A proposed rule issued Wednesday by the DOL bodes extremely well for ESG investment managers, especially because the regulator clarified that target-date funds and other default products that use the investment criteria are permissible in 401(k)s.
In its proposed rule, “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights,” the Department of Labor emphasized that environmental, social and governance factors can be considered financially material. In many cases, that would give ESG funds an advantage over others. But the DOL went a step further, noting that it is retaining the so-called “tie-breaker” test for investments, meaning that all else being equal, financially immaterial factors can give one product an edge over another. The proposal also clarifies that ESG can be material when it comes to proxy votes that plan sponsors make on behalf of participants.
“These ESG factors can be financially material,” acting head of the Employee Benefits Security Administration Ali Khawar said Wednesday. “When these are financially material factors, you shouldn’t be thinking you’re choosing this because they are ESG. You are choosing them because they are the financially best options for the participants.”
However, Khawar said, “there are any number of times when an ESG factor can be financially material, but we are not suggesting that this is the case all of the time and in every context.”
When ESG — or other factors — are not financially material, they can only be used to give one investment extra weight when that fund or product is all but identical to another that is being considered.
“The tie-breaker concept is not necessarily just ESG,” Khawar said. “It is more the question of, once you’ve gone through that initial analysis and you have a variety of options … ‘How should you decide which of those three equivalent options are the best for your participants?’”
The proposed rule seeks to address what is considered to be a chilling effect for ESG that resulted from two rules finalized at the end of the Trump administration. One rule applied to the selection of investments for retirement plans, and the other addressed proxy voting by plans.
The Biden administration directed the DOL to revisit those rules, and the regulator indicated earlier this year that it would not enforce them while it considers changes.
After the proposed rule is published Thursday in the Federal Register, there will be a 60-day public comment period. The DOL could make changes to the rule when drafting a final version.
Khawar did not comment on any aspects of the proposal that opponents would likely attack, but he noted that the agency would consider comments before making any decisions.
One area that commenters will likely address is a requirement in the proposal that plans that use the tie-breaker test for investment selection disclose that, along with their reasons for doing so, in participant communications, said George Michael Gerstein, co-chair of fiduciary governance and ESG at Stradley Ronon.
“Plan sponsors are quite risk-averse,” Gerstein said. A concern will likely be that tie-breaker disclosures could lead to ERISA litigation, he noted.
Other than that aspect of the proposal, “I don’t see a huge amount of pushback. There is going to be a large cadre of stakeholders who are going to be relieved,” he said. “This will be fairly smooth sailing for them.”
“It’s going to greatly accelerate the adoption of ESG,” Gerson said. And while the proposal “largely encapsulates longstanding DOL guidance,” it directs plan fiduciaries to consider the effects that government action will have on ESG.
“The effect of that can be quite dramatic, because the government has made it quite clear … that it has the power to issue rules,” he said.
But like the Trump administration, the Biden DOL is sidestepping the issue of exactly what ESG is, he said.
“It can actually reference up to 40 different issues. One of the ones I think of that gets overlooked is cybersecurity,” Gerson said, noting that that is a governance factor. “People don’t necessarily associate it with ESG.”
E, S AND G
The proposed rule focuses on environmental factors, and that is because of executive orders President Joe Biden has issued on climate change, Khawar said. However, social and governance factors can be just as financially material or as important to consider in tie-breaker situations.
“This proposal does come against a backdrop of two executive orders the president issued,” Khawar said. “[Climate] is just one important part of the overall context here … I wouldn’t take away from the proposal a belief that … the climate issues [are] the most important.”
For example, labor issues in a supply chain could end up being material in a fiduciary’s consideration of an investment.
WARM RECEPTION FROM THE INDUSTRY
The American Retirement Association was quick to endorse the DOL’s proposal.
“We are pleased that the DOL has established a level playing field for ESG investment considerations in retirement programs, consistent with ERISA’s requirement that plan fiduciaries’ decisions be first and foremost prudent, and in the best interests of plan participants and beneficiaries,” the lobbying and industry group said in a statement.
Natixis, a firm that provides ESG investments, including a target-date series, also voiced support.
“Fiduciaries should consider all the risks when evaluating investments for clients, and ESG is not a replacement for the fundamentals of sound investing, rather an extra layer of evaluation,” Jim Roach, senior vice president and head of distribution for ESG target date funds at Natixis, said in a statement. “ESG investing is clearly here to stay and we believe this newly proposed DOL rule addresses a demand of increasing importance to investors.”
Lisa Woll, CEO of US SIF, noted in a statement that the qualified default investment option aspect of the proposed rule was particularly significant.
“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,” Woll said.
POLITICAL DIVIDE
Democrats and Republicans had dramatically different views of the DOL’s proposal.
In a statement, Republican Reps. Virginia Foxx of North Carolina and Rick Allen of Georgia said that “the Biden administration is taking its radical climate change and pro-union boss agenda too far — this time jeopardizing American’s retirement savings.”
Meanwhile, Democratic Sens. Patty Murray of Washington and Tina Smith of Minnesota praised the proposed rule for ensuring that “financial advisers can consider ESG criteria in their investment decisions — for example, whether investments that are financially beneficial also promote racial justice, address climate change or protect human rights.”
