The regulatory approach to including environmental, social and governance funds in defined contribution plans’ lineups has left advisors and sponsors in what Sarah Bratton Hughes, head of sustainability, North America with Schroders, describes as “a little bit of a limbo period.” The confusion began last summer when the Department of Labor proposed regulations that considered ESG factors to be non-pecuniary, i.e., not financially material, to sponsors’ fiduciary considerations.
Around We Go
Response to that proposal was overwhelmingly negative so it was back to the drawing board for the DOL. The final rule issued in late 2020 as an update to the initial proposal dropped the ESG-references and focused solely on pecuniary factors that are part of a risk-return analysis appropriate for the plan’s investment objectives and funding policy.
But the final rule’s text wasn’t the full story, Bratton Hughes cautions. “The final ruling itself says nothing about ESG—it just focuses on financial materiality and fiduciary duty,” she explains. “However, the preamble, which was very long, set a tone that was very negative towards sustainable investing and put a cold shower on the whole thing. So, the rule itself was not the issue; it was the preamble.”
Changes in regulators’ position on ESG are nothing new, according to Julie Gorte, senior vice-president for sustainable investing with Impax Asset Management LLC. “DOL has gone back and forth and back and forth, depending on who’s in power in the administration, for more than two decades,” Gorte notes. “It's okay to use ESG funds; you should be careful; it's OK; no, you should be careful. And then suddenly in this last deal, we've got one that said, no, you can't use them as QDIAs (Qualified Default Investment Alternatives) because we presume that they're going to underperform.”
A New Sheriff in Town
That opinion is changing, however. Brad Campbell, a partner with Faegre Drinker, explains that upon taking office, President Joe Biden issued an executive order that directed DOL to review the rule due to concerns about its effect and its rapid promulgation. DOL did so and decided in March that the financial factors rule was confusing fiduciaries, created a false impression that selecting ESG-related investments presented more fiduciary risk, and was chilling appropriate investment in prudent ESG-related investments. Accordingly, DOL announced on March 10 that it was suspending enforcement of the financial factors rule. While the rule still exists on the books, DOL will not enforce its requirements, Campbell notes.
Biden issued a second executive order in May on climate change risk that again directed DOL to review the financial factors rule and decide whether it should be modified. That order also directed DOL—which has oversight authority over the Federal Thrift Savings Plan (TSP), the government 401(k)—to review and advise on the use of ESG funds in the TSP.
In other words, the Biden administration has strongly signaled that prudent ESG-related investments are appropriate for ERISA-defined contribution plans and that fiduciaries should consider appropriate ESG-related investments, says Campbell.
Looking Ahead
For the near- to mid-term, at least, the on-and-off gyrations in ESG regulations should subside, says Gorte: “I think we can count on both agencies (DOL and SEC), at least in the next three years, to not be heavy-handedly trying to make ESG a more difficult discipline to pursue. Whether they succeed in the long-term, we don't know, but I think the more the market gets experienced with sustainability, the more the market sees it as material.”
Campbell notes that the semi-annual regulatory agenda released in June officially announced that DOL will propose a new rule to replace the financial factors rule. The new rule likely will encourage ESG-related investments by ERISA plans; the new proposal modifying or replacing the financial factors rule is scheduled for September 2021. “Given the two executive orders and DOL’s suspension of enforcement of the old rule, we believe it is very likely that the new rule will strongly support ESG-related investments by ERISA plans,” says Campbell. “As Acting Assistant Secretary Khawar stated in the March 10 press release announcing DOL’s suspension of enforcement, “We intend to conduct significantly more stakeholder outreach to determine how to craft rules that better recognize the important role that [ESG] integration can play in the evaluation and management of plan investments” [emphasis added].
Advice for Plan Sponsors
Given the recent shifts, how should plan sponsors proceed with ESG considerations? Albert Lim, a consultant with Russell Investments, recommends sponsors assess ESG options with a few key considerations in mind:
- A DC plan menu should not be over-packed with investment products. So rather than looking to add every flavor of ESG to their plan menus, sponsors should focus on a smaller set of products that are closely aligned with the preferences of most of their plan participants.
- Is the juice worth the squeeze? In other words, is there enough participant appetite for these products to be worth the sponsor’s time and effort?
- If you do decide to add an ESG product, make sure it’s attractive from both an investment and cost standpoint.
The rule is focused on financial materiality, says Bratton Hughes. Consequently, sponsors should focus on strategies where ESG is embedded into the investment process. “If it's just a bolt-on or an afterthought, then how is the manager going to assure that it is financially material?” she asks. “The real key to the rule is ensuring that it is financially material. So, it's about looking through ESG strategies to help ascertain which strategies are authentically integrating sustainability into them and then working with your plan sponsor to ensure you have the proper documentation in place.”
Right now, we are in the “in-between” time—the old rule is not being enforced, but the new rule is not yet written, says Campbell. While fiduciaries do not have to avoid ESG-related investments, they do need to put them through the same prudent, thorough and well-documented process that they use to consider all plan investments.
ESG-related investments must be prudent based on all the criteria the plan would normally consider, but there is no reason to avoid ESG-related investments, he maintains.
“We do, however, advise our clients against so-called ‘negative screening’—that is, considering only ESG-related investments,” Campbell advises. “ESG investments may be prudently considered on the same terms as other reasonably available investments to the plan—they should not be considered exclusively.”
Lim also cites the need for a solid review process: “As with all actions taken by plan sponsors, make sure you have a consistent, thorough, and well-documented process for why and how an ESG option was added to the plan.”