The DOL’s ESG Proposal and DB Plans

There’s a lot of money in corporate defined benefit (DB) plans, and it can make a difference how those assets are invested.

Cooper Abbott, president and chairman of Carillon Tower Advisers, notes that the Department of Labor (DOL) oversees employee benefit plans that represent approximately $10 trillion in combined assets under the Employee Retirement Income Security Act (ERISA).  Of this total, about $8 trillion is in mutual and other funds, and about $2 trillion is in directly held equities (i.e., equities not in funds). “There’s a lot of power in what investments are saying,” he says.

This summer, the DOL proposed a rule that addresses environmental, social and governance (ESG) investing in retirement plans. Abbott says the proposed rule is specific that plan sponsors should not invest in ESG vehicles for which the strategy subordinates returns or increases risks for nonpecuniary objectives. Regulators and industry stakeholder have expressed concerns that plan sponsors invest in ESG funds based on fiduciaries’ or plan participants’ philosophies, rather than based on financial factors.

“I think most DB plan trustees are looking at financial factors,” Abbott says. He notes that a divestment approach that the industry used to call SRI (socially responsible investing) is a different approach than an integrated ESG worldview. “An integrated approach says no asset class out there is not fair game. If an investor wants to engage with energy companies, it can use assets to be owners and help companies make improvements,” Abbott says. “Divestment is more of a philosophical approach where the investor is on the outside looking in. I don’t think using ESG is.”

Carillon commented on the proposed rule and said the DOL is limiting how much of a “voice” investors have. “We do not see ESG considerations and returns as mutually exclusive. Secondly, in general, more choice is better for investors,” Abbott says.

He notes that Carillon’s managers have been involved in considering ESG issues for a long time. One thing that has changed in that time is that there is now better data about ESG investments. “ESG investing is a practical approach,” he says. “Understanding whether a company is polluting or whether it treats employees well aligns the interests of shareholders with business management,” Abbott says. “I don’t think these ideas are controversial or new.”

Simon Robinson, director of product management at Moody’s Analytics, says the DOL’s proposed rule about ESG investing in retirement plans is just a clarification and broader calling out of ESG funds for the existing requirement to look at investments for pecuniary benefits. “A retirement plan fiduciary should make decisions on the basis of investment characteristics and whether investments will generate good returns for the retirement plan,” he says.

DB plan fiduciaries will need to look at ESG-related funds closely, specifically when it comes to the potential for generating good returns, Robinson adds. They should be careful about how they evaluate ESG funds and the advice they get about them.

However, he says there are reasons why ESG issues are a financial factor. Asset managers can make good arguments that addressing climate change would have a beneficial impact on asset returns. So a retirement plan fiduciary should be putting ESG investments under more scrutiny to show what is driving returns and the financial impact ESG factors are expected to have.

“One thing we’re interested in looking at is performance attribution, and hopefully it shows how outperformance plays out with respect to ESG factors,” Robinson says. “It might be a way for plans to investigate their funds.

“Looking at ‘E,’ ‘S’ and ‘G,’ plan fiduciaries can construct arguments, and provide evidence as well, that companies with good governance, for example, will perform better,” he continues. “I don’t think the DOL proposal silences plans in terms of how they ‘speak’ with investments. ESG can be a factor in the context of generating strong long-term returns.”

Abbott similarly says ESG is well-suited to research-based views. “There is no black and white about these things. How consumers think about a company has to do with how it looks compared to competitors and how the company is changing over time, which affects its bottom line,” Abbott says.

“Looking at returns generated by an investment in the past and the ability of the investment team to generate returns in the future, if plan sponsors believe an ESG investment can help reduce risk, there is a value to that,” Abbott says. “Also, participating in an industry that is changing and has headwinds, that’s a positive. With more choice, a plan sponsor can align its investment strategy to deliver outperformance and mitigate volatility.”

In the ESG proposal, the DOL says it wants plan sponsors to make clear why they are investing in a given manager or a given strategy, Abbott notes. He says this is what plan fiduciaries do whether an investment is ESG-related or not. “I don’t think there will be a lot of change if the ESG proposal is finalized, because many plan sponsors already have good processes” for selecting and monitoring investments, Abbott says. “From a ‘big picture’ view, the DOL is saying, ‘Not all ESG is good, so be careful.’”

If a DB plan sponsor can’t show a beneficial impact on asset returns, it should look at the performance and future expectations for any given investment, Robinson says. “So, in general, if an investment is not performing as expected, plan sponsors should be considering whether to use it or not,” he says. “The challenge is if the plan sponsor has previously taken a strong view that it wants to hold the strategy for ESG reasons but it’s poorly performing. I would come back to the broad rule, so I would likely get rid of or replace it.”

Robinson notes that ESG factors are often suited for long-term investing, so, for DB plans, ESG investments might conflict with short-term investing strategies.

He recommends that plan sponsors talk to their ERISA attorneys about how to best interpret the DOL proposal. “The DOL doesn’t get into specifics about how to determine financial pecuniary benefits, so plan sponsors need advice about that,” Robinson says. He adds that there is “no magic way” to determine whether an investment is financially attractive or not—looking at past performance is the most concrete way, and forward looking is equally critical.

A Note About the DOL Proxy Voting Proposal

The DOL also recently proposed a rule about proxy voting by employee benefit plans, which applies to the direct investments of employee benefit plans, Abbott says. “The DOL says it wants to reduce plan expenses, and that it wants plan fiduciaries to refrain from voting when the proposal for which shareholders are voting is not going to have a financial impact on the plan,” he says. “But, equity is ownership and ownership has power. Proxy voting is a right of ownership. It seems to me that by the time fiduciaries have done the research to see if a proxy proposal will have a financial impact, they’ve already spent the money the DOL says it wants to save. So, I’m not clear what the proxy proposal is trying to do.”

As for the proxy voting proposal, he says, there could be more guidance about what type of issue matters and warrants research.

A Difference in Government Views

Back to the subject of the DOL ESG proposal, Robinson points out that there is a difference in the landscapes for ESG investing in the U.S. and the UK. In the UK, there is a similar proposal from the Department for Work and Pensions (DWP). However, the DWP proposal that is out for consultation suggests that large pensions report on ESG factors in financial disclosures. “It’s not trying to influence how pensions invest; it’s just a proposal on reporting,” Robinson says.

“In the UK, the government says ESG is good and plan sponsors should consider them, and here’s what to consider specifically,” Abbott says.

He adds that he believes interest in ESG investing will continue to grow, that views similar to those of  the UK government will take hold and that there will be more demand for ESG investing by retirement plan participants. Abbott says this can be good for competition and evolution in the marketplace, and he believes managers will continue their efforts to provide good ESG investment opportunities.

Whether the DOL proposal moves forward in its current form or not, having a more tangible process to address ESG factors in investment selection would be beneficial to plan sponsors, Robinson says.