As we count down the last few days before Biden’s labor department finalizes its new rule on environmental, social and governance (“ESG”) investments, the big question is, when will trustees be allowed to consider ESG values when making investment decisions for 401(k) plans? The Department of Labor, which sent its final version of the rule to the White House for approval, has debated when and how fiduciaries can consider non-economic ESG factors for more than 30 years, and it issued guidance in each of the Clinton, Bush, Obama and Trump Administrations. If you’re concerned about regulatory instability, we’re here to help.
What’s the big disagreement?
Jurisdictions have generally agreed that ESG factors can be considered if their consideration increases investment returns or reduces investment risk. Where Republicans and Democrats disagree is when ESG factors can be taken into account when those considerations do not improve investment performance. Republicans have suggested never unless there is a tie. Democrats have suggested whenever there is a tie. Democrats and Republicans have used the term “tiebreaker,” but the two parties have meant different things.
A simple way to think about disagreement is to draw a line down the middle of a sheet of paper. Things left and right of that line aren’t ties, traditionally Republicans and Democrats agree. Where the disagreement comes in is how to draw the line. Do you draw the line using a very narrow laser or do you draw the line using a thick Sharpie marker? Using the Republican “laser” approach, you could say there are never really any ties. Democrats would counter that comparing two investments is more of an art than a science, and that given the number of factors that determine whether an investment will succeed economically, linkages can occur with some frequency.
Another key disagreement has centered on how to determine what specific values plan trustees can take into account and what exactly “ESG” means.
What do we expect from the Biden ESG Rule?
The Biden regulation comes just two years after the Trump administration enacted its own ESG rule. In 2020, the Trump administration not only suggested that ties rarely occur, but also required additional documentation when ESG factors were used to sever ties. Additionally, it limited the use of ESG factors as a tiebreaker for all default investments in the plan. Trump’s rules were seen by many as a chill on the consideration of ESG factors.
At a minimum, we expect the new regulations to overrule the Trump administration’s rules and suggest that ties are indeed occurring. We also expect record keeping requirements and default investment restrictions to be eliminated. In the UK, for example, some pension plans are required to analyze how global warming might affect the plan; while it would be surprising to see a similar requirement in the Biden rule, it is a possibility.
What are the pros and cons of ESG in 401(k) plans?
Although ESG has been a controversial topic, it is important to recognize that there are arguments on both sides of the debate that resonate.
ESG advocates point to the size of the retirement investment market and suggest it’s too big a pool of money to put aside given the problems the world is facing. ESG advocates also suggest that telling trustees they cannot consider non-financial ESG factors is confusing and will lead trustees to avoid considering ESG factors even when those factors are material to the economic plan. ESG advocates also argue that savers can have more money in retirement even if returns are sacrificed because participants are more likely to contribute money to their 401(k) plans if there are any. investment options that match their social views.
Opponents of ESG argue that our pension system already serves an ESG purpose. 401(k) plans are designed to achieve the social goal of providing workers with a dignified retirement. Additionally, opponents argue that considering non-economic ESG factors in a situation of non-equality means that retirement savers sacrifice the performance of their investments or take on additional risk. They argue that this potentially diminished return or increased risk is at odds with the purpose of tax advantages and strict rules of fiduciary conduct. Further, they argue that not all individuals will want to invest in a way that promotes the identified ESG objectives, which could lead to lower participation.
So what should benefits do?
Benefits professionals will want to understand the rule of the Biden administration. If your company has significant participant demand for ESG investing, this could be an opportunity for further review to determine whether ESG considerations can be included without increasing the risk of litigation.
ESG investing is likely to remain a hot topic, however, and there is a real risk that a future administration will write its own ESG rules. Republicans in Congress have already signaled that there will be efforts to undo the Biden administration’s rule.
Therefore, benefits professionals will want to be nimble in adhering to rules that may continue to evolve.
Kevin Walsh and Jacob Eigner are both lawyers Marriage law group, certified. They advise plan sponsors and other ERISA trustees on how to comply with evolving ESG guidelines as well as other issues related to investing in 401(k) plans.