Retirement Plans Become New Battleground for ESG

Retirement savings plans are becoming the new battleground for environmental, social, and governance investing and sustainable investing.

At the same time that the U.S. government is removing barriers to using ESG in 401(k) plans, Republican-controlled states are increasingly adopting policies that oppose the use of ESG factors and approaches in investing, which could have effects outside their own states. These crosscurrents will challenge investors and the fiduciaries who serve them and could have consequences for younger employees just beginning to save for retirement.

The new rule by the Department of Labor, which administers the Employee Retirement Income Security Act of 1974, or Erisa, allows retirement plans to treat sustainability as any other relevant factor, based on the fiduciary standards of prudence and loyalty, says Jon Hale of Morningstar. The new rule makes clear that these factors may include climate change and other ESG issues, although it doesn’t mandate including them.

Investors Push Companies to Manage Climate Risk for Retirement Plans

In tandem with the new rule, investors are starting to push companies to show how their retirement funds manage the risks associated with climate change. For example, on Dec. 6, 8.8% of Campbell Soup CPB shareholders supported a resolution asking the company to report on how its retirement funds are managing the risk of investing in companies “contributing significantly” to climate change. The proposal failed, but the existing support is high enough to allow shareholders to resubmit the resolution next year.

On Dec. 13, meanwhile, Microsoft MSFT shareholders voted on a similar proposal. (Results of the vote weren’t yet available for this story.) As You Sow, the shareholder advocate that sponsored both proposals, says that Microsoft has invested more than $2 billion of employee savings into oil, coal-fired utilities, and agribusinesses involved in deforestation.

All these issues are related. Danielle Fugere, president of As You Sow, explains that most companies put employees who don’t choose specific investments into target-date funds for their retirement plans. (This is why they’re called the “default” option.) Such funds “are fairly high in high-carbon companies such as oil and gas,” Fugere says. In the past, companies have argued that Erisa prohibited them from addressing issues like climate change. A Trump-era rule previously banned consideration of ESG issues in decisions related to default options.

But that’s no longer the case. It’s a particularly important issue for younger employees, who often end up with the company’s default option. They will be retiring decades from now and will see climate change affect their portfolios. “This is an important fairness issue that companies will have to deal with,” says Fugere. “What future are they investing in for their employees?”

For Public Plans in Red States, No Right to Consider ESG

For public retirement plans—crucially, the ones in Republican-controlled states that oppose the use of ESG factors—no such federal rule guarantees the right to consider ESG in investing. Public retirement plans aren’t subject to Erisa and are regulated by state and local laws. Over the past year, 17 states have proposed or adopted state legislation to limit the ability of state governments, including public retirement plans, from doing business with companies perceived to be “boycotting” industries based on ESG criteria or that consider ESG factors. For example, Texas has ordered state pension funds to divest from holdings managed by a number of financial companies including BlackRock BLK, which has embraced ESG. Even if a beneficiary of a retirement system might disagree, the law bans them from suing or seeking recourse.

Florida, too, is expected to adopt legislation in the new year that will restrict sustainable investing. Florida recently withdrew $2 billion from BlackRock for its support of ESG investing.

To be sure, not all states agree. Oregon State Treasurer Tobias Read, for example, wants the state to stop investing in companies that contribute to global warming, divesting the state’s pension fund from all fossil fuels and other carbon-producing companies by 2050.

In fact, some 85% of asset owners, including pensions, sovereign wealth funds, and insurers, believe ESG information is financially relevant in the investing process, according to a survey by Morningstar.

And most voters would like the government to stay out of it. A new poll by Penn State and ROKK Solutions shows that most voters oppose government restrictions on ESG investments. Specifically, 63% of 1,261 registered voters, including majorities in both parties, said the government should not set limits on ESG investments.

Vanguard Leaves Net Zero

Even if you don’t live in those states, their policies could affect your funds and your retirement plans. Consider that on Nov. 28, attorneys general for Texas, Ohio, Indiana, and 10 Southern and Great Plains states filed a protest with the Federal Energy Regulatory Commission, seeking to block Vanguard from buying electric-power utility company shares for the next three years, citing Vanguard’s attempts to pressure utilities into disclosing fossil fuel pollution. Vanguard’s funds own 8% to 10% of the nation’s publicly traded utilities.

A week later, Vanguard decided to quit the Net Zero Asset Managers Initiative, an international group of asset managers that support the goal of net-zero greenhouse gas emissions by 2050 or sooner. Net Zero is a critical part of sustainable investing, a type of industrywide engagement to help protect investors against the systemic risk of the changing climate. Vanguard said such initiatives “can … result in confusion about the views of individual investment firms.” Indeed, that “has been the case in this instance, particularly regarding the applicability of net-zero approaches to the broadly diversified index funds favored by many Vanguard investors.”

Ironically, earlier this year, Vanguard introduced a new environmental mutual fund because it had “a clear alignment to an ESG outcome or orientation that we are increasingly hearing is important to clients.” The subadvisor of that fund, Ninety One Asset Management, remains committed to net zero by 2050 or sooner.

Vanguard’s move isn’t likely to affect public pension funds because the firm is committed to a retail audience. But the move creates a perception that Vanguard “doesn’t have any kind of commitment to ESG,” says Dan Wiener, founder of The Independent Adviser for Vanguard Investors newsletter and chair of Adviser Investments, a Newton, Massachusetts-based advisory with about $7 billion in assets.

That perception could affect its popularity with private defined-contribution retirement plans, newly freed to consider ESG. Says Morningstar’s Hale: “Vanguard is prominent in the 401(k) space, and its few ESG-oriented funds have been gaining assets among investors generally, but as more plans seek out funds that consider climate risk and ESG, they will look to those fund companies that have made more concrete commitments, such as membership in the Net Zero alliance.”

The Problem for Younger Investors

For younger investors, in particular, who will suffer the consequences of climate change, the dilemma facing pension trustees is clear. “You have a fiduciary duty to balance your responsibility with the teacher who retired today and the teacher who started last week and won’t retire for 30 years,” says Dave Wallack, executive director of For the Long Term, a nonprofit that supports the work of public fiscal officers who are focused on sustainability issues. “You have a legal obligation about how to keep the fund able to service somebody decades into the future.”

Thomas Kuh, head of Morningstar’s ESG indexes strategy, notes that the popularity of ESG, particularly with younger investors, may eventually settle the debate. “The waters have been muddied,” Kuh says. “However, in the long run, it’s going to be futile to try and use political means to override fiduciary duty.”