The Department of Labor’s 148-page final rule issued late
last week on environmental, social and governance investing in retirement plans
notably excluded some key abbreviations: E, S and G.
The DOL changed the language it had used in the proposed
version of the “Financial Factors in Selecting Plan Investments” rule to focus
on “pecuniary” and “non-pecuniary” issues, leaving ESG all but out of the
discussion.
The rule is still very much about ESG investing, even if it
does not call the products out by name. Some changes in the document bode well
in the long term for sustainable investing in 401(k)s and other
defined-contribution plans, sources said. But at least one change could make it
virtually impossible for some fiduciaries to include ESG investments as the
default options on plan menus.
“Nobody like a rule. Nobody likes being told what to do. But
I believe that generally this is a much better rule than the proposed rule,”
said John Streur, CEO of Calvert Research and Management. “They obviously took
to heart the 8,700 comment letters they received.”
By focusing on the financial materiality of investments, the
DOL’s final rule aligns well with standards developed by industry groups such
as the Sustainability Accounting Standards Board that ESG managers already
follow, Streur said. For investment providers, that is helpful, given the
attention they already pay to financially material aspects, he said.
The final rule also shifted from emphasizing what isn’t
allowed when evaluating investment options to what should be considered, he
noted.
“This says you can use strategies that do include pecuniary
factors,” Streuer said. “For plan sponsors, it sets a clear path to conducing
due diligence on potential options for their DC plans. And … it makes it to me
very clear that investment managers need to be able to document their process
analyzing an E, S or G factor from a financial materiality perspective.”
The final rule is a significant improvement over the
proposed one, Stephen Saxon, principal at Groom Law Group, said in an email.
“It allows a fiduciary to make a judgment the ESG factors
could be ‘pecuniary’ and therefore may be considered in making a prudent
judgment regarding a plan’s participation in a particular fund,” Saxon said.
That is “a big step in the right direction,” he added.
A CAREFULLY WORDED CHANGE
One of the most striking changes in the final version of the
rule is that it does not appear to expressly prohibit employing ESG criteria in
a plan’s qualified default investment option, which is usually a target-date
fund. However, the language also appears to be engineered in a way that would
still prohibit ESG almost altogether in those investments, said Patrick
Menasco, partner at Goodwin and co-chair of the firm’s ERISA and executive
compensation group.
“This final formulation might be worse than the original,”
Menasco said.
The proposed version, for example, contained a safe harbor
that would have allowed ESG-themed funds or ones that include such criteria, as
long as those investments were selected objectively for their risk and return
profiles, he said. The final version scrapped that language, instead stating
that fiduciaries must show that investments were chosen for pecuniary factors
and that any nonpecuniary factors must also be shown to be in the best interest
of retirement savers, he noted.
“There is sort of a circular dynamic going on here. On one
hand, you’re not prohibited from including ESG-themed or ESG strategy options
under the QDIA. But if you do … you still have to justify those [nonpecuniary
factors] as being in the best interests of the retirement savers and the
beneficiaries,” Menasco said. “How do you do that?”
TAKING OUT THE ESG
The DOL does call out ESG factors in the preamble to the
rule. But the fact that those criteria were removed from the rule text itself
reflected how troublesome it can be to define ESG, sources said.
“They made the right decision,” said Michael Kozemchak,
managing director at Institutional Investment Consulting. “What they came to
realize is that [with] ESG or ESG-themed investments, there’s a lack of specificity
in that definition, and that is particularly problematic.”
Despite increased interest in general among investors in ESG
funds, employers — particularly large companies — have not been seeking them
for their retirement plans, he said.
“We have some church plans we work with that wanted socially
responsible options,” Kozemchak said. “We included them for the purposes of
choice, but [they] have been really challenging” from a performance standpoint.
A STEP BACKWARD
The final rule could give plan fiduciaries “a little more
wiggle room when it comes to incorporating ESG investment products within a
QDIA,” said Shawn O’Brien, a senior analyst at Cerulli Associates.
But the regulator’s message has been consistent, even
without the ESG language in the final rule, O’Brien said. And plan fiduciaries
are ever leery of taking any potential risks, especially without clear
benefits.
“In the long term, there is a strong interest from certain
plan sponsors, and asset managers still stand behind the financial merits of
ESG investing and taking ESG considerations into account,” he said. “In the
short term, this makes adoption more difficult.”
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