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Labor Department finds compromise in ESG investment rule

Rule reverses Trump administration on retirement plan investments

Indiana Republican Sen. Mike Braun introduced a bill that would curb ESG investing in retirement plans.
Indiana Republican Sen. Mike Braun introduced a bill that would curb ESG investing in retirement plans. (Tom Williams/CQ Roll Call file photo)

The Labor Department’s rule to expand environmental, social and governance options for retirement plans is being called a healthy compromise between financial services firms that want clear rules and plan sponsors that feared strict mandates to consider such factors.

The final rule, released last week, empowers plan fiduciaries to consider climate change and other ESG factors when making investment decisions, expanding options for Americans who want their retirement savings to incorporate ESG criteria.

The rule reverses the Trump administration’s changes to the implementation of a 1974 law known as the Employee Retirement Income Security Act, a law that governs a broad range of retirement and health benefit plans. The Biden administration, investors and other ESG proponents had said the Trump administration changes created a “chilling effect” on sustainable investments’ inclusion in retirement plans.

The department unveiled its proposal in October 2021 to open ESG-focused retirement plans to more Americans. The result is expected to unleash new offerings. For example, Morningstar plans to launch an ESG Pooled Employer Plan with an investment lineup that would consider financially material ESG factors, once the rule goes into effect next year. Others are likely to follow in the coming months.

“The rule is catching up to where the marketplace has been for years,” said Lisa Woll, CEO of US SIF: The Forum for Sustainable and Responsible Investment. “The final rule helps to address the gap between the growth of sustainable investment overall and the much more limited growth of sustainable investment options in retirement plans.”

The rule gets rid of language that plan fiduciaries may only select investments based on “pecuniary,” or purely financial, factors, according to the final text. It also clarifies that the economic effects of ESG factors can be used in a risk-and-return analysis for investment decisions if plan sponsors “reasonably” determine that those impacts are relevant. 

For fiduciaries of employee benefit plans covered by ERISA, the regulation provides a “road map” and a clear interpretation of how the law’s fiduciary standards can allow the consideration of ESG, said Elizabeth S. Goldberg, a partner at Morgan, Lewis & Bockius LLP who advises retirement plan sponsors and service providers on ERISA regulations.

“There’s so much interest and discussion around ESG right now that, in providing this interpretation, it helps bring clarity to the retirement plan interest in ESG that’s out there,” she said in an interview. 

“It’s not a complete open door,” Goldberg added. “It’s not a ‘must’ standard, and so it will still be important for ERISA plan fiduciaries to engage in the right process for considering ESG or adding ESG funds.”

Mandate fears

One of the top concerns from the industry groups that represent plan sponsors and advisers was that the rule’s language could imply that fiduciaries must consider ESG factors. Those groups argued that such language would subject their members to litigation risk and would be problematic for those that want non-ESG options for participants.

To address those concerns, the Labor Department got rid of a clause in the original proposal that said plan sponsors and advisers’ consideration of a portfolio’s projected return relative to its funding objectives “may often require” evaluation of ESG factors. 

It also clarified that fiduciaries will remain true to their duty by considering participants’ preferences in constructing a menu of prudent investment options for participant-directed individual account plans.

“If accommodating participants’ preferences will lead to greater participation and higher deferral rates, as suggested by commenters, then it could lead to greater retirement security,” the rule text states. “Thus, in this way, giving consideration to whether an investment option aligns with participants’ preferences can be relevant to furthering the purposes of the plan.”

The Insured Retirement Institute and the American Retirement Association, two of the biggest retirement industry associations, said the department struck a balance between acting neutral toward investment types and giving fiduciaries clarity and certainty for developing retirement fund options.

“I think the DOL hit the right tone and level in terms of allowing for these types of investments to be considered, but not requiring them,” said Brian Graff, ARA’s CEO. The organization represents more than 30,000 actuaries and plan administrators, as well as insurance professionals, financial advisers and others.

“ESG factors can be considered as part of a prudent fiduciary process, but they’re not required to be considered if the adviser or the plan fiduciary determines they’re not relevant under the circumstances,” Graff said in an interview. “Nothing’s perfect, but I think the department did a pretty good job of addressing the concerns of both fiduciaries, advisers and employers.”

Despite the fanfare around the Labor Department’s ESG rule, the financial services industry still has to contend with the growing anti-ESG rhetoric from Republicans in Congress and statehouses across the country.

This year, Republicans in the House and Senate introduced multiple bills to reinstate the Trump administration rules to curb ESG considerations in retirement plans governed by ERISA, including measures from Sen. Mike Braun of Indiana and Rep. Greg Murphy of North Carolina. Those bills will die when this session of Congress ends, and similar legislative efforts next year would likely make it only through the GOP-controlled House. But the bills strongly indicate the party’s opposition toward ESG.

The Labor Department’s final rule will have no effect on state-run pensions because those plans are not governed by ERISA. States with Republican majorities and leadership will be able to continue to pursue legislation and regulations to curb ESG factors in their governments’ retirement funds.

“It’s hard to ignore things going on at the state level, even though they don’t directly apply to ERISA,” said Goldberg from Morgan Lewis.

“We’re going to continue to see more plans add ESG funds, but I don’t think it’s going to be a sea change, because there is continuing uncertainty about the regulatory environment because of the anti-ESG movement,” she added.

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