DOL proposal could chill prospects for ESG in ERISA plans

A proposal from the Department of Labor stipulates that ERISA plan fiduciaries cannot invest in ESG vehicles that sacrifice investment returns or take on additional risk, which sources say could curb environmental, social and governance investments.

"Private employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan," Labor Secretary Eugene Scalia said in a news release. "Rather, ERISA plans should be managed with unwavering focus on a single, very important social goal: providing for the retirement security of American workers."

ESG investing in the U.S. has grown in popularity. Data from Morningstar Inc. show a nearly fourfold increase in 2019 over the previous year in flows into U.S. sustainable funds, at $21.4 billion, and record flows into ESG funds and indexes in the first quarter of $10.5 billion. In Europe, ESG investing is even more mainstream. European funds devoted to sustainable investing attracted a record €120 billion ($135 billion) from investors last year, according to Morningstar. Also, European funds that incorporate ESG strategies held €668 billion in assets, up 58% from the prior year.

The proposal is intended to raise some significant questions about ESG investing for ERISA plan fiduciaries, said Michael P. Kreps, Washington-based principal at Groom Law Group. "It's an attempt to throw some cold water on ESG investing practices that have developed over the last decade or so," Mr. Kreps added.

The proposed rule, which was published June 23, would add regulatory text that makes clear that ERISA requires plan fiduciaries to select investments "based on financial considerations relevant to the risk-adjusted economic value of a particular investment or investment course of action," according to a Labor Department fact sheet.

Moreover, the proposal would require fiduciaries to consider other available investments to meet their prudence and loyalty duties under ERISA and outlines the requirements for selecting investment alternatives for 401(k) plans that ostensibly pursue one or more ESG-oriented objectives in their investment mandates or that include such parameters in the fund name.

The proposal also "acknowledges that ESG factors can be pecuniary factors," but only if the economic risks or opportunities associated with them are material, according to the fact sheet.

The proposal is a missed opportunity, said Heather Slavkin Corzo, Washington-based head of U.S. policy for the United Nations-supported Principles for Responsible Investing. "We are seeing increasing interest from investors in ESG investment options, there's increasing evidence that ESG factors are material financial factors, and we think the time is right for the DOL to clarify that fiduciaries actually have an obligation to consider ESG factors as they're making investment decisions," she said. "This missed the boat in that regard."

Fiona Reynolds, CEO of the Principles for Responsible Investing, said in a statement the proposed rule reflects an outdated understanding of the importance of ESG integration. "The DOL acknowledges explicitly in the rule proposal that ESG factors can create business risks and opportunities, and evidence is incontrovertible that climate change will have a material impact on our economy and on asset prices — yet this administration is once again standing in the way of progress on integration of ESG considerations by investors," Ms. Reynolds said.

Others welcomed the proposal. Thomas Quaadman, executive vice president of the U.S. Chamber of Commerce's Center for Capital Markets Competitiveness in Washington, said in a statement that the proposal makes investor return the central focus for workers' pension funds and employee retirement accounts. "Special-interest activism has no place, any time, in meddling with the retiree investments of hard-working Americans," Mr. Quaadman said.

While the Plan Sponsor Council of America does not promote specific investment fund types, it also does not "want rules imposed that could decrease investment options available to plan sponsors and ultimately participants," said Will Hansen, executive director of the PSCA and chief government affairs officer at the American Retirement Association in Washington, in an email. "We are reviewing the proposed rule and plan on submitting a comment."

Olena Lacy, who served during the Clinton administration as assistant secretary of labor for the Pension and Welfare Benefits Administration — now the Employee Benefits Security Administration — said it's unclear what problem the Labor Department is trying to solve with its rule proposal. "I don't see pension funds and 401(k) funds all over the United States running out doing irresponsible things without documentation to further social purposes," Ms. Lacy said. "The only reason I could see for this (rule proposal) is to have a chilling effect on this kind of investment."

Ms. Lacy noted that there's evidence ESG funds and strategies have performed well in recent years. Of note, an MSCI comparison of four standard MSCI ESG indexes to their parent indexes during the COVID-19 sell-off found that the ESG ones, representing a range of approaches, all outperformed the parent index in the first quarter of 2020.

"Why would you try to discourage investments that are both prudent and have positive impacts on the environment?" Ms. Lacy said.

As part of its 62-page proposal document, the Labor Department outlined its concerns with ESG investing, including its perception that there is "no consensus about what constitutes a genuine ESG investment," and adding that "ESG rating systems are often vague and inconsistent, despite featuring prominently in marketing efforts. Moreover, ESG funds often come with higher fees, because additional investigation and monitoring are necessary to assess an investment from an ESG perspective."

In 2018, the Labor Department published a field assistance bulletin on ESG investing that said ESG issues can be material to investment performance in ERISA-governed plans, but it also cautioned fiduciaries not to assume that any ESG consideration is economic.

On a call with reporters, a senior Labor Department official said the 2018 guidance reiterated the department's long-standing position that ERISA does not allow plan fiduciaries to sacrifice returns or take on risk to promote "non-pecuniary" goals.

However, "to the extent that a particular ESG factor is relevant to financial merits of an investment decision, it is appropriate for an ERISA plan fiduciary to consider that factor," the senior department official said.

ESG strategies can still be consistent with ERISA's fiduciary duties if several boxes are checked, said George Michael Gerstein, Washington-based co-chairman of the fiduciary governance group at Stradley Ronon Stevens & Young, in a client brief. That includes documenting the basis for the strategy's materiality determination; whether other "qualified investment professionals" would similarly conclude that the ESG factor is material to investment performance based on "generally accepted investment theories" and the ESG investment is measured against "other available alternative investments" with respect to diversification, liquidity and potential risk-return of the plan portfolio, the brief said. Mr. Gerstein noted that the last point is crucial because "it is arguably de facto the tiebreaker test, which the DOL historically used only when the ESG factor was not material to investment performance, and will raise compliance risk for ERISA fiduciaries."

ERISA plan fiduciaries can hire ESG managers; "there's just a heightened degree of procedural prudence and consideration that (fiduciaries) need to give to the decision and they probably need to make sure that they document it carefully," Mr. Kreps said.

In an email shortly after the rule was proposed, Mr. Gerstein took note that it eliminates the possibility that an ESG fund — themed or not — can be a qualified default investment alternative or even part of a QDIA.

"The department does not believe that investment funds whose objectives include non-pecuniary goals … should be the default investment option in an ERISA plan," the proposal states.

The proposal will have a 30-day comment period, which Mr. Kreps said is "incredibly short," but makes sense given the proximity to the Nov. 3 election. "If the effective date falls after the start of a new administration, it's a lot easier for them to pull back the rule," Mr. Kreps said.

"However, if the rule is final and effective prior to a new administration coming in, it's much (more difficult) to unwind it," he said. "I think that's what they're gunning for — they just looked at a calendar and saw how much time is left and set an aggressive schedule for getting this done just in case Democrats take the White House."