Industry sounds off against DOL proposal on ESG

A Department of Labor proposal that would likely curb environmental, social and governance investments in ERISA plans has drawn sharp criticism from the retirement community.

In a 30-day comment period that concluded July 30, stakeholders roundly admonished the Labor Department's proposal to add 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," as stated in a Labor Department fact sheet.

More than 1,500 comment letters were filed from asset owners, asset managers, trade associations, record keepers, lawmakers and others, many of whom took issue with the Labor Department's initiative, which was unveiled June 23. It's unclear if the comments could prompt the Labor Department to take another look at the rule or when a final rule might be issued.

Broadly, stakeholders said the Labor Department did not sufficiently justify its reason- ing behind the proposal and said the proposal would create barriers for considering ESG risks; add to fiduciary confusion regarding if and when ESG factors may be considered material; and lead to increased documentation costs.

Aron Szapiro, Morningstar Inc.'s head of policy research based in Washington, said if the rule were to go into effect, plan sponsors would move away from any investments that consider ESG factors just to avoid the liability and additional costs, which would be to the detriment of retirement savers.

"We think it's really fundamentally out of step with (fiduciaries) using ESG factors as part of a process for investing," Mr. Szapiro said. "It's a rule that seems to be 15 years behind the current thinking, at least."

ESG investing in the U.S. has grown in popularity. Data from Morningstar 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 into strategies based on ESG indexes in the first quarter of $10.5 billion.

The proposal would require fiduciaries to consider other available investments to meet their prudence and loyalty duties under ERISA. It also 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 proposed rule "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.

"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 after the proposal was unveiled. "Rather, ERISA plans should be managed with unwavering focus on a single, very important social goal: providing for the retirement security of American workers."

The $246 billion California State Teachers' Retirement System, West Sacramento, integrates ESG factors into its investment decision-making because it thinks they are "financially material and, foremost, because we have an obligation to our plan participants as long-term stewards of their capital," Aeisha Mastagni, CalSTRS' portfolio manager of sustainable investment and stewardship strategies, said in a comment letter.

"If the proposal is finalized with these amendments, fiduciaries will struggle to fulfill their obligations to deliver optimal returns by integrating all financially material risk factors which have been repeatedly proven to be pecuniary," she said.

Though not governed by ERISA, CalSTRS said given the long-term nature of its liabilities, it is "keenly interested in the rules and regulations that govern the securities market." Moreover, in 2018 it created an eight-manager pool to execute specific strategies focused on ESG investments as opportunities arise. CalSTRS could eventually invest a total of $1 billion to pool managers to diversify its $6 billion sustainable investment and stewardship strategies portfolio, it said last year.

Melissa Kahn, Washington-based managing director of retirement policy for State Street Global Advisors' defined contribution team, said in an interview the Labor Department proposal missed the mark. "We weren't surprised that they weren't going to embrace ESG solutions in retirement plans, but I think we were surprised at how they went about it and the breadth of what they did," she said.

In particular, Ms. Kahn and other stakeholders have called into question a provision in the proposal that eliminates the possibility that an ESG fund — themed or not — can be a qualified default investment alternative or even part of a QDIA.

"That provision, perhaps the most significant of the changes in the proposed rule, would appear to prevent a plan fiduciary from offering an ESG-themed fund with the name ESG even as a small component of the QDIA," the Council of Institutional Investors wrote in its comment letter. "We believe DOL has not explained why the ESG name alone disqualifies an investment from the QDIA, let alone as a small component of the QDIA."

The Principles for Responsible Investment voiced similar concerns with respect to QDIAs, writing in its comment letter that the Labor Department failed to clarify what investment options are "ESG-themed funds." By not making that clarification and "prohibiting the inclusion of investment options that integrate ESG as part of risk mitigation," the proposal may "actually make it difficult for plan sponsors to find any well performing funds that can serve as QDIAs," the United Nations-supported PRI said.

The Labor Department has also received letters from Capitol Hill both questioning and welcoming its proposal.

Thirteen Senate Democrats, including Patty Murray of Washington, ranking member of the Senate Health, Education, Labor, and Pensions Committee, said the proposal rule would undermine the ability to consider firms' records on race and diversity when making decisions.

The senators said that while people across the country are demanding more tools to fight for racial and economic equity, the Labor Department "is moving in the opposite direction. ESG investing allows retirement savers to support long-term change by building a system that rewards and values inclusion and diversity in corporate culture from the board to the workforce."

But some lawmakers applauded the Labor Department's efforts, including nine House Republicans in a letter that also asked the department to amend the proposal to require any company seeking eligibility for American retirement fund investments meet U.S. transparency standards. The congressmen who signed the letter cited concerns over retirement funds investing in Chinese companies.

Comment letters from business trade groups mostly welcomed the proposal.

"Individual companies are free to pursue appropriate ESG agendas for their businesses, their communities, and their shareholders, and individual investors and plan participants are free to select funds that match their ESG values — but ERISA fiduciaries cannot select investments based on non-pecuniary ESG factors when plan participants' retirement savings are at stake," the National Association of Manufacturers said.

Stakeholders from across the world, including Europe, Canada and Australia, submitted comment letters in opposition to the proposal. The Brunel Pension Partnership, Bristol, England, which has about £30 billion ($36.3 billion) in assets, said in its comment letter that ESG factors can be financially material. "If the proposal goes into effect, it will undermine our ability to act in the long-term best interests of our beneficiaries," its letter, signed by CEO Laura Chappell, said.

In Europe, ESG investing is 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.

Many letters called on the Labor Department to extend the 30-day comment period, which didn't happen, or withdraw the rule entirely.

State Street was part of the latter camp. Ms. Kahn said the Labor Department should "go back to the drawing board," adding that she thinks the department doesn't understand how stakeholders look at ESG today. "Most ESG factors are very 'pecuniary,' to use their word," she said. "If you have a company that's dumping hazardous waste or has had issues in the past with how they've handled company accounts, that's a very important factor to look at and will have an impact on that company's financial performance."