Editor's note: This article originally ran in November 2020. It’s since been updated this year to reflect changes under the Biden administration.
The Department of Labor said today it won’t enforce the ESG rule in retirement or the proxy voting rules, moving away from the Trump administration’s decidedly anti-ESG stance. These rules ignored substantial evidence that the use of ESG considerations can improve long-term investment returns for retirement plans and were already having the effect of shutting off growing demand for ESG options in defined-contribution plans.
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 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.
Here's what we had wrote in 2020 about the ruling.
Sustainable investing is fast becoming part of the investing mainstream in the United States. Investor interest is high, and sustainable funds have been attracting flows at a record pace. Professional asset managers are increasingly incorporating ESG considerations into their investment decisions. These trends have been occurring without much public policy or regulatory support.
In the final year of the Trump Administration, however, the regulatory environment has shifted from benign to negative as the Department of Labor and the Securities and Exchange Commission have taken decidedly anti-ESG stances in several rule-makings, and the SEC has not addressed requests to require corporate disclosure of climate or other financially material environmental and social risks.
We expect the regulatory environment for sustainable investing to improve markedly under the Biden Administration.
Let's start with the DOL, which just two weeks ago finalized a rule intended to limit the use of ESG funds in retirement plans regulated under ERISA, including 401(k) plans. While the final rule was weakened after the agency incorporated public comments, which were overwhelmingly opposed to the original proposed rule, the final rule requires plan fiduciaries to apply additional scrutiny in selecting funds that offer "non-pecuniary benefits" by requiring increased documentation of selection decisions along with a complete ban on such funds as default options in defined-contribution plans.
The preamble to the regulation makes it clear that the DOL has in mind those ESG funds that exclude certain industries or companies for ethical rather than financial reasons. Most ESG funds are focused on financially material ESG factors but often eschew issuers that perform below certain minimum ESG standards. At a time when more plan participants are asking for ESG options in 401(k) plans, the rule would have had a chilling effect on plan administrators.
The Biden DOL will look at ways to clarify if not reverse the rule. We expect subregulatory guidance such as FAQs and advisory opinions to help bring things back toward the old status quo. First, the DOL will make clear that material ESG factors are pecuniary and can be considered by plan fiduciaries as part of their fiduciary duty. The Obama DOL issued guidance to that effect in 2015. Second, the department will take a less skeptical view of ESG strategies that offer collateral benefits alongside financial return and put less scrutiny on the "all things equal" standard by allowing such strategies to be selected so long as their risk/return characteristics are comparable to conventional alternatives covering the same asset or subasset class. We think it is also likely that a Biden DOL will promulgate new regulations for a selection of ESG funds as default options. Because that part of the recently passed regulation has a delayed effective date, the new administration has some time to put new rules in place.
The Trump DOL also has a rule pending that would limit the ability of defined-benefit plans to fully exercise their proxy-voting rights. If it is finalized during this lame-duck period, the Biden DOL will almost certainly look at ways to reverse it.
Speaking of proxy-voting rights, the SEC passed rules this year raising the ownership threshold for shareholders to file resolutions at company annual general meetings, raising the levels of support resolutions need to make them eligible for re-filing and restricting the manner in which proxy advisors make recommendations to shareholders on how to vote proxies. The five-person SEC includes two commissioners selected by each party and a chair selected by the president's party. The two sitting Democratic-appointed commissioners opposed these moves, although only one was on the commission for the proxy-advisor decision. With a likely future 3-2 Democratic majority on the SEC, we expect these rules to be revisited.
Last but certainly not least, we expect a 3-2 Democratic majority on the SEC to begin the work of requiring public companies to disclose climate-related financial risks and greenhouse gas emissions in their operations and supply chains. The SEC, under Trump, has shown little interest in the subject, despite pressure from investor groups, including the SEC's own Investor Advisory Committee. The SEC may also consider widening the scope of mandatory disclosures to include all financially material social and environmental risks, as requested by a wide range of investors in a 2018 petition.
These moves will not only shift the regulatory environment to be more favorable toward sustainable investing, mandatory disclosure of climate and other material social and environmental risks will also help all investors make better-informed decisions.
For more insights on the evolution of the U.S. sustainable funds landscape and regulation of these products, sign up for our webinar.
Jon Hale (firstname.lastname@example.org) 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.
Aron Szapiro is head of policy research for Morningstar. Szapiro is responsible for developing research reports on policy matters, coordinating official responses to regulatory proposals, and providing investor-focused comments on policy issues to clients and the press. He also chairs Morningstar's Public Policy Council. His research has been covered in The New York Times, The Wall Street Journal, The Washington Post, The Journal of Retirement, and on National Public Radio.