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Regulation

DOL bulletin on ESG factor use puzzles investors

King & Spalding’s Kenneth A. Raskin

The Department of Labor's recent attempt at clarifying earlier guidance on ESG investing and shareholder engagement by ERISA fiduciaries has some industry stakeholders scratching their heads.

While it does not rescind guidance issued in 2015 and 2016 on these subjects, sources said the April 23 field assistance bulletin takes a more cautious tone, warning fiduciaries bound by the Employee Retirement Income Security Act to avoid "too readily" treating environmental, social and governance factors as "economically relevant" to investment choices.

Kenneth A. Raskin, New York-based partner at law firm King & Spalding LLC, said he believes the field assistance bulletin will make it "potentially more difficult" for defined contribution plan fiduciaries to feel comfortable offering ESG funds in their lineups.

Currently, the number of ERISA- ​ governed defined contribution plans offering ESG funds is quite low. According to the latest Plan Sponsor Council of America survey of U.S. 401(k) or profit-sharing plans, 2.4% of the 590 respondents had ESG funds in 2016. (The DOL bulletin also applies to ERISA-governed defined benefit plans, which were not a part of the PSCA survey.)

While the new bulletin might discourage some U.S. fiduciaries from incorporating ESG factors in their investment choices, in Europe, ESG factors have become important aspects to investing retirement assets.

The DOL said the field assistance bulletin "clarifies earlier interpretations" issued on ESG investing, but Mr. Raskin, who is also board chairman of the PSCA, argued it appears to be "a little more than a clarification." While the field assistance bulletin reaffirms previous interpretive bulletins that said fiduciaries can consider ESG factors when those factors might have an economic impact on the plan, it also appears to "backtrack from previous guidance," Mr. Raskin said, pointing to the line in the new bulletin that states fiduciaries "must not too readily treat ESG factors as economically relevant."

The previous guidance "didn't have any such specific restriction on the ability to use ESG economic factors when making investment choices," Mr. Raskin said.

Industry experts said the DOL's cautiousness also comes through in the line that states: "It does not ineluctably follow from the fact that an investment promotes ESG factors, or that it arguably promotes positive general market trends or industry growth, that the investment is a prudent choice for retirement or other investors."

A DOL spokesman declined an interview request with officials to discuss the new bulletin.

"It seems like (the DOL is) basically saying under a lot of this, that (it is) looking for more precise economic justifications rather than more abstract linkages between ESG and economics," said David Levine, Washington-based partner at Groom Law Group.

Said Alex Bernhardt, Seattle-based head of responsible investment U.S. at Mercer: "All of this, I think, underscores the need for plan sponsors to document their processes and to be clear that (they believe) the ESG-themed options that they might add to a plan ... are economically viable."

Mr. Bernhardt said the investment consulting firm has received a number of questions from clients that already have adopted ESG investment options, as well as those considering it, about how to interpret the field assistance bulletin.

"I think the tone of the document being somewhat negative has raised concerns but ... we don't really think that it alters prior bulletins in substance, nor does it really alter our existing practices when it comes to advising clients in how to select these fund options since we have always been focused on their financial performance," Mr. Bernhardt said.

Ed Farrington, Boston-based executive vice president of retirement strategies at Natixis Investment Managers, said the firm, which offers ESG target-date funds along with stand-alone ESG strategies through its affiliate Mirova, agreed with the bulletin's overall point — be sure you are putting the economic interests of the plan first.

"We think that is absolutely fine, and we don't think that is in any way a conflict with ESG" investments, Mr. Farrington said. "For us, that appears to mean ... that we need to continue to educate that ESG is an investment framework."

"The managers we choose to put in our target-date fund or stand-alone equity or green bond fund ... are looking for ESG criteria as an information advantage when it comes to selecting investments," Mr. Farrington added. "That is in our opinion completely supported by the notion of being a fiduciary."

Mr. Farrington noted the recent bulletin, which also offers new wording around qualified default investment alternatives, appears to set a higher bar for implementing ESG options as QDIAs.

Regarding the selection of ESG strategies as QDIAs, the bulletin said: "Nothing in the QDIA regulation suggests that fiduciaries should choose QDIAs based on collateral public policy goals. In the QDIA context, the decision to favor the fiduciary's own policy preferences in selecting an ESG-themed investment option for a 401(k)-type plan without regard to possibly different or competing views of plan participants and beneficiaries would raise questions about the fiduciary's compliance with ERISA's duty of loyalty."

Regarding the addition of ESG strategies as non-QDIAs, however, the April bulletin said: "Adding one or more funds to a platform in response to participant requests for an investment alternative that reflects their personal values does not necessarily result in the plan forgoing the placement of one or more other non-ESG themed investment alternatives on the platform. Rather, in such a case, a prudently selected, well-managed and properly diversified ESG-themed investment alternative could be added to the available investment options on a 401(k) plan platform."

Meg Voorhes, Washington-based director of research at US SIF, The Forum for Sustainable and Responsible Investment, said she believes the main reason for the April bulletin was to clarify the use of ESG investment options as QDIAs.

Ms. Voorhes, who described the field assistance bulletin overall as "rather dense" and "a little impenetrable," said the general feeling among US SIF members is that the bulletin "could be confusing for (plan sponsors) that are just getting started on this route." One section in the bulletin that Ms. Voorhes and others identified as particularly muddled was a footnote saying in part that ESG-themed funds "should be distinguished from non-ESG-themed investment funds in which ESG factors may be incorporated ... as one of many factors in ordinary portfolio management."

Natixis' Mr. Farrington said he did not believe the bulletin would choke growth of ESG investing, but could give "skeptics" a reason "not to look further."

One company that believes ESG considerations fit within its fiduciary duty is stok, a sustainability focused real estate services consulting firm with 35 employees. Most participants in the approximately $400,000 401(k) plan have elected to invest in a series of fossil-free, target-risk portfolios managed by HIP Investor Inc., said Burke Pemberton, a principal at stok. The San Francisco firm offers additional ESG-specific and traditional fund options as part of its 401(k) plan. HIP Investor provides impact ratings for all fund options.

Pointing to ESG investing as a potential way to achieve higher long-term investment returns and mitigate risk, Mr. Pemberton said company executives felt that making ESG factors a part of its 401(k) plan aligned with its fiduciary duties.

Clarifying proxy voting

The April bulletin also sought to clarify earlier guidance on proxy voting and other forms of shareholder engagement. Here, too, sources observed the DOL adopting a more cautious tone.

While it reaffirms earlier guidance that said fiduciaries can participate in proxy voting and other forms of shareholder engagement if "there is a reasonable expectation that such activities ... are likely to enhance the value of the plan's investment," the new bulletin emphasizes it might not be appropriate for plans to routinely incur significant expenses because of engagement with public companies, Mr. Bernhardt pointed out.

Mr. Bernhardt said he did not expect the new bulletin to have a big impact on current shareholder engagement practices because many ERISA-plan sponsors delegate those responsibilities to their managers and few are actively involved in shareholder advocacy campaigns.