How Advisors Can Help Clients Invest Sustainably Outside of 401(k)s
Investors have more choices but face greater complexity.
This article is part of a series providing a framework for incorporating sustainable investing into your advisory practice.
My previous column, “How Advisors Can Help Clients Invest Sustainably in Retirement Accounts,’' explored the limitations and opportunities of investing sustainably within employer-sponsored retirement plans such as 401(k)s. Advisors supporting clients in investing sustainably outside of these accounts may find more choice but also more complexity.
With taxable brokerage accounts and IRAs, investors are not limited in their sustainable investment options the way they typically are in employer-sponsored retirement plans. Brokerage platforms can host a wide, and growing, range of sustainable index funds, mutual funds, and exchange-traded funds. The downside of choice is that it can be difficult to assess how investment products labeled as “green” or “social” are actually doing on sustainability metrics. Investors can assess the sustainability ratings of public funds using free screening tools such as As You Sow, Ethos, and USSIF’s Sustainable Investment Mutual Funds and ETFs Chart. Advisors can also use Morningstar’s Sustainability Ratings, Ethos’ subscriber version for additional capabilities such as custodial linking, and YourStake’s subscription-only screening platform that also allows for custodial linking to client accounts for a full portfolio assessment.
Fixed-income impact investments through publicly listed offerings, such as the LISC Impact Notes, Capital Impact Investment Notes, and Calvert Community Investment Note, are investable through taxable accounts and standard IRAs. To learn about private investments grounded in building equitable wealth, such as Community Land Trusts, community loan funds, and direct investments in cooperatively run businesses, consider The Next Egg, which is a subscription-based online learning community. Some traditional custodians allow private investments on their platforms within taxable or standard IRA accounts, especially for large account holders.
If you have a client with a specific alternative investment that you’re not sure can be held in their account, get in touch with your custodian’s alternative investments team. They can review and approve the alternative investment, or they may be able to work with the alternative investment provider to approve holding the investment on your custodial platform.
The Next Egg also has resources on using self-directed retirement accounts. A self-directed IRA, or SDIRA, can hold nontraditional private investments, such as community loan funds, real estate, and investments in local businesses. It’s important to note that SDIRAs come with additional administrative fees that standard IRAs typically do not charge.
There are two types of SDIRAs: custodial and checkbook. Each varies in the level of independence and responsibility required of the investor. In the custodial SDIRA, the custodian where the account is held performs the transactions, handles the account administration, and may limit what investments are available on their platform beyond IRS rules. In the checkbook IRA, the account is held in an LLC or trust. The IRA account is the sole member of the LLC and, therefore, has the decision-making capability. The accountholder performs the transactions on their own and handles the account administration, which includes bookkeeping, filing tax returns, and filing annual reports. The accountholder does not need approval of what they invest in, although they must still stay within IRS rules.
It’s possible to practice sustainable investing for clients across income and wealth spectrums, but not without limitations beyond the type of accounts they have access to. There’s also the reality that Americans in the top 10% of net financial worth own 84% of all Wall Street investments. About half of Americans do not own any stock investments and one third do not have access to an employer-provided retirement plan. Those who might have some ability to save may also need to prioritize medical debt, student loan debt, and rising housing costs, over investing for the future. I’ve seen people of all ages divest or disengage completely from capital markets due to a combination of these barriers and challenges.
Some private investments require accredited investor status, and the minimum investment requirement of sustainable public investments can be as high as $3,000 for some mutual funds in taxable accounts. One of the benefits of investing within a defined-contribution employer plan or IRA is that mutual fund minimums are typically waived. However, there is a growing universe of sustainability focused ETFs where the minimum investment is the price of one share.
Outside of funds, direct indexing allows investors to track the performance of an index by directly owning the collection of individual holdings rather than an associated index fund. The technology was available to advisors and individual investors through OpenInvest before its sale to J.P. Morgan in 2021. Other major custodians are moving in this direction. Vanguard acquired Just Invest and is offering its direct indexing portfolio-management tool directly to advisors. Advisors can access similar investment customization technology for their clients through companies such as Ethic and Vise. Ethic acts as a subadvisor and works with advisors to apply environmental, social, and governance screening data to exclude unwanted companies from portfolios based on client sustainability preferences. Vise supports advisors in customizing client portfolios based on a set of financial and nonfinancial filters, such as industry type. Morningstar is also launching a direct indexing tool for advisors. With direct indexing, there are often minimum account balances set by the provider.
For investors without access to an employer-sponsored retirement plan or accounts that hold the investments they want, investing sustainably is still possible. In Put Your Money Where Your Life Is (2020), Michael Shuman wrote about investing within and outside of custodial accounts, such as directly in your home and local community. Better Banking Options and Mighty Deposits are two ways to evaluate banks and credit unions.
Investors can also self-custody private or direct community investments. Most impact investments available to retail investors are in the form of unsecured promissory notes that pay a fixed interest rate over a term chosen by investors, as in the case of impact investing through CDFIs. It’s not necessary to own promissory notes within a custodial account since these can be purchased directly through the organization.
A drawback of holding individual notes outside of custodial accounts is forgoing potential tax benefits such as tax deferral or tax-free growth available in retirement accounts. There’s also the responsibility of account administration that comes with self-custody, such as keeping track of loan notes and purchase agreements and tracking interest payments over time. These activities can become unwieldy as the number of private impact investments in a portfolio grows. One method to stay organized is to have recurring interest paid to a dedicated account so the investor or advisor can keep track of these payments for tax reporting as well as manage reinvestment of the funds. Another option is to have interest automatically reinvested in the note and paid out only at maturity along with the principal.
Answering the question “Where and how can investors invest sustainably?” depends on how the investor defines sustainable investing, their financial resources, and the types of accounts and investment choices they have access to. And, as always, your recommendations as an advisor must align with the clients’ goals for the short and long term.
Both investors and advisors can have a hand in increasing access to sustainable options for themselves and future generations of investors. In my next column, I’ll explore how advisors can differentiate and evaluate sustainable investments to mitigate “greenwashing” and ensure that the strategies they’re applying to client portfolios are meeting their financial and impact goals.
About Morningstar, Inc. Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The Company offers an extensive line of products and services for individual investors, financial advisors, asset managers and owners, retirement plan providers and sponsors, and institutional investors in the debt and private capital markets. Morningstar provides data and research insights on a wide range of investment offerings, including managed investment products, publicly listed companies, private capital markets, debt securities, and real-time global market data. Morningstar also offers investment management services through its investment advisory subsidiaries, with approximately $251 billion in assets under advisement and management as of June 30, 2021. The Company has operations in 29 countries. For more information, visit www.morningstar.com/company. Follow Morningstar on Twitter @MorningstarInc.
Phuong Luong, CFP, is an educator and financial planner focused on economic justice and closing racial wealth divides. She is a Principal at Saltbox Financial, a virtual, fee-only RIA. She is also the online facilitator for the Boston University Financial Planning Program. Phuong is a subject matter expert in ESG and regenerative investing. Follow Phuong on Twitter: @pt_luong The views expressed in this article do not necessarily reflect the views of Morningstar.