Labor Department Proposes New Rule to Limit Use of ESG Funds in Retirement Accounts

Robert Powell, CFP®

The Labor Department in late June proposed a new rule that would limit the use of ESG funds in retirement accounts.

The proposal, according to the Labor Department, is designed, in part, to make clear that ERISA plan fiduciaries may not invest in ESG vehicles when they understand an underlying investment strategy of the vehicle is to subordinate return or increase risk for the purpose of non-financial objectives. Read Notice of Proposed Rulemaking on Financial Factors in Selecting Plan Investments Amending “Investment duties” Regulation at 29 CFR 2550.404a-1.

“Private employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan,” said Secretary of Labor Eugene Scalia. “Rather, ERISA plans should be managed with unwavering focus on a single, very important social goal: providing for the retirement security of American workers.”

Not surprisingly, ESG experts criticized the proposed rule as misguided.

In an article published on Callaway Climate Insights, Tony Davidow, president and founder of T. Davidow Consulting, wrote that the Labor Department misses “the point about how these funds work, and what the historical data have shown us. The DOL naively assumes that retirees will sacrifice performance by trying to further social goals.”

Read Labor Dept. misses the point with new ESG rule.

In an interview with Retirement Daily, Davidow said the Labor Department seems to be assuming that “retirees would be disadvantaged because (ESG) funds would lag their unconstrained brethren.”

And the data doesn’t support that. Indeed, ESG funds outperformed conventional funds in the second quarter of 2020 (read Sustainable Stock Funds Held Their Own in Second-Quarter Rally) and the first quarter as well (read Sustainable funds buoyed in Q1).

“These strategies actually outperform the market,” said Davidow. “And, and again, I think it's a naive sort of assumption of individual investors being disadvantaged. When in fact, by taking these tools away from investors, I'd argue, they're actually disadvantaging them.”

Comments on the proposal must be submitted on or before July 30, 2020. The proposal includes instructions on submitting comments to www.regs.gov.

“It's more than likely that industry groups will challenge it,” said Davidow of what he expects to happen during the comment period. “At the end of the day… we want individual investors making better-informed decisions.”

According to Davidow, the Securities and Exchange Commission had previously suggested that better disclosure and awareness is what’s needed. “And I would agree wholeheartedly,” he said. “We need to do a much better job as an industry.”

In terms of educating investors, Davidow says helping investors and advisers learn the difference between ESG and Social Responsible Investing (SRI) is critical. SRI funds, he said, “often came with a haircut.”

In other words, by excluding certain underlying investments, they'd lack the performance of a larger universe of funds available. “And that, of course, comes at a price,” he said.

ESG, by contrast, is something completely different. Those funds, Davidow said, are providing relative screening based on three pillars: environment, social and governance.

“Sometimes we fixate on the E and we forgot about the S or the G, but it's the three pillars and each one is independent and each one is equally important,” he said. “If we look at ESG, it's a much more evolved way of thinking about these screening and weighting methodologies.”

Now, the Labor Department’s proposal isn’t necessarily precluding ESG funds from being offered in 401(k) plans. But the ESG fund would have to pass muster with the plan’s fiduciary to be included among the 401(k) plan’s investment options. (Read the guidelines below.)

And that could be a tall order, according to Davidow.

“It is probably a bit more difficult for a fiduciary to add an ESG fund side by side with an unconstrained fund,” he said. “The belief is that these funds are out to do a social good rather than do good to the individual investors. And I think implicit in that is the belief that these funds would come at a price.” That is, these funds would lag unconstrained funds. And that, said Davidow, is a naïve point of view that begs for further education.

For those who might want to invest in ESG funds in their retirement accounts, Davidow offered this guidance:

1) Don't invest in anything unless you really understand what it does. “If I were an individual investor and I saw an ESG fund, I wouldn't just invest in it because it had ESG on the name,” he said. Learn, for instance, how the fund screens and weights securities.

Why so? You’re likely to see vastly different results depending on the methodology.

2) Is the organization behind the ESG fund “a new thing where somebody is chasing where the return and the opportunity is or is it actually something that's built into the DNA of the organization?” asked Davidow. “I would evaluate it the way that I would evaluate any underlying investment that I was considering getting into.”

One possible outcome to the proposed rule, said Davidow, is a compromise between the Securities and Exchange Commission and the Labor Department that includes better education and better disclosure, and not a restriction. “I think that if we got to that point, that everyone's making better-informed decisions, that's a win, win all-around,” said Davidow.

Davidow also praised that the Labor Department’s proposed rule to allow private equity (PE) inside the investment options in a 401(k) plan, such as a target-date fund. “It’s a very positive development and very forward-looking,” he said. “Private equity has historically been the exclusive domain of very large sophisticated families. Why wouldn't we make it more generally available?”

As with ESG funds, Davidow said what’s needed is better education “so people understand how private equity works.”

Guideposts for Plan Fiduciaries

According to the Labor Department, the proposed rule is intended to provide clear regulatory guideposts for plan fiduciaries in light of recent trends involving environmental, social and governance (ESG) investing.

The Labor Department’s proposal would make five core additions to the regulation:

  • New regulatory text to codify the Department’s longstanding position that ERISA requires plan fiduciaries to select investments and investment courses of action based on financial considerations relevant to the risk-adjusted economic value of a particular investment or investment course of action.
  • An express regulatory provision stating that compliance with the exclusive-purpose (i.e., loyalty) duty in ERISA section 404(a)(1)(A) prohibits fiduciaries from subordinating the interests of plan participants and beneficiaries in retirement income and financial benefits under the plan to non-pecuniary goals.
  • A new provision that requires fiduciaries to consider other available investments to meet their prudence and loyalty duties under ERISA.
  • The proposal acknowledges that ESG factors can be pecuniary factors, but only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories. The proposal adds new regulatory text on required investment analysis and documentation requirements in the rare circumstances when fiduciaries are choosing among truly economically “indistinguishable” investments.
  • A new provision on selecting designated investment alternatives for 401(k)-type plans. The proposal reiterates the Department’s view that the prudence and loyalty standards set forth in ERISA apply to a fiduciary’s selection of an investment alternative to be offered to plan participants and beneficiaries in an individual account plan (commonly referred to as a 401(k)-type plan). The proposal describes the requirements for selecting investment alternatives for such plans that purport to pursue one or more environmental, social and corporate governance-oriented objectives in their investment mandates or that include such parameters in the fund name.
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