ESG funds brought in about $120 billion in inflows last year, a figure that will likely increase in 2022. But, while ESG has become popular among investors, many asset managers struggle to balance their fiduciary duty with their clients’ environmental objectives. After all, their primary goal is to maximize investment returns, not achieve climate goals.
Let’s take a look at how new Department of Labor (DOL) rules could make it easier for fiduciaries to add ESG to their investment goals.
Be sure to check out our ESG Channel to learn more.
Who Does the Rule Affect?
The DOL creates rules for U.S. employers, including regulations governing retirement plans. In particular, the Employee Retirement Income Security Act (ERISA) protects the retirement assets of American workers by implementing rules that qualified plans must follow to ensure fiduciaries don’t misuse plan assets.
The new DOL rules apply to investment managers that act as ERISA fiduciaries. That’s significant because, in aggregate, ERISA rules cover roughly 684,000 retirement plans, 2.4 million health plans, and 2.4 million non-retirement benefit plans with a total of $7.6 trillion in assets covering over 140 million workers and their beneficiaries.
A Brief History
Fiduciaries have a legal responsibility to act in the best interest of their customers. Of course, the term ‘best interest’ refers to financial best interest—not the world’s best interest—and there’s a growing debate whether ESG factors should play a role.
The DOL initially weighed in on ESG investing back in 2008, when it discouraged the integration of non-financial factors. Then, in 2015, the DOL updated its guidance to say ESG factors could be variable financial considerations. And in 2018, it stressed that fiduciaries not readily treat ESG factors as economically relevant.
In 2020, the DOL made it clear ERISA fiduciaries must focus solely on the plan’s ‘pecuniary factors’ (e.g., financial returns) in their investment decision-making process. While they didn’t explicitly call out ESG factors, the rule prohibited adding “qualified default investment alternatives” (e.g., default plan investments) that reflected non-pecuniary objectives.
Since President Biden took over, the DOL has walked back some of this anti-ESG rhetoric. A proposed rule, published on October 14, 2021, is far less hostile to the idea of ESG as a factor in an ERISA fiduciary’s investment decision-making process. However, the agency makes it clear investment returns are still at the heart of a fiduciary’s duties.
What Are the Key Changes?
The DOL’s new rule stipulates ESG factors could come into play in a couple of ways.
First, fiduciaries can consider ESG factors in selecting an investment when such factors are material to the risk-return analysis. For example, climate change could have a material impact on an investment. That said, the DOL makes it clear fiduciaries cannot sacrifice investment return or take on additional risk to promote unrelated goals, like climate change.
Second, fiduciaries can choose to support ESG factors when both investments equally serve the financial interests of the plan. This rule replaces the current standard whereby fiduciaries can only consider collateral benefits when two investment choices are otherwise ‘indistinguishable’ based on risk and return, an almost impossible standard to achieve.
The new rule also no longer prohibits choosing a qualified default investment alternative (QDIA) that considers ESG factors if it best serves the financial interest of the plan. QDIAs are investments that come into play when an employee contributes to a plan without specifying how the money should be invested (e.g., they don’t choose a specific plan).
Be sure to check our Portfolio Management Channel to learn more about different portfolio rebalancing strategies.
The Bottom Line
Under President Biden, new DOL rules now permit ERISA fiduciaries to incorporate ESG factors into their decision-making processes. However, they are still generally required to consider financial returns above all else.
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