DOL proposal opens door for ESG investment

A new rule proposal from the Department of Labor would explicitly permit retirement plan fiduciaries to consider climate change and other environmental, social and governance factors when selecting investments and exercising shareholder rights.

The proposal, unveiled Oct. 13 and called "Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights," makes clear "that climate change and other ESG factors are often material and that in many instances fiduciaries … should consider climate change and other ESG factors in the assessment of investment risks and returns."

The Labor Department's much-anticipated announcement comes after months of stakeholder outreach on the subject and follows an executive order by President Joe Biden in May directing federal agencies to assess and mitigate financial risks related to climate change.

When the Biden administration took office in January, it wasted little time in signaling a more accepting position on ESG investing than the Trump administration.

In a call with reporters Oct. 13, Ali Khawar, acting assistant secretary for the Employee Benefits Security Administration, said it was important for the Labor Department to tackle this issue in the Biden administration's first year in office. "We're quite concerned that the outcome of the Trump administration's rule was actually going to lead to less retirement security because fiduciaries would feel like they needed to stay on the sidelines, not incorporate these kinds of factors into their decision-making," Mr. Khawar said. "And having that hand tied behind their back, we were concerned that ultimately it would lead to worse financial outcomes."

In 2020, under the Trump administration, the Labor Department finalized two rules — one called "Finan- cial Factors in Selecting Plan Investments," which stipulates that ERISA plan fiduciaries cannot invest in "non-pecuniary" vehicles that sacrifice investment returns or take on additional risk; and the other, "Fiduciary Duties Regarding Proxy Voting and Shareholder Rights," which outlines the process a fiduciary must undertake when making decisions on casting a proxy vote. Both rules drew sharp criticism from the plan sponsor and sustainable investing community.

The financial factors rule excludes a fund from being a qualified default investment alternative if its investment objectives, goals or principal investment strategy include or consider the use of one or more non-pecuniary factors. It was finalized in November 2020 and took effect Jan. 12, just days before the Biden administration took office. Mr. Biden signed an executive order on his first day in office ordering a review of the rule. It's often referred to as the "ESG rule" because the initial proposal, which was unveiled in June 2020, focused on ESG investment factors, but the final rule walked back the ESG language.

The proposal unveiled Oct. 13 would remove the special rules for QDIAs that apply under the Trump administration rule.

On proxy voting, the proposed rule would make changes to the Trump administration's rule that was finalized in December 2020 and took effect Jan. 15. Specifically, the proposal would eliminate the statement in the current regulation that "the fiduciary duty to manage shareholder rights appurtenant to shares of stock does not require the voting of every proxy or the exercise of every shareholder right."

Mr. Khawar said voting proxies are a part of a fiduciary's core responsibilities. "The bias that the previous administration's rules created was to really favor not voting and not taking action," he said. "But these are assets that are owned by participants and beneficiaries, and the obligations that fiduciaries have in other contexts don't stop when you're talking about proxy voting."

In March, the Labor Department said it would not enforce either of the Trump administration's rules, but investor confusion has persisted.

"The department has also heard from stakeholders that the current regulation, and investor confusion about it, including whether climate change and other ESG factors may be treated as 'pecuniary' factors under the regulation, has already had a chilling effect on appropriate integration of climate change and other ESG factors in investment decisions, which has continued through the current non-enforcement period, including in circumstances that the current regulation may in fact allow," the Labor Department said in its rule proposal.

A 60-day comment period began upon publication in the Federal Register Oct. 14.

A variety of stakeholders welcomed the proposal.

"We appreciate the work done by DOL to address the damage done by the previous administration and to ensure that ERISA fiduciaries have new rules for the road," said Lisa Woll, CEO of Washington-based US SIF: The Forum for Sustainable and Responsible Investment, in a statement. "The proposed guidance should help address the gap between the growth of sustainable investment overall and the much more limited growth of sustainable investment in retirement plans."

Jim Roach, senior vice president, head of distribution-ESG target-date fund at Boston-based Natixis Investment Managers, said in a statement that "ESG investing is clearly here to stay, and we believe this newly proposed DOL rule addresses a demand of increasing importance to investors."

Sarah Bratton Hughes, New York-based head of sustainability for North America at Schroders PLC, said in a statement that the proposed rule would provide much needed clarity to the market on the permissibility of ESG factors and strategies in ERISA investment options. "The proposed text has shifted the conversation from ESG as a pecuniary factor to a focus on the evaluation of ESG factors as part of a plan sponsor's fiduciary duty of prudence," she said.

In Congress, Sens. Patty Murray, D-Wash., chairwoman of the Senate Health, Education, Labor, and Pensions Committee, and Tina Smith, D-Minn., said in a joint statement that it's "just common sense that ERISA fiduciaries be allowed to consider the environmental, social and governance factors that are shaping the future. The Biden administration's step to acknowledge this reality is a win for workers, retirees, investors, businesses, communities, the environment — everyone."

Two Republicans on the House Committee on Education and Labor — Ranking Member Virginia Foxx of North Carolina and Rick Allen of Georgia — had a different viewpoint on the proposal. "The Biden administration is taking its radical climate change and pro-union boss agenda too far — this time jeopardizing American's retirement savings," the lawmakers said in a statement. "Millions of American workers depend on their retirement savings to ensure a secure future for themselves and their families. The financial interests of workers and retirees should never take a backseat to the whims of the green lobby and Big Labor."