A new ESG Rule is needed to allow sustainable investing of retirement plan assets.
The Biden Administration faces extraordinary problems: a pandemic, an economic crisis, climate change, and increased racial strife. With so many crises at hand, it may seem odd that the Administration included an obscure retirement plan regulation on a list of immediate priorities. But the regulation’s bland title, “Financial Factors in Selecting Plan Investments,” understates its impact on sustainable businesses. Revising this rule could lead to the investment of trillions of dollars in sustainable investments.
As the millennial generation enters their prime earning years, the dual risks of climate change and retirement insecurity are mounting threats. Amending the blandly titled U.S Department of Labor regulation—also known as the ESG Rule—could stimulate millennials’ retirement savings by removing barriers to investing retirement funds in sustainable businesses.
ESG stands for environmental, social, and governance. ESG investing involves directing money to companies with a positive global impact, as measured by certain non-financial factors. Research firms evaluate companies for their environmental, social, and governance impacts, and the companies may receive an ESG designation or be included in an ESG fund or investment lineup.
Millennials are particularly interested in ESG. According to recent surveys, 87 percent of high net worth millennials considered a company’s ESG track record to be “an important consideration in their decision about whether to invest.” Ninety percent “wanted to tailor their investments to their values.”
Values-driven millennials are not the only Americans drawn to ESG. A 2019 study showed that among the general population of investors, 85 percent expressed interest in sustainable investment, up from 71 percent in 2015.
ESG investments, on average, yield returns that are at least as good as non-ESG investments. A 2019 study found that a high ESG portfolio outperformed a low ESG portfolio by 16 basis points per year. The factors underlying a company’s high ESG ratings also help to drive value, lowering risks of worker safety incidents, pollution spills, litigation, and other public relations disasters that can damage a company’s brand and valuation.
The current regulatory framework for ESG investments, however, makes it difficult for Americans to invest their 401(k)s and other kinds of employer-sponsored participant-directed retirement accounts in ESG funds. Limiting access to ESG investing for these kinds of retirement plans limits Americans’ access t0 ESG because more than 20 percent of American households only invest through an employer-sponsored retirement account. That reality also limits the amount of investment dollars that can be invested in ESG because the assets in these types of retirement plans exceed $7 trillion. Lowering the regulatory barriers to investing retirement funds in ESG will increase access to and investment in ESGs, and could simultaneously encourage increased retirement savings.
The Labor Department regulates ESG investing under a federal law known as ERISA, which governs employee benefit plans. ERISA imposes stringent fiduciary duties of loyalty and prudence on the managers of retirement plans. The Department has gone back and forth on whether employee benefit plan fiduciaries can consider ESG factors when determining which investment options to include in the plan’s lineup. In 2015 the Obama Administration’s Labor Department issued a generally “pro-ESG” interpretive bulletin stating that ESG issues may directly impact a plan’s economic value, and are “proper components of the fiduciary’s primary analysis of the economic merits of competing investment choices.”
The Trump Administration’s Labor Department, however, issued the less ESG-friendly “Financial Factors in Selecting Plan Investments” rule, warning that “private employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives” but rather to “provide for the retirement security of American workers.” Although this recent ESG Rule acknowledged there may be instances where fiduciaries could consider ESG factors as part of the investment process, it laid out a complex set of factors to weigh when deciding if ESG considerations are sufficiently “pecuniary.”
The recent Trump rule will likely raise compliance costs for offering an ESG option in retirement plan investment lineups. Risk-averse retirement plan providers may feel compelled to compile a record proving the ESG factors are pecuniary or to rely on the rule’s “tie-breaker” exception, which allows a fiduciary to consider non-pecuniary factors if they extensively document the rationale.
The Trump Administration’s argument that ERISA’s goal of “secure retirement for American workers” justifies strict regulation of ESG investing for employer-sponsored retirement accounts sets up a false dichotomy between good financial returns and ESG factors. The current ESG Rule fails to recognize that employers can encourage retirement saving through values-based investing.
The Biden Administration should amend the Trump-era ESG rule to lower the burden of proving ESG factors are pecuniary (or state they are presumed to be pecuniary) since, in many cases, they align with investment performance. This change will lower plan providers’ costs of offering an ESG option.
Studies have shown a positive correlation between ESG factors and investment performance, so simply offering a high-quality ESG option may on its own increase retirement savings.
Making it easier for employers to offer ESG options should encourage more values-driven millennial employees to participate in their retirement plans. The Biden Administration’s Labor Department just announced a non-enforcement policy for the Trump ESG Rule, but it should take further action and adopt a new rule clearly supporting ESG funds in ERISA-regulated plan lineups. With a definitive rule, the Administration can work toward two lofty goals: increased economic security and progress on environmental and social protection.