In mid-October, the US Department of Labor (DOL) proposed a revised rule clarifying fiduciary responsibilities when selecting investment options for defined contribution (DC) plans. In our view, the new rule is a big step forward in encouraging fiduciaries to consider environmental, social and governance (ESG) factors when designing plan investment menus.
The rule, formally known as “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights,” sets out the standards for key plan-sponsor duties. They include selecting plan investment options, along with qualified default investment alternatives (QDIAs), exercising shareholder rights—such as proxy voting—and the use of written proxy-voting policies and guidelines.
Several Recent Twists and Turns in ESG Rulemaking
The proposed rule would revise the standards for plan fiduciaries considering ESG in investment selection. It would supersede a previous iteration of the rule finalized in November 2020, which included a last-minute pivot from the DOL. The late change eliminated any references to strategies with an ESG theme in ERISA plans, in the process removing language that had elicited a strong negative response from the investment community.
At the time, we referred to the pivot as a welcome development, because it smoothed out a wrinkle that might have inhibited some DC plan sponsors from considering ESG investment options. In making the change, lawmakers seemed to acknowledge our view (and that of many others) that material ESG factors are indeed financial factors. While the rule removed potential confusion, the investment community hoped for more tangible support for plan sponsors considering ESG in designing investment menus.
Shoring Up Support for ESG in Retirement Plans
Under a new administration, the DOL decided to take a fresh look at the rule in an effort to add greater clarity and increase support for ESG considerations. The new proposed rule, in our assessment, would represent substantial progress.
Among the enhancements? It would explicitly recognize that a plan fiduciary making an investment decision can consider ESG factors material to the risk-return analysis. It also states that a prudent investment “may often require” considering these factors. That’s a strong note of support for plan sponsors when evaluating investment options.
The rule would also remove a number of special guidelines on ESG considerations in QDIA selection; the same standard would apply to QDIAs as applies to all other investment options. And the rule would reduce the burdens of the “tie-breaker” standard, which allows plan sponsors to consider “collateral benefits” in their decision-making process, such as ESG factors that aren’t clearly material from an economic perspective.
Another notable change in the DOL’s new rule is the elimination of proxy-voting provisions that could have had a chilling effect on plan fiduciaries from exercising their ownership rights as shareholders. ESG proposals, from both company management and shareholders, can—and do—impact shareholder value. We applaud the DOL for recognizing this point with the new proposal.
Where We Hope the Rule Can Go Further
In our view, material ESG considerations are financial considerations. This is true whether it relates to an equity manager assessing modern slavery risk in a clothing manufacturer’s supply chain, an analyst gauging the impact of the net-zero transition on a utility or a plan sponsor evaluating a purpose-driven investment strategy aligned with the United Nations Sustainable Development Goals.
In our letter to the DOL during the rule’s open comment period, we supported the proposed rule as a very positive measure. And, along with the Defined Contribution Institutional Investment Association, we agree that the rule brings us closer to a principles-based approach, where plan fiduciaries incorporate the impact of material ESG considerations when evaluating plan investments.
Are there areas that can be improved? Yes. As it stands, the rule lists specific examples of ESG factors. But listing some ESG factors might imply that others not listed aren’t relevant. Keeping the rule broad to encompass any material financial factor would give plan sponsors more flexibility. Also, eliminating the tiebreaker rule altogether would, in our view, reduce confusion.
We welcome the proposed DOL rule, and we’re optimistic that it can be enhanced further based on public comments. For DC plan sponsors, the added clarification that ESG considerations can be material in evaluating investments will provide comfort in incorporating ESG options more proactively—and to talk to investment managers about ESG integration in portfolio management. In fact, many plan sponsors are likely already using investment managers that integrate ESG.
By fostering better plan investment menus, we believe that the new clarity from the DOL rule—and additional suggested enhancements—can ultimately lead to better outcomes.