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Sustainable Investing

The ESG Advisor: Here's What to Know About the Labor Dept.'s Proposed Rule to Ease ESG Investing in Your 401(k) Plan

Proposed new rule is a model of rational policymaking, allowing fiduciaries to factor in climate change and other risks.

The growth of sustainable investing in the United States, thus far, has taken place outside of the retirement plans that represent the primary investments of millions of American workers. Last year, as sustainable funds attracted record flows from investors, the Trump Administration Department of Labor rushed into place two rules that cast significant doubt on whether retirement plan fiduciaries could consider environmental, social, and governance factors in their investment selection and monitoring and in their proxy voting.

But elections have consequences, and in October, the Biden Administration DOL proposed a single rule of its own that would replace both rules. With the public comment period coming to a close on Dec. 13, now is a good time to review the proposal and how it differs from the existing rules.

Called "Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights," the proposed rule would remove barriers, real and perceived, to ESG investing in retirement plans governed under the Employee Retirement Income Security Act of 1974, which includes 401(k) defined-contribution plans.

The proposed rule relies on the extensive and growing body of evidence on the materiality of ESG issues--of climate change, in particular--and on the views of stakeholders who commented during last year’s rulemaking, many of whom were consulted by the DOL after the new administration took office this year.

Last year's rules, by contrast, reflected the Trump Administration's policy of refusing to take any action on climate change, never once so much as mentioning the term in the voluminous written materials it prepared during the rulemaking process, and there is no evidence that any outreach to stakeholders took place. In response to the nearly unanimous opposition to last year's rules in public comments, the final version of the fund-selection rule was watered down but in a way that left a lot of open questions, creating a chilling effect on the integration of ESG considerations by plan fiduciaries.

The proposed rule addresses both investment selection and proxy-voting activities. Here’s a more detailed rundown of what’s in it:

ESG Considerations in the Selection and Monitoring of Plan Investments

First, the proposed rule makes clear that a retirement plan fiduciary may consider any factor material to a risk/return analysis, including climate change and other ESG factors, when making decisions about plan investments. If the fiduciary prudently concludes that any of these factors are material, then they should be considered in fund selection and monitoring, “as would be the case with respect to any material risk-return factor.”

This is consistent with prior DOL guidance and with real-world evidence on the risks and opportunities posed by climate change, as well as certain other ESG-related issues. The existing rule, by contrast, “created a perception that fiduciaries are at risk if they include any ESG factors in the financial evaluation of plan investments,” the Biden DOL said in its discussion of the rule.

Second, the proposed rule retains and clarifies the “all things being equal” test for selecting investments that offer so-called “collateral” benefits, or benefits beyond investment returns. This idea has been part of the DOL’s guidance since 1994.

Collateral benefits don’t have to pertain only to ESG, but some ESG funds may seek to provide broader positive impacts on the world through impact assessments and active ownership activities. Even some exclusions, I suppose, might be said to have collateral benefits. For example, a fund with a tobacco exclusion may offer emotional and/or expressive benefits to plan participants who don’t want to make any money off an industry whose main product kills people even when used correctly.

For any investments offering collateral benefits, the proposed rule is that they can be selected provided that they offer financial benefits that serve the plan equally as well as alternatives that don’t offer collateral benefits. Put more plainly, if a plan fiduciary were choosing between two large-cap growth funds--one a traditional fund and the other let’s call an “ESG impact” fund--the ESG impact fund could be selected provided the plan fiduciary has prudently concluded that it will serve the financial interests of the plan as well as the traditional fund.

Third, the proposed rule adds a new disclosure requirement for any funds that are chosen because of their collateral benefits. The “collateral-benefit characteristic” of the fund “must be prominently displayed in disclosure materials provided to participants and beneficiaries.”

Fourth, the proposed rule makes it possible to select qualified default investment alternatives that take into account climate change and other ESG-related factors and to apply the “all things being equal” test in the context of a QDIA decision for investment options that may offer collateral benefits. The existing rule prohibits funds with collateral benefits from being considered as QDIAs and, in my view, is unclear whether funds that simply consider material climate change and other ESG risks in their investment process can be chosen as QDIAs.

The Biden DOL notes that any fund that considers climate change and other ESG factors can be considered as a QDIA provided it meets the protective standards set out in the department’s QDIA regulation and is a financially prudent choice.

Retirement Plan Proxy Voting and Shareholder Rights

In late December 2020, the Trump DOL also approved a rule that discouraged plan fiduciaries from voting proxies and exercising other shareholder rights. The proposed rule would make four changes to that rule:

First, it eliminates the statement in the current regulation that ‘‘the fiduciary duty to manage shareholder rights appurtenant to shares of stock does not require the voting of every proxy or the exercise of every shareholder right.’’

The Biden DOL thinks plan fiduciaries may take the current rule to mean they should be “indifferent to the exercise of their rights as shareholders, particularly in circumstances where the cost is minimal as is typical of voting proxies.” A plan has always had the ability to refrain from voting a proxy when it finds the vote would not be in the plan’s best interest.

Second, the proposed rule eliminates the heightened monitoring obligations in the current rule for plan fiduciaries that outsource proxy voting to investment managers or proxy advisors. The Biden DOL argues that such obligations are unnecessary because the general prudence and loyalty duties of plan fiduciaries long established in ERISA already impose a monitoring requirement for all service providers, and there is no good reason to require heightened obligations for proxy voting.

(The backstory is that the Trump Administration had it out for proxy advisors, whom it believed were somehow misleading their investor-clients into voting in favor of ESG-related issues on proxy ballots.)

Third, the proposed rule removes the two ''safe harbor'' examples for proxy-voting policies deemed permissible under the existing regulation. These allow plan fiduciaries to a priori determine what types of proxy votes they will vote on and to establish a nonvoting policy for voting proxies at issuers in which the plan holds only a small stake.

The Biden DOL believes these safe harbors will be taken as “regulatory permission for plans to broadly abstain from proxy voting without considering their interests as shareholders and without legal repercussions.”

Fourth, the proposal would eliminate the requirement that plan fiduciaries maintain records on their decisions on whether to vote proxies or exercise other shareholder rights.

The Biden DOL argues that these provisions appear to treat proxy voting and other exercises of shareholder rights differently from other fiduciary activities and “may create a misperception that proxy voting and other exercises of shareholder rights are disfavored or carry greater fiduciary obligations, and therefore greater potential liability, than other fiduciary activities.”

Combined with the safe harbors, this provision put plans in a sort of catch-22: Either adopt the safe harbors and reduce proxy-voting participation or potentially incur more costs documenting why participation is necessary, keeping in mind that any benefits to the plan must be demonstrated to exceed those costs.

What to Make of All This?

At a time when sustainable investing is exploding in the United States and around the world and at a time when the specific investment risks surrounding climate change are becoming more and more serious, the Trump Administration’s message to retirement plan fiduciaries was this:

Incorporate ESG and climate-change considerations at your own risk. If you nonetheless include these matters in your investment selection or proxy-voting activities, you must expend plan resources on excessive documentation of your decisions to mitigate the risk of lawsuits for not meeting a set of vague standards (that is, don’t over-assume that ESG risks are material, collateral benefits can sway an investment selection only when the choices are indistinguishable, don’t vote proxies unless you can demonstrate that benefits to the plan outweigh the costs).

By contrast, the new proposal is a model of rational policymaking. Reflecting what’s happening in the real world, it says, of course climate change and other ESG issues are material and therefore something plan fiduciaries should prudently consider in their decisions. On the selection of funds that offer so-called collateral benefits, it says these funds can be chosen as long as they serve the financial interests of the plan equally as well as alternatives. On QDIAs, which are designed to be long-term investments for retirement plan participants, it says funds that incorporate climate change and ESG considerations should not be disadvantaged or disallowed. On proxy voting and other shareholder activities, it says these tools should be used in a prudent manner to enhance the long-term value of the plan.

Where Does It Go From Here?

The public comment period ends on Dec. 13. In preparing the final rule, the DOL must take account of comments and, in fact, has specifically asked for comments on several elements of the proposal. Thus, the final rule may include some changes, but I expect them to be at the margins. By early 2022, we should have a final rule and, finally, some clarity on this issue. Millions of American workers saving for retirement will be better off because of this rule.

Further Reading:

This Guide to Sustainable Retirements, published by the Intentional Endowments Network, provides useful information to plan fiduciaries and stakeholders on how to add sustainable investment options in retirement plans.

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