option. Another survey found that more than 60% of voters oppose government restrictions on ESG investing (closer to 70% among Republican voters).

And yet, fewer than 15% of 401(k) plans offer an ESG fund in their investment lineup. A working paper by UCLA Anderson’s Jane Danyu Zhang, a Ph.D. candidate, documents that politics plays a role in this curious mismatch between savers’ desires and what their 401(k) offers.

Danyu makes a case that the politicization of climate change and social justice initiatives (such as diversity, equity and inclusion policies in the workplace) is a factor in whether a plan does or doesn’t offer an ESG fund. She finds that in plans that operate in regions overseen by conservative U.S. circuit courts, the prospect of “anti-woke” litigation getting a friendly ear in court results in fewer plans offering an ESG fund compared with plans that operate in regions overseen by liberal circuit courts. 

Danyu’s analysis adds to a long history of the executive and legislative branches of the federal government seemingly politicizing the question of whether 401(k) plans are on firm footing in considering whether to offer an ESG fund. 

401(k) Regulatory Rules and ESG Funds

Workplace retirement plans must follow rules enforced by the U.S. Department of Labor. The heart of DOL oversight is that every plan must act as a “fiduciary” by prioritizing the financial interest of participants. Yet how that pertains to the inclusion of ESG funds as an investment option seems to be presidential administration fluid.

A 2008 (George W. Bush was president) DOL letter effectively made it too risky for plans to consider offering ESG options. But in 2015 (Barack Obama) another DOL communique said it was fine for plans to consider ESG when analyzing what funds to offer in their lineup. In late 2020 (Donald Trump), DOL said ESG should not be a factor in what a plan chooses to offer, which the Joe Biden DOL said in early 2021 it wouldn’t enforce, and in late 2022 formally rolled back the Trump DOL ban. That decision was challenged by two dozen state attorneys general; a U.S. district judge (and Trump appointee, for those keeping score) upheld Biden’s move in September 2023. 

Amid that head-spinning change, you can’t blame plan sponsors for being wary about possible litigation if they opt to consider, yet alone actually offer, an ESG fund as an investment option. 

Danyu sorted more than 1,700 401(k) plans from 2010 to 2019 into the federal circuit court that the plan’s headquarters resides in. There are 12 circuits, staffed with judges whose lifetime appointment is clearly political: The White House nominates and the Senate confirms. Danyu excludes the Washington D.C. circuit, given its jurisdiction over many federal agencies. Circuits in shades of gray in the map below are liberal leaning, shades of red connote conservative political leaning. 

On average, among the plans Danyu studied, 8% residing in liberal circuits offered an ESG fund, compared with 2% in conservative circuits. This gap persisted after controlling for demographics, the types of firms operating in a district and local political preferences.

She then used the changing regulatory wind of the 2015 DOL notice as a way to study how politics at the judiciary level may be a factor. That 2015 DOL notice effectively neutralized the role of circuit courts in deciding if considering/offering an ESG fund met a plan’s fiduciary role. With the DOL clearly stating that it was fine for plans to include ESG funds (under certain criteria) when analyzing what offerings to put in their plan, the fear of litigation subsided.

(An aside: All of this wrangling is about whether it is kosher for a plan to merely offer an ESG fund. It is entirely up to each individual plan participant to decide what investments in their plan they want to plunk money in. At no time do plans default participants into ESG funds.) 

An ESG Translates to Investing More

Danyu found that plans in liberal circuits had a 6 percentage point greater likelihood of offering an ESG fund than plans in conservative judicial circuits. This gap is partially explained by differences in investor and firm preferences such as demographic variations, local political leanings, types of firms and financial service providers. Although these factors explain approximately half of the gap, the remainder of the difference remains significant. Yet once the DOL effectively provided some litigation cover, Danyu found that the probability of a plan offering an ESG investment option rose 2.7% more for firms in conservative circuits compared with plans in liberal circuits. She offers evidence that the uptick in ESG investments in conservative circuits is driven by smaller and “greener” firms operating in liberal counties within conservative district circuit courts.

Meanwhile, the inclusion of an ESG offering seems to compel participants to save more. Danyu finds that plan participants who invest in an ESG fund aren’t merely shifting money they already have invested in another fund into the ESG fund, but increasing their overall level of payroll contributions. This suggests that providing investors with greater flexibility, particularly in the form of ESG investments, not only heightens their commitment to socially responsible investing but also leads to an overall rise in their contributions to 401(k) plans.