DOL inquiry could put chill on ESG investments

The U.S. Department of Labor has initiated a behind-the-scenes industry inquiry into the use of ESG investments in defined contribution plans, a move that many say supports proposed regulations to make it harder to include socially responsible funds in retirement plans.

In an enforcement letter sent to employers with environmental, social and governance-themed funds in their investment lineups, the agency requested a slew of documents, including materials showing the "names, addresses and responsibilities of all persons or entities with responsibility for making investment decisions."

A letter viewed by Pensions & Investments gives the plan sponsor two weeks to provide the requested materials for a three-year period beginning Jan. 1, 2017. The letter is dated May 5.

"The Department seeks to better understand the plan fiduciaries' selection of ESG funds for inclusion in the plan's investment options and compliance with their duty to administer the plan prudently and solely for the purpose of providing benefits to participants and beneficiaries, and defraying reasonable expenses of administering the plan," said Thomas Licetti, New York regional office director for the Labor Department's Employee Benefits Security Administration, in the letter.

Other requested materials include investment policies and procedures, proxy voting materials, meeting notes and "portfolio statements for any investment holdings included in the plan's portfolio in whole or in part based on the consideration of ESG factors." It also requests prohibited transaction exemptions relied on for the plan's investment in proprietary funds.

The department also sent letters to registered investment adviser firms and other service providers to plan sponsors. The letters are reported to have gone out in waves from different regional offices, according to Michael L. Hadley, a partner with Washington law firm Davis & Harman LLC.

“The Department of Labor does not comment on enforcement activities,” said a Department of Labor spokesperson on Aug. 21.

The Labor Department's inquiry, which began before the agency's release in June of proposed regulations to restrict the use of ESG funds in retirement plans, is largely seen as a way for the DOL to understand how plan sponsors are making decisions regarding their ESG investment options.

"I think the DOL is generally reviewing both through its guidance and enforcement programs how ESG is taken into account as part of the retirement plan investment process," said David Levine, a principal at Groom Law Group in Washington.

Some, however, believe the inquiry was precipitated by President Donald Trump's April 2019 executive order on energy infrastructure, which references ESG issues and directs the Labor Department to collect information regarding retirement plans' investments in the energy sector.

"I've surmised that the latest enforcement efforts are part of a larger effort to collect information about plans' investments," Mr. Hadley said, referring to the executive order.

Whatever the genesis of the inquiry, plan sponsors are flummoxed. "I think plan sponsors are curious as to the DOL's ultimate goal associated with the inquiries and how they relate to the proposed regulations," said Joy M. Napier-Joyce, an attorney with Jackson Lewis PC in Baltimore.

Ross Bremen, a Boston-based partner at NEPC, put it more simply. "The department has everybody's attention," he said.

For many plan sponsors, the confusion stems from the fact that "the DOL's guidance to this point has generally been supportive of the use of ESG factors," Mr. Hadley said.

Whatever its intentions, the Labor Department is clearly signaling that it will implement and enforce a tougher standard on ESG investing, according to industry experts.

"These regs and these data requests are suggesting that it's going to be a much higher bar to meet to be able to put ESG funds in plans," Ms. Napier-Joyce said.

The proposal adds regulatory text that makes clear that ERISA requires plan fiduciaries in both private defined benefit and defined contribution plans to select investments "based on financial considerations relevant to the risk-adjusted economic value of a particular investment or investment course of action."

Critics of the proposal are seething over the agency's apparent companion inquiry. "The request suggests unwarranted skepticism by the DOL about environmental, social and governance issues. A growing body of research indicates E, S and G factors can be material to value creation and help mitigate risk in investing," said Amy Borrus, Washington-based executive director of the Council of Institutional Investors.

Will Hansen, executive director of the Plan Sponsor Council of America in Washington, also attacked the Labor Department's probe. "We remain concerned that this nationwide investigative program could hinder plan participant fund options as well as decrease retirement savings if an ESG-type fund is not an available fund option within the retirement plan. This type of investigation on top of the recent rule-making from the DOL may cause a plan sponsor to not provide an ESG fund in the fund lineup."

Industry observers believe that the inquiry and proposed rule-making are likely to have a chilling effect on plan sponsors looking to add ESG investments to their plans. Sponsors are "stepping carefully," Mr. Levine said, noting that processes to add socially responsible funds "may have slowed down" in some cases.

"I think plan sponsors are probably more reluctant to take a risk and add a fund that is not 100% best of its class if it has an ESG factor to it," Ms. Napier-Joyce said.

Others see plan sponsors taking a wait-and-see approach. Sponsors will want to see whether the new rules have "any additional hurdles that they would have to meet prior to adding the new ESG offerings," Mr. Bremen said.

For sponsors already offering the investments, the Labor Department's recent moves will likely have them on their toes, according to industry experts. Plan sponsors will be monitoring their funds more closely to make sure that they continue to "check all the boxes," Ms. Napier-Joyce said.

ESG funds already in plans must "stand on their own financially" and be "a top performer with low fees," she said. "If a fund is not performing in the way that it should be and there's a better option out there for a core fund, then that has to be considered."

David Fischer, executive director of the New York State Deferred Compensation Plan, Albany, says he has no intention of dropping the ESG fund the $28.3 billion retirement plan offers participants.

"The fund was selected on performance, and we would expect that we would not continue to offer an ESG option if the performance wasn't competitive," Mr. Fischer said of the Pax Global Environmental Markets Fund, which held $41 million in assets as of July 31.

Mr. Fischer, who has not received a letter from the DOL, said the board is unlikely to "overreact" to a proposal that has yet to be finalized.

Regardless of whether and when the proposed regulations go into effect, industry observers do not anticipate a new area of litigation against plan sponsors. "There is always the risk that a plaintiff will question an investment choice by plan fiduciaries whether ESG or another type of investment," Mr. Levine said. "Given the significant diligence by many plan fiduciaries in selecting investments, I do not think that the ESG focus will automatically trigger a next generation of lawsuits on this topic in itself."

Ms. Napier-Joyce also agreed that the proposed regulations will likely not lead to a new area of litigation because the regulations provide "a clear road map in term of a process to follow. It will behoove plan fiduciaries to make sure that they are following that process and making investment choices that align with this guidance because the failure to do so certainly could be used in litigation."

Mr. Hadley disagreed. "Certain aspects of the DOL's recent proposal on ESG factors in investing could have the unintended consequence of encouraging more of the baseless litigation that has consumed 401(k) plans," he said.

All this leaves the future of ESG funds in defined contribution plans up in the air, according to industry observers.

"I think it's too early to tell," Mr. Bremen said, referring to ESG funds' future prospects in retirement plans. "We have a proposed rule, we have an upcoming election, we have a lot of questions that have been asked by the industry and views presented via their comment letters, so I think we're in a period of uncertainty."

Still, he said, the clamor among millennials, endowments and foundations for socially responsible investments is "not going away," a trend that will work in the funds' favor.

"How restrictive the new rule ultimately is and how high the bar it sets will directly impact whether the ESG trend will be able to make future inroads into defined contribution programs," Mr. Bremen said.