The Biden Labor Department will soon finalize a new rule on environmental, social, and corporate governance (ESG) investments, and one big question remains: When will fiduciaries be permitted to take ESG values into account as they select investment options for 401(k) plans?
The Department of Labor, which has sent its final version of the rule to the White House for approval, has wrestled for more than 30 years with when and how fiduciaries can consider non-economic ESG factors. It issued guidance related to this question in each of the Clinton, Bush, Obama, and Trump administrations.
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These administrations have generally agreed that ESG factors can be taken into account if their consideration boosts investment return or reduces investment risk. Where Republicans and Democrats have disagreed is around when ESG factors can be considered if they do not boost investment performance. Republicans have suggested the correct answer is never, unless there is a tie between prospective investment vehicles. Democrats have suggested that ESG should be considered as a factor whenever there is a tie. Both Democrats and Republicans have used the "tie-breaker" phrasing, but the parties have meant different things by it.
An easy way to think about the disagreement is to consider drawing a line down the middle of a piece of paper. Things to the left and right of the line are not ties, and traditionally Republicans and Democrats have agreed about how to treat them. Where the disagreement lies is in how to draw the line. Do you use a very narrow laser, or do you draw the line using a thick Sharpie marker? Under the Republican "laser" approach, you could argue that there really aren't ever 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 go into deciding whether an investment is likely to be economically successful, ties can occur with some frequency.
Another key disagreement has revolved around how to determine what specific values plan fiduciaries may consider and what, exactly, "ESG" means.
What Do We Expect in the Biden ESG Rule?
The Biden rule-making 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 anytime ESG factors are used to break a tie. Further, it limited the use of ESG factors at all, even as a tie-breaker, in selecting plans' default investments. The Trump rules were viewed by many as chilling the consideration of ESG factors.
At a minimum, we expect the new rule-making to undo the new Trump Administration restrictions and to suggest that ties do, in fact, occur. We also expect the record-keeping requirements and default investment restrictions to be eliminated. Other changes are possible as well. For example, some retirement plans in the U.K. are required to analyze how global warming could impact the plan. It would be a surprise to see a similar requirement in the Biden rule, but it is a possibility.
What Are the Arguments for and Against ESG in 401(k) Plans?
Although ESG is sometimes a contentious topic, it is important to recognize that there are arguments which resonate on both sides of the debate.
ESG advocates highlight the size of the retirement-investment marketplace and suggest that it is too big of a pool of money to force to the sidelines, given the issues that the world is facing. ESG advocates also suggest that telling fiduciaries they cannot take nonfinancial ESG factors into account is confusing, and that it will lead fiduciaries to avoid considering ESG factors even when those factors are important economically.
Advocates of loosening the restrictions also argue that retirement savers with ESG options may put more money in their retirement accounts, even if returns are sacrificed, because participants are more likely to contribute money to their 401(k) plan if its investment options align with their social views.
However, ESG opponents argue that our retirement system already serves an ESG purpose: 401(k) plans seek to achieve the social goal of providing workers with a dignified retirement.
Additionally, opponents argue, consideration of nonfinancial ESG factors in a non-tie situation means that retirement savers are either sacrificing investment performance or taking on additional risk. They argue that this potentially decreased return or increased risk is at odds with the purpose of 401(k)s' tax advantages and strict rules for fiduciary conduct. Further, they argue, not all individuals will want to invest in a manner that promotes the identified ESG aims, which could reduce participation in the plan.
So, What Should Plan Sponsors Do?
First, companies need to understand the Biden Administration's rule, once it comes out. If your company has significant participant demand for ESG investing, the rule change could provide an opportunity for a fresh review of whether ESG considerations can be included without increasing the risk of litigation.
ESG investing is, however, likely to remain a hot topic, and it is probable that future administrations will write their own, additional ESG rules. Republicans in Congress have already signaled that they will try to undo the Biden Administration rule.
As a result, companies that offer defined-contribution plans will want to be nimble in complying with rules that are likely to continue to evolve.
Kevin Walsh and Jacob Eigner are both attorneys at Groom Law Group, Chartered. They advise plan sponsors and other ERISA fiduciaries on how to comply with evolving ESG guidance as well as other issues related to 401(k) plan investing.
From: BenefitsPRO
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