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Commentary

Labor Department Says It Won’t Enforce ESG Rule

We believe without this action, the rule could have reduced the availability of investments using ESG considerations.

Editor's Note: This article originally ran in July 2020. It’s since been updated this year to reflect changes under the Biden administration.

The Department of Labor is backing away from enforcing a Trump-era rule that we believe ignored substantial evidence that the use of environmental, social, and governance (ESG) considerations can improve long-term investment returns for retirement plans.

The rules were already having the effect of shutting off growing demand for ESG options in defined-contribution plans. ESG investing is increasingly mainstream as it should be. ESG risks are financially material risks. Trying to define particular types of ESG strategies as unfit for 401(k) plans is not helpful and not necessary.

In his first week in office, President Joe Biden had signed an executive order that will call for a review of the Labor Department's 2020 ruling on ESG investments.

The rule would make it more difficult for 401(k) plans to include investments that consider environmental, social, and governance factors in their retirement plans. Last summer we responded by writing to the Department with a simple message: The rule is a bad idea that would take away important options from retirement investors and deny them access to the best analysis on mitigating ESG risks.

Here's what we had wrote in 2020 about the ruling.

Simply stated, the Labor Department's proposed rule is out of step with the best practices that asset managers and financial advisors use to integrate ESG considerations into their investment processes and selections. Indeed, as we outlined in our recent paper, ESG risk analysis should be part of any prudent investment analysis--and not be called out for special, unique scrutiny.

Today, we welcome the announcement to not enforce the rule.

To us, this signals that DOL will continue to review and hopefully replace the rule going forward. We believe without this action, the rule could have reduced the availability of these investments.

ESG Analysis in 401(k) Plans Can Help Retirement Savers Manage Risks
In fact, rather than avoiding ESG analysis, we believe that 401(k) plan investment committees should have an obligation to consider ESG risk. Doing so is fundamental to evaluating the long-term performance of an investment.

For instance, firms without a plan to cope with climate change may be caught flat-footed in the face of new regulation or environmental realities. And beyond being an issue of investor preference, human capital management is a financially material concern given the reputational and regulatory risks that companies face if they have poor labor relations. Many large asset managers already integrate ESG factors into their analysis for exactly this reason.

Investors themselves increasingly want access to ESG investment options, either because they want to mitigate ESG risks or because they want to align their investing with their values--without giving up returns.

Investors from all demographic groups report interest in incorporating sustainability into their investment choices. Morningstar's behavioral research team finds that all generations and genders of U.S. investors are interested in sustainable investing. In the same report, Morningstar researchers found that 72% of the U.S. adult population expressed at least moderate interest in sustainable investing.

The Proposal Would Hurt Ordinary Investors Saving for Retirement
Meanwhile, the Labor Department's approach would put up barriers to considering this ESG information that many professional investors and asset managers view as material, worsening outcomes for ordinary investors saving for retirement. The proposed rule would require employers that offer a retirement plan to go through additional steps to offer ESG plans, which the Labor Department assumes most employers will not do. In fact, in the regulatory impact analysis accompanying the proposal, the Department estimates the costs for compliance will be low because employers will avoid these kinds of investments entirely.

Most retirement savers in 401(k) plans and other defined-contribution plans use the default investment option. These options are typically target-date funds, which adjust their asset allocations as investors get closer to their retirement dates. Since that's where most retirement investments are housed, it's critical to understand that the Labor Department's proposal would bar ESG investments from being offered as qualified defaults, while not completely defining these investment types. That would hurt investors because it could leave ESG risks unmanaged in their retirement savings.

In addition to managing ESG risks, many participants want investment options that match their values. To the extent that plans can offer funds that support these values without sacrificing returns--and we believe that they can--such designated investment alternatives could bring in a new set of investors, furthering the overall goal of enhancing U.S. retirement security.

We believe the Labor Department should encourage plan sponsors to offer these funds that have a track record of both reflecting investors' values and achieving competitive returns. Doing so would encourage more ordinary people to invest.

Still, it's not only up to the Labor Department. For its part, Congress should update antiquated sections of law that were designed to limit corruption in defined-benefit plans but have been used to justify keeping ESG out of defined-contribution retirement plans. Congress should make it clear that ESG investing is appropriate for 401(k) and other defined-contribution plans. That would set a new policy course that reflects the major evolution in ESG investing since these laws were first passed in 1974.

Even if Congress does not act, the Labor Department's proposal is a big step in exactly the wrong direction. It's time regulators catch up to investors and embrace ESG investing.

For more insights on the evolution of the U.S. sustainable funds landscape and regulation of these products, sign up for our webinar.