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Sustainability Matters

Trump's Labor Department Really Doesn't Want You to Have ESG Options in Your 401(k) Plan

Proposed rule is based on the premise that workers’ retirement security could be compromised by investments that consider climate and other material ESG risks.

At a time when virtually the entire investment world has acknowledged that environmental, social, and governance risks and opportunities are relevant material considerations for investors, the U.S. Department of Labor has proposed a rule that would limit the ability of retirement plans to include investment funds or strategies that integrate ESG factors into their investment process. Such plans covered under ERISA include most corporate defined-benefit plans that provide a pension to beneficiaries and defined-contribution plans, such as 401(k) plans, in which plan participants choose their contribution level, direct their investments into a set of what are usually mutual fund options, and then use the proceeds during their retirement.

Let's focus on what the rule proposes for 401(k) plans.

Note that DOL guidance has allowed plan fiduciaries to select ESG fund options for years under the so-called "all things equal" test. If plan fiduciaries want to include an ESG fund, they must find it to be substantially similar to other possible investments from the standpoint of risk-adjusted return and fees. If that's the case, a fund's ESG focus, which is said to be merely a "collateral" benefit, can be used, in essence, to break the tie with a conventional fund. ESG considerations are here assumed to provide possible benefits to the environment, society in general, or corporate governance but not to offer any financial benefits that conventional funds could not provide. That's an increasingly dubious assumption that we'll get back to in a minute.

So, you may wonder, what's wrong with the "all things equal" test? Have plan fiduciaries been misusing it somehow? Have they been choosing ESG funds that are inferior investments? No evidence of that is provided in the DOL proposal. It only notes the increasing use of ESG in investment strategies and the increase in assets into such strategies. It might have also noted, in full disclosure, that the Trump Administration sees ESG as a threat to fossil-fuel investments, and a 2019 executive order aimed at encouraging fossil-fuel development asked the DOL to review rules related to energy investments in retirement plans. ESG investments sometimes underweight fossil fuel or avoid it altogether.

The proposed rule tightens the "all things equal" standard by allowing an ESG fund to be selected only if it doesn't require the plan to forgo adding other non-ESG-themed investment options, the fiduciary uses only "objective" risk/return criteria to select and monitor all investments, and it does not designate the ESG fund as a Qualified Default Investment Alternative. With a QDIA, plan participants' money is invested for those who don't specifically allocate their contributions to other fund options. For 401(k) plans that have designated QDIAs (mostly target-date fund series), the overwhelming majority of participant assets go into those funds. The DOL apparently thinks designating an ESG fund or target-date series as a QDIA would be forcing some unsuspecting plan participants to invest in collateral environmental, societal, and corporate-governance benefits they don't believe in at the expense of investment returns.

As a result, any fund that offers such collateral benefits as improving the environment, society at large, or the way corporations are governed is automatically removed from QDIA consideration, no matter how good of a financial investment it may be, and may only be offered in a 401(k) lineup if it doesn't take up space for non-ESG options. The proposal also warns plan fiduciaries to carefully document any selection of an ESG fund option.

So, while there is no demonstrated need for the rule other than the Trump Administration's desire to protect the fossil-fuel industry, the biggest problem with the proposal is that it reflects a (willful?) misunderstanding of what ESG investing is about today. The DOL is stuck in the 20th century, when the precursor to what we call ESG investing--socially responsible investing--was a niche investment approach practiced by relatively few investors who wanted to align their investments with their values. For some, these were religious values; for others, these were progressive values. In so doing, these funds excluded some portion of the market from their portfolios, and because these exclusions caused tracking error that sometimes led to underperformance, they were considered by many to be inferior investments, even though empirical research generally found no performance penalty.

But two decades into the 21st century, that's simply not what ESG investing is about. First, ESG investing is about investors carefully evaluating a set of risks and opportunities that are now both measurable and analyzable because of the existence of ESG data. Until the past decade or so, investors couldn't manage ESG risks because they couldn't measure them. Now they can. Second, ESG investing is about focusing on financially material ESG risks, which clearly exist today across a range of issues. The proposed rule mentions materiality only in passing, saying ESG factors may be material "but only if they present economic risks or opportunities that qualified investment professionals would treat as material," then proceeds with its treatment of ESG investing as though it is only about delivering "collateral" benefits, earned at the possible expense of returns.

But note that qualified investment professionals throughout the world today are treating ESG issues as material risks and opportunities and are using ESG assessments to generate competitive returns. They are not primarily focused on providing "collateral" benefits, nor interested in trading off returns. More than 2,300 asset managers with nearly $80 trillion in assets under management have signed the Principles for Responsible Investment, which commits them, among other things, to incorporate ESG issues into investment analysis and decision-making processes. The world's largest asset manager, BlackRock, has made sustainability its new standard, "driven by an increased understanding of how sustainability-related factors can affect economic growth, asset values, and financial markets as a whole." According to the CFA Institute, "more thorough consideration of ESG factors by financial professionals can improve the fundamental analysis they undertake and ultimately the investment choices they make."

The Sustainable Accounting Standards Board and the Global Reporting Initiative have painstakingly identified material ESG issues across industries. SASB, for example, found climate change was likely to be material in 72 out of the 77 industries it covers, which includes 93% of U.S. equities by market capitalization. Climate change, perhaps not surprisingly considering the source, doesn't merit a single mention in the DOL's 62-page proposed rule. Sustainalytics, now a Morningstar company, assesses material ESG risk via 21 Material ESG Indicators, or MEIs, applied across 138 subindustries, each one having its own unique MEI footprint. MEIs related to corporate governance, business ethics, human capital, and product governance are financially material across most industries. 21st century ESG analysis allows investment professionals to create a more holistic view of a company than was possible when analysts were dependant only on financial-statement metrics.

Finally, a sizable body of academic literature and industry studies has found that sustainable funds do not sacrifice performance compared with conventional strategies. Yet the DOL proposal fails to cite a single ESG performance study, despite premising much of its rationale on the supposed willingness of ESG funds to trade off performance for the sake of delivering collateral benefits. One study analyzed the findings of more than 2,000 academic papers, concluding "the business case for ESG investing is empirically very well founded." Roughly 90% of the studies it consulted found a nonnegative relationship between ESG and financial performance, and a large majority reported positive rather than neutral findings. Another study investigated ESG materiality, finding that firms with good ratings on material sustainability issues significantly outperformed those with poor ratings over a 20-year period. Morgan Stanley studied the returns of nearly 11,000 funds from 2004 through 2018, finding that sustainable funds perform on par with traditional funds but have lower downside risk. Speaking of which, sustainable funds in the United States have outperformed during this year's volatile markets.

An estimated $7 trillion is in 401(k) plans, so the DOL should be requiring that our best investment thinking be brought to bear on behalf of American workers, not proscribing it based on outdated views or an administration's attempts to prop up a fading industry. Far from limiting ESG in retirement plans, the DOL should recognize the reality that "qualified investment professionals" already see a wide range of ESG issues as posing material financial risks and opportunities, that plan fiduciaries acting prudently on behalf of plan participants and beneficiaries should take ESG into account in all their decisions, and that plan participants should have investment options in their plans that benefit from ESG analysis, especially in QDIAs. And if an artifact of material ESG analysis leading to strong financial performance is that overall climate risk is reduced, workers are treated better, and companies are run more ethically and transparently, what's not to like about that? Reduced systemic risks should feed back into better investment performance over the long run and enable more Americans to enjoy a better retirement.

Jon Hale has been researching the fund industry since 1995. He is Morningstar’s director of ESG research for the Americas and a member of Morningstar's investment research department. While Morningstar typically agrees with the views Jon expresses on ESG matters, they represent his own views.