After years of uncertainty around how U.S. retirement plans could consider ESG factors, the dust is finally settling. It’s official: A Nov. 22 rule issued by the Department of Labor (DOL) allows retirement plans to consider financially material ESG factors when selecting investments and exercising shareholder rights. What’s more, the neutrality of the final rule increases the odds the rule will endure under future administrations.
What changed, and is this actually a change?
In many ways this isn’t a change, rather a clarification. The DOL claims that the “the Department has consistently recognized that ERISA (the Employee Retirement Security Act) does not prohibit fiduciaries from making investment decisions that reflect ESG considerations, depending on the circumstances”, but two rules issued during 2020 under the Trump administration had a chilling effect, leaving plans wary of any decisions that may be perceived as considering climate change or other ESG factors.
The first1 of the two 2020 rules required plan fiduciaries to select investments based solely on pecuniary factors. Countless debates ensued around what constituted a pecuniary factor: did prevalence of overtly financially material ESG events justify inclusion of ESG considerations into investment decision making? Rather than splitting hairs, better to be safe than sorry was a common stance among fiduciaries of ERISA plans.
The second2 2020 rule related to proxy voting and exercising other shareholder rights. This rule stated that fiduciary duty did not extend to voting all proxies or the exercise of every shareholder right. And, an explicit safe harbor was introduced that allowed fiduciaries to limit voting. Two such acceptable approaches included limiting voting to only those proposals having a material effect on the value of the investment and refraining from voting when the size of the plan’s holdings in the securities were below quantitative thresholds set by the fiduciary. The rule also appeared designed to dissuade voting on non-pecuniary (generally interpreted as ESG) goals or those without a clear economic benefit to the plan participants.
Then in a dramatic gesture on day 1 of the Biden presidency, an executive order on climate change was signed. While not the sole focus of the order, the two 2020 DOL rules on ESG factors were effectively put on notice, and in March 2021 the DOL followed up by clarifying that the two 2020 rules were under review and would not be enforced.
What’s in last week’s final rule?
Recall one could argue this rule was a clarification rather than a change. The final rule released last week is still subject to the long-standing statutory principle: the duties of prudence and loyalty require ERISA plan fiduciaries to 1) focus on relevant risk-return factors, and 2) not subordinate interests of participants to other objectives. The DOL expressly acknowledged that ESG factors may be appropriate considerations in making prudent investment decisions, using unbiased language that provides room for fiduciaries to make their own investment decisions on weight to be accorded such factors. It was also clarified that the fiduciary duty extends to the right to vote proxies, eliminating the bias against voting implied in the 2020 rule. In short, it is now explicitly OK to consider ESG factors.
Additional points clarified in last week’s rule included removing the word pecuniary and the prohibition on non-pecuniary vehicles, updating the tiebreaker test and removing special considerations on qualified default investment alternatives (QDIAs) in the 2020 rules. In the last of these, the rule removed a 2020 prohibition on using ESG funds as a default defined contribution plan investment, making standards the same for QDIAs and other investment options. Also notable given the DOL’s historic guidance, the new rule clarifies that a plan fiduciary does not violate the duty of loyalty solely because they take into account participants’ preferences. One rationale underpinning this clarification is that participants may save more if they like the saving options.
Is this purely political and likely to ping-pong from one administration to the next?
Following the headlines, you’d be tempted to say yes, this is just another volley in a politicized ESG landscape. But as others have noted, the final rule features notably more neutral language than the 2020 rules or even the original proposed rule. It does not favor or disfavor products with an ESG focus. Differences between the proposed and final rule provided notable examples, such as removing reference to specific ESG considerations which may have given the impression these things had to be considered. In our view, this attempt at political neutrality will increase the likelihood that the rule sticks under subsequent administrations.
The industry response and the direction of travel outside the U.S. also will likely work in favor of the rule persisting. Over 900 written comments and 20,000 petitions were received during the DOL’s 60-day comment period. According to analysis of the comments by a sustainable Investing organization3, 97% reportedly supported the DOL reversing the 2020 rules and clarifying that ESG considerations and proxy voting are consistent with fiduciary obligations.
How does the U.S. landscape compare to global regulation? Global regulation on the issue of ESG factor inclusion in investment processes has been frenetic over the last few years, with the European Union leading the charge with particularly ambitious rules. Indeed, some of these rules are specifically designed to help investors identify economic activities in line with social or environmental and climate objectives. While the U.S. remains squarely focused on financial materiality, European rule makers have embraced the concept of double materiality, which recognizes that companies and financial institutions should manage and take responsibility for the actual and potential adverse impacts of their decisions on people, society and the environment. The U.S. on the other hand is, and is likely to remain, squarely focused on financial materiality of ESG factors.
What’s next?
We expect that the integration of financially material ESG factors will continue to become mainstream and more sustainable and ESG-related funds will become available to retirees benefiting from ERISA plans. Indeed, John Hancock found that a rising number of DC plans for which it provides recordkeeping services were offering standalone ESG funds in their lineup, from 7% in 2019 to 11% in 2021.4
Ultimately, the issue of integrating ESG factors and funds into investment plans may prove less political than the headlines would have us believe. This latest rule puts the ball squarely in the hands of fiduciaries to exercise their own best judgment in considering ESG factors when making investment decisions on behalf of ERISA plan participants and beneficiaries.
1 “Financial Factors in Selecting Plan Investments”, Nov 13, 2020
2 “Fiduciary Duties Regarding Proxy Voting and Shareholder Rights” Dec 16, 2020
3 https://www.ussif.org/Files/Public_Policy/DOL_Comment_Analysis_1.25.22.pdf
4 https://retirement.johnhancock.com/us/en/viewpoints/investing/esg-funds--place-in-the-retirement-plan-investment-lineup
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