ESG Factors in Retirement Plan Investments – DOL Allows New Avenues for Employees

Interest in environmental, social and governance (ESG) and sustainable investment is increasing substantially every year, with investors across the globe pouring record amounts into ESG mutual funds and exchange-traded funds (ETFs). As per PwC, ESG assets are anticipated to reach $33 trillion by 2026— totaling 21.5% of total assets under management. However, ESG options are not common within retirement funds. As per the Schroders 2021 U.S. Retirement Survey, only 37% of 401(k) and 403(b) plan participants reported that they were offered ESG-related investment options.

To bolster adoption, the Department of Labor (DOL) removed barriers (imposed by the previous US administration led by Donald Trump) to considering ESG factors in retirement plan investments in December 2022. Under the ‘Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights’ rule, retirement plans can now consider financially material ESG factors when selecting investments and exercising shareholder rights; they are, however, not mandated to do so.

So, what changes?

This issue has been one of the top priorities of the Biden-Harris administration. In May 2021, President Biden issued an executive order on ‘Climate-Related Financial Risk,’ which set the foundation for policies that ease climate-related financial risk and directed the US government to take actions that safeguard the financial security of America’s families, businesses, and workers. The initial DOL proposal, made in October 2021, overturned the decision made by the previous administration, which had warned against the integration of climate change and ESG factors. The rationale was that these investments do not meet a fiduciary’s obligation to make the best investment decisions for participants.

However, the current administration said that by treating ESG factors as financial risks, these regulations are within the Employee Retirement Income Security Act of 1974 (ERISA) framework. ERISA governs about 734,000 retirement plans in the US, which have a total investment of $12 trillion. Retirement plans regulated by ERISA are administered by fiduciaries, who are required to meet certain obligations when determining how to invest plan assets. As per the factsheet released by the DOL, a key change adopted in the final rule is: "The addition of regulatory text clarifying that a fiduciary's duty of prudence must be based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis and that such factors may include the economic effects of climate change and other ESG considerations on the particular investment or investment course of action."

The rule also allows fiduciaries to include climate change and ESG factors when selecting a Qualified Default Investment Alternative (QDIA) and exercising shareholder rights, such as proxy voting.

Many industries have resisted incorporating sustainable options due to the fear of low performance. However, return data proves the opposite to be true. About 90% of studies find a non-negative relationship between ESG funds and financial planning, and a majority show a positive trend, according to the Journal of Sustainable Finance & Investment. Studies based on long-term historical performance show that ESG strategies’ performance is similar to that of comparable traditional investments on an absolute as well as a risk-adjusted basis.

As of March 2023, total U.S. retirement assets under management was valued at $35.4 trillion, which represents about one-third (31%) of all US household financial assets. Since retirement accounts are a significant source of market capital, any rules that govern how and where these assets get invested/allocated can have major implications. This is the reason why Democrats and Republicans have been at loggerheads about the inclusion of ESG analysis in account management.

How do these developments impact stakeholders?

This ruling impacts all stakeholders directly or indirectly, including plan participants, plan sponsors, ERISA fiduciaries that make investment decisions (e.g., in-house fiduciary committees), investment consultants, asset managers, and other service providers (such as recordkeepers).

Employees / plan participants: Interest amongst plan participants has remained high. Today’s employees not only want to have a safe future, but also want to save the world and invest in funds that align with their key interests / value systems. The Schroders 2021 U.S. Retirement Survey also reported that 9 out of 10 employees who were given ESG-focused options chose to invest in them, while 69% said they might / would increase their overall contribution rate if ESG options were offered within their plans.

Most of the social causes that employees care about – climate change, gender equality and inclusivity, LGBTQ issues, and gun control – can be supported through existing retirement funds and programs. However, the majority of employees often have no idea about their options and may feel overwhelmed / confused or misled by the wide-reaching term ‘ESG.’

Investment consultants and asset managers: For firms that provide investment line ups in retirement funds and also serve as investment consultants and recordkeepers (e.g., Vanguard, Fidelity, and T. Rowe Price), these developments may result in greater inflows in the ESG funds they offer. Some of these companies also provide target-date funds, which hold a majority stake in the QDIAs. Sustainable investment strategies have already gone mainstream, and these companies are among the top providers of ESG funds.

Employers / plan sponsors and retirement plan fiduciaries: For this category of stakeholders, it could be a challenge to implement the new approach, because of changing legal standards and compliance issues. They cannot violate the ERISA’s duty of loyalty by considering participant preferences in constructing a participant-directed defined contribution fund menu. The responsibility of prudence still applies, which implies that an ‘imprudent’ investment cannot be included in a plan fund menu even if participants want it, and plan sponsors could face legal troubles for considering ESG funds that are not in the best interest of plan participants. These stakeholders will be standing at the crossroads and facing many questions, such as: ‘what happens when there are competing participant preferences?’ or ‘How much importance will courts give to a fiduciary’s consideration of participant preference in case the investment is challenged as imprudent?’. The onus of fiduciary duty still lies on, and will continue to restrain, plan sponsors.

For those employers who have shown interest, the messaging to participants will change (from a branding and marketing perspective). The removed barriers will likely lead to a change / reallocation of their budgets. These developments are set to have an impact on investment options, advice, guidance, and tools and resources offered to employees.

Was the decision politically driven and likely to change from one administration to the next?

The answer is ‘probably no.’ Compared with the rest of the world, the US has lagged in including ESG factors in investment processes. The EU has been at the forefront in this regard for many years now, leading the charge with particularly ambitious regulations. While the US gives utmost importance to financial materiality, European governing bodies have embraced double materiality, which suggests that firms and financial institutions together should manage and be accountable for the actual and potential adverse impacts of their decisions on people, society, and the environment.   

During the DOL’s 60-day comment period, more than 900 written comments and 20,000 petitions were received. Almost all (97%) of these comments reportedly supported the DOL’s decision to reverse the 2020 rules and make clarifications about ESG considerations and proxy voting consistent with fiduciary obligations.

Also, more neutral language has been used in the final rule, compared with the 2020 rules or even the original proposed rule. This shows that while the change is not a mandate, neither is it entirely for or against products with an ESG focus. It only removes barriers to adoption of such products and does not prohibit fiduciaries from making investment decisions that reflect ESG considerations, depending on the circumstances. Therefore, due to its neutrality, the probability of this rule continuing under subsequent administrations remains high.  

What can be expected next?

We believe the systematic integration of financially material ESG factors will continue to become mainstream and accelerate, and retirees benefiting from ERISA plans will have more sustainable and ESG-related fund options to choose from.

Given that this ruling puts the ball in the court of fiduciaries, they are likely to exercise their own judgment about ESG factors and to make the best investment decisions as they deem fit on behalf of ERISA plan participants and beneficiaries.    

However, amid the strong arguments from both Democrats and Republicans, one thing is certain that with the legislative, judicial and executive branches all pitching in on ESG, investors are finding it difficult to navigate conflicting guidance from a broad range of government officials. For that reason, they are choosing to remain silent on communicating their ESG initiatives and are waiting for the dust to settle.

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Garima Malik
Senior Manager, Asset and Wealth Management Posts

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