Slow and steady return to ESG predicted after DoL rule change

Expectations of a rapid increase in ESG investments after US lawmakers reversed Trump-era rules that restricted the use of sustainable investments in pension plans are likely to be wide of the mark, experts have said.

The US Department of Labor (DoL) confirmed that institutional investors overseeing corporate 401(k) plans, and the corporate sponsors themselves, may now consider environmental, social and governance (ESG) factors when selecting investments.

The Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights rule was first proposed in October 2021, and its confirmation just prior to Thanksgiving reverses two Trump-era rules.

Those rules – that have now been overturned – stated that fiduciaries could not invest in “non-pecuniary” vehicles (essentially those whose investment thesis is based on something other than financial return alone) that sacrifice investment returns or take additional risk. They also outlined a complex process that a fiduciary must take when casting proxy votes – largely disincentivising voting at annual general meetings.

After consulting with stakeholders, the DoL decided that the Trump-era rules “unnecessarily restrained plan fiduciaries’ ability to weigh environmental, social and governance factors when choosing investments, even when those factors would benefit plan participants financially”.

But some have noted that the operative word in the new rules is “may”, and not “must”, when it comes to the ability to consider ESG factors. This is a tone that is softer than some proponents might have wanted, and which is also potentially indicative that a return to ESG assets will take time.

Treading delicately

That could simply be smart politics, though, as a rule that forced fiduciaries to consider ESG factors might be easier to appeal through the courts.

Marcia Wagner, founder of the Wagner Law Group in Boston, told Forbes that it wasn’t surprising that the final ESG regulations rejected the Trump administration’s ESG rules and that it would be appropriate for an ERISA [Employee Retirement Income Security Act) fiduciary to take into account ESG factors.

“However, the DoL also sought to make clear, in both the preamble and the text of the final regulations, that it was not requiring consideration of any ESG factors or seeking to place its thumb on the scale in favour of a fiduciary’s obligation to consider such factors,” she added.

Few commentators expect a legal appeal, based on the view that if one were set to take place, it would probably have been publicised by now.

In spite of the rule change, several commentators do not necessarily believe that ESG investments will come flooding back into 401(k) plans overnight.

“The previous rules certainly did have a chilling effect on the inclusion of ESG investment, and so I think we will see more flows into ESG products from retirement plans,” said Bryan McGannon, director of policy and programs at US SIF, the forum for sustainable and responsible investment.

“But we won’t see this on day one, as retirement plans tend to take time to switch out of products, so any growth in ESG investments within them is likely to be more noticeable in two to three years.”

However, a special provision in the Trump rules that prohibited ESG-focused funds being considered as qualified default investment alternatives (QDIAs) has also been overturned.

With the vast majority of 401(k) savers selecting the default option for their pension savings, according to McGannon, this could mean that more individuals gain access to ESG investments over time.

Ethical aspirations

Research by Schroders in its retirement survey found that 87% of participants did want investments aligned with their values.

This shows intent on behalf of the end-investor, but high-level consideration will be required to implement an investment strategy that echoes these wishes, especially if such a strategy had been altered recently to adhere to the Trump-era rules.

“Now that this highly anticipated step forward has been finalised, the question is no longer ‘are plan sponsors allowed to consider ESG factors and provide sustainable investment options?’, but, rather, ‘how do sponsors go about assessing and implementing ESG-integrated and/or sustainable investment options?,” said Lazaro Tiant, sustainability investment director at Schroders.

“This is to be expected; choosing any investment option as part of a retirement plan lineup is never a simple task.”

Tiant added that fiduciaries would need to demonstrate that a sustainable investment option was in line with the core principles that remain in the new rules, notably that there is a duty of loyalty, prudence and governance upon fiduciaries in relation to selecting investments for participants and beneficiaries.

“When it comes to the question of implementation, demonstrating that a sustainable investment option is in line with these core principles is the path forward,” Tiant said.

“This is the key challenge for plan sponsors and asset managers: establishing the value of these investment options.”

However, some commentators expect that both plan sponsors and fiduciaries could be keen to reintroduce ESG investments into the pension plans they oversee.

“I’m not really sure which of those two will be the dominant force,” said Aron Szapiro, head of retirement products and public policy at Morningstar.

“But it’s important to keep in mind that around 2,000 employers sponsor plans that make up 50% of assets, so it only takes a small number of employers to really drive change in the system.”

While Szapiro stated that the new rules announced by the DoL “don’t exist in a vacuum”, they “remove barriers and provide clarity”.

“As a result, we expect more plan sponsors to look at investment strategies that incorporate ESG analysis,” he said.

Furthermore, US SIF’s McGannon said that anecdotal evidence suggested that younger workers were keen to embrace sustainable investing, meaning that firms might need to include these as options in their pensions to attract new talent.

“From what we’ve heard, it’s common for younger employees to demand these types of investment, and they want to work at places that care about sustainability,” he said.