A A recent survey by the Employee Benefits Research Institute (EBRI) reveals a significant knowledge gap among retirement savers. Data shows that many pension plan account holders do not understand two main types of investment: environmental, social and governance (ESG) funds and target date funds (TDF).
ESG funds can be polarizing: investors tend to either love them or hate them. And TDFs are one of the most common investments available in 401(k) plans. Confusion or uncertainty about either type of investment affects your ability to manage risk in your retirement portfolio.
There is little room for risky mistakes in retirement planning. Get clarity on ESG funds and TDFs now with the quick refresher below.
Definition of ESG funds
ESG stands for environment, social and governance – three areas that investors and companies use to measure corporate citizenship and sustainability. ESG companies have demonstrated their commitment to protecting the environment, fostering the growth of 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 have a positive impact on people and the planet.
What you need to know about ESG investing
When you invest in an ESG fund, you support profitable companies that engage in sustainable business practices. Depending on your values, this could be a pro or a con.
ESG investors believe that a company’s commitment to sustainability reduces short-term downside risk and improves long-term earnings potential. Several studies (like this one) support the conclusion that good business practices promote better financial performance.
Critics argue that ESG investing has a negative impact on the economy. One of the major concerns is the oil and gas industry, valued at around $110 billion in the United States. As investors pour money into sustainable businesses, it leaves less capital available for oil and gas. This contributes to lower oil production and higher gas prices, both of which have far-reaching effects on the US economy.
You should also know that ESG funds set their own investment criteria, without too much control. A fund might have “ESG” in its name, for example, but still invest in controversial sectors like arms manufacturing. To make sure a fund truly matches your values, you need to thoroughly review the documentation and holdings.
Definition of TDFs
A TDF is a target date fund, which holds stocks and bonds in a mix designed to match your retirement schedule. This mix begins aggressively and gradually becomes more conservative as your retirement date approaches. The strategy is to maximize growth when you’re young and then move into a more protective position later.
What you need to know about TDF investing
Three tips will help you get the most out of your TDF investment:
- Review the fund’s glide path. The glide path defines how the fund transitions from aggressive to conservative over time. Identify when the fund reaches its most conservative point and check your comfort level with that moment. An aggressive portfolio in your early retirement years improves growth potential as well as volatility. A conservative portfolio in retirement will have more stability, but limited growth.
- Select the fund year that corresponds to your retirement date – usually. Generally, if you plan to retire in 2050, you would invest in a 2050 TDF. The exception is if you are not comfortable with the glide path of the TDF available in your 401(k). Say the 2050 TDF is too aggressive for your taste. In this case, you can choose the 2045 TDF instead. The earlier era TDF will reach its most conservative allocation five years early. On the other hand, if the TDF 2050 is too conservative, you will choose a later vintage.
- Invest only in TDF. The TDF should be the only asset in your retirement account. Mixing a TDF with other funds upsets your overall asset allocation. You will end up with too much or too little risk as a result.
There is a lot to know about ESG funds and TDFs. If you are not yet comfortable with your knowledge in these areas, keep learning. You’ll refine your investment approach during the process, make more consistent decisions, and achieve better wealth management results.
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Catherine Brock has no position in the stocks mentioned. The Motley Fool has no position in the stocks mentioned. The Motley Fool has a disclosure policy.
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