A recent survey from Employee Benefit Research Institute (EBRI) reveals a critical knowledge gap among retirement savers. The data shows that many retirement plan accountholders don't understand two primary investment types: environmental, social, and governance (ESG) funds and target-date funds (TDFs).
ESG funds can be polarizing -- investors tend to love them or hate them. And TDFs are one of the most common investments available in 401(k) plans. Confusion or uncertainty about either investment type affects your ability to manage the risk in your retirement portfolio.
There's little room for risk missteps in retirement planning. Get clarity on ESG funds and TDFs now with the quick refresher below.
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ESG funds defined
ESG stands for environmental, social, and governance -- three areas investors and companies use to measure corporate citizenship and sustainability. So-called "ESG companies" have a demonstrated commitment to protecting the environment, fostering growth for their employees and local communities, and operating with business integrity.
Third-party companies like MSCI and Sustainalytics track companies' ESG performance and assign scores. The scores help investors and funds identify companies that positively impact people and the planet.
What to know about ESG investing
When you invest in an ESG fund, you support profitable companies that are committed to sustainable business practices. Depending on your values, this could be a pro or a con.
ESG investors believe a company's dedication to sustainability lowers downside risk in the short term and improves earnings potential in the long term. Several studies (like this one) support the conclusion that good corporate practices foster better financial performance.
Critics argue that ESG investing negatively impacts the economy. One primary concern is the oil and gas industry, valued at about $110 billion in the U.S. As investors funnel money into sustainable companies, it leaves less capital available for oil and gas. That contributes to lower oil production and higher gas prices -- both of which have far-reaching effects on the U.S. economy.
You should also know that ESG funds set their own investment criteria, without much oversight. A fund might have "ESG" in its name, for example, but still invest in controversial sectors like gunmaking. To ensure a fund truly aligns with your values, you must review the documentation and holdings in detail.
TDFs defined
A TDF is a target date fund, which holds stocks and bonds in a composition designed to match your retirement timeline. That composition begins aggressively and gradually gets more conservative as your retirement date approaches. The strategy is to maximize growth when you're young, and then later shift to a more protective stance.
What to know about TDF investing
Three pointers will help you get the most from your TDF investment:
- Review the fund's glide path. The glide path defines how the fund shifts from aggressive to conservative over time. Identify when the fund reaches its most conservative point and check your comfort level with that timing. An aggressive portfolio in your early retirement years improves growth potential as well as volatility. A conservative portfolio at retirement will have more stability, but limited growth.
- Select the fund year that aligns with your retirement date -- usually. Generally, if you plan to retire in 2050, you'd invest in a 2050 TDF. The exception is if you're not comfortable with the glide path of the TDF that's available in your 401(k). Say the 2050 TDF is too aggressive for your taste. In that case, you could choose the 2045 TDF instead. The earlier-vintage TDF will reach its most conservative allocation five years earlier. On the other hand, if the 2050 TDF is too conservative, you would pick a later vintage.
- Invest in the TDF only. The TDF should be the only asset in your retirement account. Mixing a TDF with other funds upsets your overall asset allocation. You'll end up with too much or too little risk as a result.
Keep on learning
There's a lot to know about ESG funds and TDFs. If you're not yet comfortable with your knowledge in these areas, keep on learning. You'll refine your investment approach in the process, make more consistent decisions, and drive better wealth results.
