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.
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."
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.
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.
In Wall Street Journal opposing opinion columns last month, two economics professors at Northwestern University's Kellogg School of Management in Evanston, Ill., squared off over the appropriateness of ESG funds in retirement plans.
Aaron Yoon, an assistant professor of accounting and information management, wrote that "Offering employees the option of investing in [ESG] funds in their 401(k) retirement-savings plans is essential. If individuals are making clear that they want the option to invest this way, there is no good reason to deny them the opportunity to do so in their 401(k) accounts."
He wrote that research he conducted with colleagues showed companies with good ESG ratings relevant to the sector in which the company operates delivered superior stock returns.
In a counter-argument, Phillip Braun, a clinical professor of finance and associate chairman of the finance department at the Kellogg School of Management, wrote that ESG funds "tend to be more expensive than other funds"—and that according to a Morningstar study, the asset-weighted average expense ratio of U.S. ESG funds was 0.61 percent in 2020, compared with 0.41 percent for all U.S. open-end mutual funds and 0.12 percent for traditional index funds. He noted that higher fund fees are correlated over time with lower returns on dollars invested, compared to similar funds with lower fees.
"Determining whether a stock or a fund is truly advancing ESG goals is difficult because the investment industry lacks a comprehensive ESG measurement framework," Braun added. "Even those who are willing to pay extra to support sustainability and a 'green' agenda cannot be sure that ESG funds deliver on that either."
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:
[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.
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.
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