Labor Department Proposal to Clear Way for Retirement Plans to Consider ESG

On Oct. 13, 2021, the Labor Department proposed a new rule, making it much easier for employers to offer investments in their workplace retirement plans that take environmental, social, and governance information into account.

In doing so, the department has started the process to shift course dramatically from the Trump administration. That administration tried to raise significant barriers for retirement plans that wished to incorporate ESG considerations into their investment strategies. We think these considerations can be financially material, so we believe this new proposal will improve outcomes for investors who are saving for retirement. While this is only a proposal, we expect it to be finalized in more or less this form by early 2022.

What the Proposal Would (and Would Not) Do to Clarify the Place of ESG in Retirement Plans

The most important part of the proposal is more about what it would undo rather than what it would do. Most critically, the proposal would lift rules that made it extremely difficult and risky for employers that wanted to use investment options with ESG considerations as default investments for workers they automatically enrolled in a qualified plan. Most people access retirement investments through these defaults when they are available, so undoing this rule is key to mainstreaming ESG.

Unlike the current regulations, which require additional analysis for plans to consider ESG in their investment selections, this proposal provides several examples and clarifications to make it clear that ESG considerations can be financially material. Similarly, the Labor Department also clarifies how and when plan fiduciaries can consider ESG as part of a tiebreaker test. The upshot is that the rule would make it much easier to consider ESG information as part of a plan fiduciary's approach to selecting investments, without special or additional documentation.

The rule would also put more responsibility on employer-sponsored plans to vote on shareholder resolutions on behalf of their participants. While we initially thought this issue would primarily matter for defined-benefit pensions, as asset managers such as BlackRock start to allow institutional clients to vote proxies on assets they manage, this change could make plan sponsors a bigger voice in the resolution process.

Morningstar Views the Proposal as an Important Step in the Right Direction

As we have argued for some time, the Labor Department's new proposal is consistent with common practices that asset managers and financial advisors use to integrate ESG considerations into their investment processes and selections. Because of previous rulemaking at the tail end of the Trump administration, employers shied away from assessing ESG risks in selecting investments. Indeed, since most participants use qualified default investment options--and ESG considerations were previously barred in these options--most participants would not get the benefits that ESG risk analysis can deliver.

We told the department last summer that ESG risk analysis could be part of any prudent investment analysis--and should not be called out for special, unique scrutiny. Instead, many asset managers view ESG risk as a pecuniary matter that is fundamental to evaluating the likely long-term and increasingly medium-term performance of an investment. This proposal appears to address that concern.

To be more specific, firms without a plan to cope with climate change may be caught flat-footed in the face of new regulation or environmental realities. Human capital management is not just about an investor's preferences, but the financial concern about the reputational and regulatory risks that companies face if they have poor labor relations. Many asset managers already integrate ESG data into their analysis for exactly this reason.

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 will show 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.

What will this mean for people saving for retirement? We think most people will not even notice the rule change initially. But if the rule is finalized, over time, more and more participants' investment managers will consider lurking ESG risks as part of the effort to maximize long-term risk-adjusted returns. Further, participants who want to may be better able to pick funds with specific ESG goals. None of this will happen overnight, but this new regulation will start to nudge employers to take ESG into consideration in making investment selections.

Concluding Thoughts

In conclusion, we have argued for some time that the Labor Department should not have raised barriers for plan sponsors that wish to use ESG analysis to select investments. In fact, ESG considerations can be financially material, and many asset managers integrate them into their analysis. While we will analyze the rule over the next two months and provide any constructive feedback, this is a step in the right direction, and we believe this rule will ultimately help people saving for retirement to achieve their goals.