Investors have long had an interest in a company’s corporate governance, as well as in environmental and social issues. Years ago, retirement plans were called on to divest from companies that did business in countries accused of genocide, that polluted the environment or that made their money making alcohol, tobacco or firearms.

Such efforts have been called responsible investing, socially responsible investing and, more recently, environmental, social and governance, or ESG, investing. And there has been a move from solely divesting from certain companies to investing in companies that exhibit good ESG practices. Environmental and social issues have been increasingly in the spotlight this year, yet amid that, the Department of Labor (DOL) has issued a proposed regulation that seems to create stricter limits for ESG investing in retirement plans.

In a statement about the proposed rule, Robert Smith, president and chief investment officer (CIO) of Sage Advisory Services in Austin, Texas, said, “The language is written in such a way that ESG-oriented funds are given second-class status when considering investment alternatives for a plan.” Smith pointed out that Millennial investors and defined contribution (DC) plan participants in general “would prefer a choice architecture that better reflects their investment attitudes and goals.” He concluded, “We are not sure this statement truly reflects those well-supported long-term demographic trends that will continue to affect the DC plan world in the future.”

Lisa Woll, CEO of US SIF: The Forum for Sustainable and Responsible Investment in Washington, D.C., said in a statement, “The proposed rule suggests, but without evidence, that the growing emphasis on ESG investing may be prompting ERISA [Employee Retirement Income Security Act] plan fiduciaries to make investment decisions for purposes distinct from providing benefits to participants and beneficiaries and defraying reasonable expenses of administering the plan. However, the DOL proposal is out of step with professional investment managers, who increasingly analyze ESG factors precisely because of risk, return and fiduciary considerations.” She noted that three-quarters of asset managers polled by US SIF in 2018 cited the desire to improve returns and to minimize risk over time as motivations for incorporating ESG criteria into their investment process. Fifty-eight percent of asset managers cited their fiduciary duty obligations as a motivation.

“Generating more hurdles to the incorporation of ESG criteria will have a chilling effect, leading to plan participants losing access to ESG options—many of which have outperformed their indices over time and especially during the market shock related to COVID-19. The DOL also seeks to limit the universe of plan participants able to access ESG retirement options by prohibiting ESG investments to be ‘added as, or a component of, a qualified default investment alternative [QDIA],’” Woll stated.

However, the Institute for Pension Fund Integrity (IPFI) said it applauds the DOL’s efforts to clarify and correct guidance on the fiduciary obligations of pension fund managers as far as ESG investing is concerned. “The question at hand is whether the plan managers, bound by fiduciary duty to their beneficiaries, are sacrificing investment returns or increasing risks in order to meet ESG goals unrelated to the participant’s bottom-line financial interests. Adherence to fiduciary duty is a cornerstone of pension fund management. Any effort to inject politics or political opinion into the management of other people’s money is plainly dead wrong,” it said.

Discouraging But Not Prohibiting

Andrew Oringer, co-chair of Dechert LLP’s ERISA and Executive Compensation Group, based in New York City, points out that the basic principal that financial economic returns have to be paramount in selecting retirement plan investments has always existed. He says varying administrations bounce between subtle changes in tone: Generally, Republicans discourage ESG investing in retirement plans and Democrats seek to keep the door more open. “This administration indicated an even more pointed dissatisfaction with ESG principles when it comes to retirement plan investments, not just a change in tone,” he says. “The proposal seems to say the DOL is dissatisfied with current guidance not being strong enough to discourage using ESG, so it’s going to amend rules, although not with a flat prohibition, but by discouraging it.”

The proposed rule expressly notes that an ESG fund cannot be a plan’s qualified default investment alternative or a component of the QDIA. Oringer says the DOL seems to be saying that even if a plan fiduciary can conclude that an ESG-centric investment is consistent with ERISA, the agency thinks if participants are going to be defaulted into an investment, the selection of that investment should be based solely on financial considerations.

Steven Rabitz, a partner at Dechert in New York City, says the DOL proposal not only represents a change in tone, it says things that cast doubt on the validity of ESG factors generally. “With respect to QDIAs, it says your ESG-themed fund with the name ESG in it is problematic in the QDIA or even in one of its components. There will be a lot of pressure there,” he says. “That being the case, it doesn’t necessarily mean, from our perspective, that there isn’t a place for empirical ESG metrics within a TDF [target-date fund] or QDIA. In other words, much in the same way plan sponsors can use ESG as a healthy empirical metric, perhaps there’s a place for that in a QDIA as well. It’s more about calling something ESG. That’s when scrutiny will be high.”

Prior guidance from the DOL suggested that ESG factors could be considered as a tiebreaker when considering two investments similar in performance and cost. Rabitz says there is interesting language in the preamble to the proposed regulation that suggests the DOL is going to keep open the “break the tie, all things being equal” idea, but that the agency expects that true ties rarely, if ever, occur. “They are sending a pretty strong message that it will be difficult and plan sponsors better be able to demonstrate it very quantitatively,” he says.

“I think the DOL is saying it’s not impossible for ESG to be a tiebreaker, but it is skeptical,” Oringer says. “The DOL is skeptical that plan fiduciaries can make the point that deciding based on ESG factors isn’t hurting participants. They’re saying, ‘If you’re eliminating investments looking at non-economic factors, how can that not hurt you?’”

Brendan McCarthy, head of DCIO National Sales at Nuveen in Boston, says he believes tiebreakers are rare. “When doing due diligence and matching investment selections to the objectives of the plan, the ESG component could add an element that pushes one forward based on its investment merits, not the fact that its ESG-centric,” he says.

Brian Pinheiro, attorney and head of the Employee Benefits and Executive Compensation group at Ballard Spahr in Philadelphia, says the DOL has taken a dim view of ESG investments in retirement plans over the past several decades, starting in the early 1990s. “Originally, the DOL said plans could not invest in ESG-centric investments, then it created a tiebreaker. But, of course, in investing, there is no such thing as a tiebreaker,” he says.

Pinheiro notes that in 2018, the agency softened its stance in guidance that acknowledged ESG factors can be economic factors, and, if so, they are appropriate to take into account. He says he feels the proposed rule is taking another baby step forward. “[The proposed regulation] provides a roadmap for fiduciaries of DC plans to use objective criteria to identify ESG investments, to document the criteria used and document their decisions. As long as ESG investments are not part of a plan’s QDIA, it seems like the DOL is saying can be included. As long as plan sponsors are not excluding a non-ESG fund for an ESG fund,” he says.

Pinheiro concedes that the proposed rule is still not particularly supportive of ESG investing, but says it acknowledges that plan sponsors and participants have an interest in investing this way. “The most important thing the DOL said is just because an investment is ESG-centric, it doesn’t change the needed analysis. Plan sponsors still have to consider risk, return and fees. If, after the evaluation, the plan sponsor still decides it’s a prudent investment, it can be used in the plan,” he says.

Rabitz notes that previous input from the DOL has been what the preamble to the proposed regulation calls “subregulatory advice.” He says the DOL is “upping the ante and trying to take a real position they think will be long lived.”

Being an election year, Rabitz says the DOL is signaling its intent by only providing a 30-day comment period. “This suggests [the agency] is trying to accelerate the process. And, in the last couple of months, there’s been an uptick from the DOL in investigating ESG practices. These things suggest the department may be taking it on the fast track,” he says.

Oringer says that if the proposed regulation becomes final in its current form, it will make it harder to change if there is a political shift with the upcoming elections. Since prior guidance was interpretative, it opened the door for successive administrations to put their own mark on it, but it is more complicated to roll it back if it becomes a regulation.

To get the pendulum to swing back, Oringer says, the message to convey would have to be that it is OK to consider other things in retirement investing. “With the Employee Retirement Income Security Act, one can’t argue that things that are other than for the best interest of participants are OK to consider,” he notes. “Saying ESG will help me pick better-performing companies does work with ERISA, but focusing on ESG to better the world does not.”

The public comments the DOL receives and its reaction to those comments will be important to determine what the final regulation will look like, Pinheiro says. “I think there’s a chance that the final rule will be more permissive because I think there will be a lot of comments by those who think ESG should be invested in,” he says. “I think there will also be a lot of comments about ESG being a component of a QDIA.”

“We’ve been advising our clients on this for years. There is a tendency for [retirement plan] fiduciaries to want to consider ESG investments and add them to a plan’s lineup. Our reaction is, you shouldn’t add it unless there’s participant interest in it. That’s the time to have the conversation. There’s no reason to even start to consider ESG investments unless participants voice an interest,” Pinheiro says.

Current and Future Implications

McCarthy says that in Nuveen’s recently released Fifth Annual Responsible Investing Survey, 54% of investors said they would invest their entire retirement balance into a fully diversified responsible investing (RI) portfolio. Nearly six in 10 (59%) said they would choose an employer based on the availability of an RI option in their 401(k) plan. Since 2015, McCarthy says, nearly three-quarters of investors expressed that having an RI option in a retirement plan makes them feel good about working for their employer.

A majority of investors (53%) in the recently released survey cited better performance for prompting them to choose responsible investments. It was the top choice.

Megan Fielding, senior director, Responsible Investing, at Nuveen in San Francisco, says, “At first glance, we disagree with the DOL’s premise—particularly the aspect that investors will give up performance with every responsible lens.” She says the finding in Nuveen’s survey of more than 1,000 high-net-worth investors that performance is the highest factor considered in selecting ESG investments is in contrast to whatever is guiding the DOL. She notes that this is the first year that the survey found better performance is the top reason for selecting ESG investments. “The investor has spoken. Aside from academic studies, the real-life experience of investors is speaking to us,” she says.

“This is not a huge surprise,” Fielding adds, “but what continues to be confirmed is that investors continue to look for competitive returns as well as positive social or environmental outcomes, not just one or the other.”

McCarthy says the notion that ESG factors can negatively impact performance is outdated, and investment managers recognize ESG investing can reduce risk and improve investment outcomes.

For those investment managers able to offer valid investment strategies that can withstand empirical analysis on an apples-to-apples basis, there will be pressure on them to develop and market those types of strategies, Rabitz says. “The DOL is not making things easier, but it’s not all doom and gloom. The DOL is not shutting the door entirely,” he says.

McCarthy says he doesn’t think the regulation, if passed in its current form, would affect what Nuveen is seeing and ESG investments within DC plans. “We are still seeing increased demand from participants, as well as plan sponsors, to offer ESG options within the menu, and I don’t think that will change,” he says.

McCarthy says plan sponsors should understand this is not yet a rule. It is a proposed regulation up for public comment; there will be a lengthy process before it is finalized and it is subject to change.

“This is an area where advisers or consultants can be most helpful,” he says. “Most of them already have a process in place to select and monitor investments consistent with a plan’s objectives.”

For plan sponsors that already hold ESG investment options on their defined contribution plan investment menu, McCarthy says, most likely, the options were selected based on their investment merits and the advantages ESG components can bring. “Barring ESG TDFs, which were called out in the proposed regulation as being prohibited, most plan sponsors are probably already in a good place,” he says.

Even though the regulation is only proposed and subject to comment before a final regulation is issued, Oringer says he thinks it will have an effect on the market immediately. Plan sponsors will want to put something new into place considering this regulation could become final. “I think in the past, plan sponsors that wanted to pursue ESG investments set up prudent procedures and created a record that showed they considered pertinent factors, then proceeded. There’s no question this intentionally raises the bar here,” Oringer adds.

For plan sponsors considering ESG investments for both returns and to “save the world,” Rabitz says that can be challenging. If investment managers that offer ESG products can determine on an empirical basis that following ESG metrics offers better performance, they are doing what the proposed regulation says to do. However, Rabitz notes, each manager approaches it with different perspective, so it will be a facts and circumstances evaluation.

Rabitz says it is difficult to predict what effect the regulation would have on the adoption of ESG investments in DC plans. “Certainly, the regulation as proposed makes it a greater challenge for many, not all, ESG strategies,” he says. “Therefore, plan fiduciaries will focus more on responsibilities for things they have to be able to determine and document. At a minimum, even if they find an investment strategy that will deliver empirically wonderful results and it happens to be ESG factored, they still must go through a thorough analysis. It’s not that they aren’t documenting already, but practices need to be revisited.

“What hasn’t changed,” Rabitz continues, “is those who are picking ESG investments for the wrong reason—trying to push a social goal—they will continue to be at risk.”

Fielding notes that advisers who were surveyed said even though they’re seeing increased adoption of RI, they’re seeing a problem with terminology and transparency to aid in the due diligence process. “ESG investments are more confusing than traditional investments, and the proposed rule will only add to the confusion,” she says. “The need for education will be greater regardless of what the final regulation says. I can see where firms like us will be working with a lot of consultants and plan sponsors to help peel back what the rule is saying.”