The Department of Labor (DOL) doesn't want you to invest your 401(k) contributions in companies that pursue social or environmental initiatives -- or at least that's the message embedded in a recently proposed rule for 401(k) plans.

Specifically, the proposal targets ESG funds. These are mutual funds that use environment, social, and governance criteria to select positions for their portfolios. The DOL's stance, in a nutshell, is that 401(k) plans should offer investments that pursue financial returns, not social ones.

The proposed rule doesn't outright ban plan administrators from offering ESG funds in 401(k)s. It does, however, subject administrators to more extensive documentation and benchmarks to justify the inclusion of ESG funds. The rule also strengthens the argument that offering a socially focused fund to 401(k) participants could be a violation of fiduciary responsibility. The language is strong enough to discourage administrators from bothering with ESG funds at all.

A woman dressed in white leaning forward on a small green house, which is in a row of multicolored small houses.

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What's wrong with ESG funds

From the DOL's perspective, a fund that integrates social criteria into its selection process will either sacrifice financial performance or increase risk for shareholders. Given that the 401(k) is supposed to create financial security for American workers, those trade-offs aren't acceptable. Savers shouldn't have the option to sabotage their own retirement by funding environmental, social, or governance agendas.

The problem? ESG funds don't automatically underperform or carry more risk. There are, of course, good ESG funds and bad ones, as there are good target-date funds and bad ones. But looking at the performance of ESG funds generally in recent years, it's hard to prove that a social agenda always sacrifices returns. It might be easier to make the opposite argument: Protecting the environment and being good to employees and communities actually benefit the bottom line.

What's right with ESG funds

According to a Morningstar analysis, ESG funds were more resilient during the volatile first quarter of 2020 than their conventional counterparts. Specifically, 70% of ESG equity funds ended the quarter in the top halves of their Morningstar categories. Plus, 10 out of 12 large-blend ESG funds held up better than the iShares Core S&P 500 ETF (IVV 0.04%), which lost 20% in that first quarter. ESG funds outperformed conventional funds in the second quarter as well.

Resilience in a downturn is important, but so is performance in normal market conditions. ESG indices can provide a quick gauge of longer-term performance. For example, as of July 21, 2020, the five-year annualized return of the S&P 500 ESG index is 9.57%. For the same time period, the conventional S&P 500 index shows slightly lower returns of 8.98%. Ten-year annualized returns for the two indices are nearly the same, with the ESG index retaining a very slight edge.

In other words, holding ESG funds won't automatically kill your returns or ruin your retirement.

Investing in ESG funds outside your 401(k)

You might not see ESG funds in your 401(k) plan anytime soon, but you can still invest in socially responsible portfolios through your IRA or taxable brokerage account. There are many fund options, ranging from general ESG ETFs to funds that address specific issues like climate change or clean energy. You might start by researching the issues that interest you. Then, narrow your options through due diligence. Review fund strategies, selection processes, and portfolios -- as well as past performance, fund size, and expense ratios.

Your research will quickly show you that ESG funds vary widely in their selection criteria. Some exclude entire industries, such as tobacco or gunmaking. Other funds might include players from unpopular industries if those companies have substantial ESG initiatives. Be comfortable with where that line is drawn before you invest.

The future of ESG funds and 401(k)s

The DOL's proposed rule is open for public comment through July, and it is likely to receive some opposition. But even if the rule is shot down or radically overhauled, ESG funds probably won't appear in your 401(k) anytime soon. If you're eager to kick off an ESG investing strategy now, you can do so in your IRA or traditional brokerage account -- where the DOL has no authority.