On Tuesday, the Biden administration finalized a set of rules that will make it easier for employers to include so-called impact investment funds in their retirement plans. Specifically, the Department of Labor will no longer prohibit employers and advisors from considering extraneous factors such as social impact when evaluating investment assets for an employer-sponsored retirement plan. This has been hailed as a victory for the environmental and social movements, but employers may need to heed a rule that can change hands with each new administration in Washington.
To help you understand how this helps your retirement investment options, consider working with a financial advisor.
What is the DOL ESG rule?
The new rule is written broadly, meaning it can allow employers to explore different categories of investment. But it specifically aims to create more opportunities for ESG, or “environmental, social and governance” investing. Otherwise known as impact investing, these are portfolios that invest around specific social and political goals. For example, a portfolio may explicitly choose not to invest in fossil fuels and dirty industries, or it may proactively invest in renewable energy companies.
ESG investing has grown aggressively in recent years. A September study by Dow Jones called this “the number one growth opportunity for investment professionals,” predicting the sector will double between 2022 and 2025.
However, employer-sponsored retirement funds have recently shunned this category of investments due to a rule passed by the Trump administration.
The Trump-era rule amended ERISA to specifically prohibit employers and advisors from considering factors other than risk, return, and financial performance indicators when selecting assets for a retirement portfolio. Specifically, it required employer-sponsored retirement plan trustees “to select investments and investment courses of action based solely on financial considerations relevant to the risk-adjusted economic value of a particular investment or investment course of action.”
Employers who appeared to be considering extraneous factors could be subject to legal scrutiny by the Department of Labor. Failure to comply with this rule has been deemed a breach of fiduciary duty, a serious charge that may merit enforcement action up to and including the loss of license for any financial professional involved.
While these rules didn’t specifically mention ESG funds, the Trump administration made it clear in external statements that it intended to cool down impact investing. It seems to have worked. While hard data is scarce, anecdotal reports suggest that employers have avoided ESG funds in their 401(k) and related plans to avoid attracting investigations from Trump’s Department of Labor.
This rule has received significant criticism not only from social activists but also from the financial community at large. As MarketWatch reported in 2020, approximately 96% of all public comments opposed this change to ERISA, and professional investors noted that ESG funds actually tended to outperform the broader market in 2020. This rule forced employers to not only avoid funds that their employees might personally prefer, potentially harming an employer’s ability to hire young talent, but that could also be the best investment at the time.
The Biden administration’s rule reinstates these requirements in three specific ways.
First, employers are no longer required to consider only raw benefits when considering a retirement investment. Instead, “a fiduciary’s duty of prudence shall be based on factors which the fiduciary reasonably determines are relevant to an analysis of risk and return and [such] factors may include the economic effects of climate change and other ESG considerations on a particular investment or investment policy.”
Second, an employer can use ESG funds as default investment options in their retirement plan. They can’t tie financial performance to unrelated goals, which means they can’t select an underperforming impact fund. However, as long as the fund’s returns are strong, an employer can choose ESG funds as their first choice.
Finally, employers can use impact issues such as “breakeven” when choosing between equally competitive funds. The Trump-era rule required competing investments to be “economically indistinguishable” before an employer could choose based on impact issues. Given the range of data available for any investment product, this was a functionally impossible standard to meet and required scrutiny by an openly hostile regulator.
What does the Biden ESG rule mean for fiduciary duty and your investments?
The new rule reaffirms “the long-standing principle that the trustee cannot accept reduced returns or greater risks to secure collateral benefits”. In this context, however, an employer may select investments based on impact issues as long as the trustee can “prudently conclude that competing investments or investment courses of action equally serve the plan’s financial interests over the time horizon.” appropriate”. In other words, as long as competing investments are substantially similar, they don’t have to be identical.
The result is a mixed outcome for employers looking for ESG investment opportunities. This is a field that can have both financial and employee culture benefits for many employers. Impact investing tends to post competitive results and is highly popular with younger workers. Employers who want to seek out those returns or those employees can now.
However, there is also a significant risk of whiplash in the future. Republican politicians have emerged as openly hostile to ESG, and many national figures have made opposition to impact investment an election issue. The upshot is that employers may need to anticipate rules that change every time a new party wins the presidency, a potential headache for plan administrators who would like to think in terms of decades rather than presidential administrations.
The Biden administration has rolled back a Trump-era rule that limited investments in funds focused on environmental, social and governance issues. While employers can now freely pursue these investments, they should be careful about an issue that has become increasingly politicized in recent years.
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