DOL Proposes Rule to Support ESG Funds in Retirement Plans

The U.S. Department of Labor (DOL) has proposed removing barriers put in place by the prior administration that would have limited plan fiduciaries' ability to consider climate change and other environmental, social and governance (ESG) issues as risk factors affecting workers' financial security when fiduciaries select retirement plan investments and exercise shareholder proxy voting rights.

Some analysts are questioning whether the proposal, as currently worded, could require fiduciaries to consider the economic effects of climate change and other ESG factors when evaluating funds for retirement plans.

The proposed rule, Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights, would apply to investments included in 401(k) and other defined contribution plans, as well as to defined benefit pension plans. The proposal, published in the Federal Register on Oct. 14, follows an executive order signed in May by President Joe Biden directing the federal government to treat climate change as a threat to workers' retirement savings.

In 2020, the administration of former President Donald Trump had issued a final rule, subsequently blocked by the Biden administration, that would have required sponsors of investment-based employee plans to strictly apply the fiduciary duties of prudence under the Employee Retirement Income Security Act (ERISA) when considering plan investments that promote nonfinancial objectives, such as reducing carbon emissions. A separate Trump administration final rule would have barred retirement plan fiduciaries from casting corporate-shareholder proxy votes in favor of social or political positions that don't advance the financial interests of retirement plan participants.

Duties of Prudence and Loyalty

Under the Biden administration, the DOL takes the position that ESG factors, and climate change issues in particular, pose financial risks that plan sponsors should consider as prudent fiduciaries.

According to a DOL fact sheet, the proposed rule "retains the core principle that the duties of prudence and loyalty require ERISA plan fiduciaries to focus on material risk-return factors and not subordinate the interests of participants and beneficiaries (such as by sacrificing investment returns or taking on additional investment risk) to objectives unrelated to the provision of benefits under the plan," a position similar to the prior guidance.

The proposed rule, however, also "addresses the [DOL's] concern that the 2020 [Trump administration] rules have created uncertainty and are having the undesirable effect of discouraging ERISA fiduciaries' consideration of climate change and other ESG factors in investment decisions, even in cases when it is in the financial interest of plans to take such considerations into account."

Acting Assistant Secretary for the Employee Benefits Security Administration Ali Khawar said the new proposal "will bolster the resilience of workers' retirement savings and pensions by removing the artificial impediments—and chilling effect on environmental, social and governance investments—caused by the prior administration's rules." 

He added, "A principal idea underlying the proposal is that climate change and other ESG factors can be financially material, and, when they are, considering them will inevitably lead to better long-term risk-adjusted returns, protecting the retirement savings of America's workers."

A 'Significant Change'

According to R. Sterling Perkinson, a partner in the Raleigh, N.C., office of law firm Kilpatrick Townsend, the proposed regulations "represent a significant change in the DOL's viewpoint of fiduciary duties that relate to ESG factors and shareholder activism, but they do not fundamentally alter the fiduciary duties to make investment decisions and to vote proxies and exercise shareholder rights to enhance investment returns. They may nevertheless have an impact by removing potential barriers from selecting funds that, for example, take into account climate change impacts or corporate governance practices as part of their investment strategies."

Looking ahead, Perkinson noted, "It remains to be seen whether the DOL will go a step further in final regulations by mandating consideration of certain ESG factors, or whether they will maintain a more neutral position that they are no different than other traditional investment criteria."

Along those lines, retirement plan consultancy October Three highlighted the section of the proposal stating that a fiduciary, when evaluating a plan investment, must generally give appropriate consideration to:

"The projected return of the portfolio relative to the funding objectives of the plan, which may often require an evaluation of the economic effects of climate change and other environmental, social, or governance factors on the particular investment or investment course of action. [Emphasis added.]"

The firm advised that "the italicized language, added by this new proposal, can be read not just to authorize consideration of ESG factors but to require it 'often.' "

William D. Jewett, a partner at law firm Verrill Dana in Boston, recommended that "fiduciaries should proceed with caution until the DOL's back-and-forth on ESG has settled into a durable set of rules. The partisan reactions to the proposed regulation that have appeared to date suggest that the back-and-forth is far from over."

ESG Default Investments

The proposed rule reverses the prior rule's prohibition on using ESG funds as qualified default investment alternatives (QDIAs), which are types of mutual funds that plan sponsors can select as the default option in automatic enrollment 401(k)-type defined contribution plans.

QDIAs can be target-date retirement funds, which automatically reset their asset mix to become less risky as the specified target retirement year nears. Mutual fund companies have begun marketing target-date funds made up of investments that meet their ESG criteria.

"This will be a huge win, if the final rule ends up looking like the proposal, for some asset managers who rolled out ESG target-date funds over the past few years," Jason Roberts, CEO of the Pension Resource Institute consultancy in San Diego, told RIABiz, an online publication for investment advisors.

Proxy Voting by Plan Fiduciaries

Shareholder proxy votes have increasingly focused on ESG corporate issues, including climate change policies. The former ESG rule barred plan fiduciaries from casting corporate-shareholder proxy votes in favor of social or political positions that didn't advance the financial interests of retirement plan participants.

As regards fiduciaries voting on behalf of plan participants in shareholder proxy initiatives, attorneys at law firm Seyfarth explained that the DOL's proposed rule "eliminates several provisions that were couched as 'safe harbors' in the [Trump administration's] rule based on the DOL's concern that they were being construed as permission for fiduciaries to abstain [from proxy voting] without properly considering the plan's interests."

The newly proposed rule also "prohibits a fiduciary from following the recommendations of a proxy advisory firm or other service provider unless the fiduciary determines that its proxy voting guidelines are consistent with the guidance in the proposal," Seyfarth noted.

Comments Sought

The comment period for the proposed rule will run through Dec. 13, 2021. Comments can be submitted at https://www.regulations.gov/.

[Update}

ESG Proposals Generate Strong Responses

The DOL's proposed rule garnered responses on both sides of the issue, as did a related Securities and Exchange Commission (SEC) request for public input on climate change disclosures by public companies.

While proponents of ESG investments favor removing barriers they see as needlessly preventing fiduciaries from offering funds that reflect plan participants' values in 401(k)-type plans, critics have questioned whether ESG funds are a marketing ploy by investment companies.

Below are excerpts from two comment letters on ESG investments:

In Support:

[I]n one analysis regarding physical risks from climate change, nearly 60 percent of the companies in the S&P 500 have assets with a high risk of exposure to extreme weather events resulting from climate change. Analyses regarding transition risks to a low-carbon economy also suggest significant impacts to companies, such as stranded assets worth trillions of dollars. … While we have focused on climate change in this letter, we believe that ERISA fiduciaries should be able to consider other ESG factors as well. As the DOL observed in its rule package, there are studies showing the positive correlation between social factors like workforce diversity and treatment of employees, on the one hand, and company success on the other.

-- A comment letter on the proposed DOL rule signed by attorney generals from California, Connecticut, Delaware, the District of Columbia, Maryland, Massachusetts, Minnesota, New Mexico, New York, North Carolina, Oregon and Vermont.

In Opposition:

My main worry with ESG disclosures is that they would give credence to the army of asset managers currently promoting ESG investing to retail and institutional investors as a way to "make money by doing good."… Recent ESG research by the [Center for Retirement Research at Boston College] finds that the major state and local government pension plans that have incorporated ESG factors into their investment policies underperformed those that did not. The study also finds that most retail ESG funds have higher fees and worse performance than similar index funds. At worst, ESG investing is a marketing ploy by financial services firms to repackage actively managed investments—which were becoming increasingly less appealing—in a trendy wrapper.

-- A comment letter on the SEC's request for public input by Jean-Pierre Aubry, assistant director of research, the Center for Retirement Research at Boston College.

Related SHRM Articles:

401(k) 'Windows' Reconsidered as Portals for ESG Investments, SHRM Online, July 2021

DOL Won't Enforce Rules Limiting 401(k) Plans' Use of Nonfinancial Factors, SHRM Online, March 2021

[Small businesses can find offering a retirement plan to be daunting. SHRM is offering a program through Raymond James that may help. Visit www.shrm.org/401k to learn more.]