End of Week Notes
DOL finalizes rushed anti-ESG rule
This afternoon, at 2 p.m. EDT, on the Friday before an election that is widely expected to turn this Administration out of office, the Trump Department of Labor (DOL) has posted its final rule that limits the use of ESG funds in retirement plans regulated under ERISA.
In response to public comment, which was massively opposed to the proposed rule, the final rule avoids the use of “ESG” and “ESG-themed funds” and instead uses a “pecuniary/non-pecuniary” distinction. The rule restricts the use of funds that offer “non-pecuniary” benefits, which are not well defined by examples, in retirement plans.
Here’s what the rule says, based on my initial and relatively quick read (emphasis mine):
- A fiduciary may not subordinate the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to other objectives, and may not sacrifice investment return or take on additional investment risk to promote non-pecuniary benefits or goals.
- When choosing between or among investment alternatives that the plan fiduciary is unable to distinguish on the basis of pecuniary factors alone, the fiduciary may use non-pecuniary factors as the deciding factor in the investment decision provided that the fiduciary documents:
- why pecuniary factors were not sufficient to select the investment
- how the selected investment compares to the alternative investments
- how the chosen non-pecuniary factor or factors are consistent with the interests of participants and beneficiaries in their retirement income or financial benefits under the plan.
3. The above provisions apply to selection/retention of funds and strategies in both traditional pension and 401(k) plans.
A plan fiduciary is not prohibited from considering or including an investment fund in a 401(k) plan lineup solely because the fund promotes, seeks, or supports one or more non-pecuniary goals, provided that:
- fiduciary satisfies the points listed in 1 and 2 above
- the fund is not deemed a Qualified Default Investment Alternative (QDIA) or is part of a QDIA.
The Upshot
Even though the final rule avoids calling out ESG by name, it still singles out what are commonly known as ESG strategies from all other types of investment approaches. It requires fiduciaries to apply additional scrutiny in selecting ESG funds and requires increased documentation.
Of course, most funds and strategies that focus on ESG seek to provide competitive investment performance and don’t seek to provide specific “non-pecuniary” benefits. Most of what this rule implies as being non-pecuniary benefits, in the case of sustainable or impact strategies, are actually long-term benefits that should ultimately bolster rather than hinder the returns of retirement plan participants and their beneficiaries.
Nevertheless, the rule leaves open the exact definition of non-pecuniary benefits in the context of sustainable investing and leaves open how far a fiduciary needs to go to document the analysis that a fund deemed to have a desirable non-pecuniary benefit is indistinguishable from a conventional alternative on a risk/return basis.
It also just out-and-out bans the use of a fund that has a non-pecuniary benefit from use in QDIAs, but this provision won’t be enforced until 2022.
For the most part, I think ESG funds with strong risk/return profiles will be able to withstand the extra scrutiny, and those that have a purely “pecuniary” focus should be permissible as QDIAs.
Back to the Future?
For decades, an “all things equal” standard has been applied that allows a strategy that has “collateral” or “ancillary” benefits to be selected so long as its risk-return characteristics were comparable to conventional alternatives covering the same asset class or sub-asset class.
The Obama administration’s DOL went further, recognizing that ESG as widely practiced today is not simply about providing collateral benefits, but is intended to identify material investment risks and opportunities. It issued guidance suggesting that the evaluation of material ESG factors by plan fiduciaries may be considered as part of their fiduciary duty.
Despite there being no evidence that the existing standards were not working, overwhelming evidence that ESG factors are material (climate-risk, for example, was never mentioned in the 60-page proposal describing the rationale for the rule), and decades of research showing that ESG funds perform at least on par with conventional funds, the DOL has seen fit to move forward with a last-minute rule that itself was based on a rushed rule-making process.
If there is a Biden Administration, this rule should be short-lived.
What happens next?
- Election Day is Tuesday.
- If Trump wins, then the only recourse would be for the rule to be challenged in court as arbitrary and capricious. Potential issues include inadequate impact analysis and the failure to consider evidence and research even after it was presented in public comments, which were overwhelmingly opposed.
- If Biden wins, I think the rule will be reversed but that will take some time. A new Assistant Secretary heading up the Employee Benefits Security Administration needs to be confirmed, a new proposed rule written, a public comment period has to last at least 30 days, and then a final rule written that takes public comment into consideration.
- If Biden wins and Democrats control the Senate, there is the possibility of legislation reversing the rule and addressing other ESG-related policies, such as corporate ESG disclosures.
An ESG agenda for policymakers
Speaking of which, check out US SIF’s policy recommendations for the next administration:
ESG fund flows continue to set records
Flows into ESG funds available to US investors so far this year are 50% higher than flows for all of 2019. And 2019 flows were themselves 4 times greater than in any other year.
In September, ESG fund flows accounted for 24% of overall fund flows in the U.S. See the full report here:
Global ESG fund flows totaled $81 billion in the third quarter, about 75% of which are coming from Europe. Download our Global Sustainable Fund Flows Q3 report here:
Sustainable equity funds continue to outperform
Back in the U.S., here’s an update on performance through Q3. This shows sustainable funds’ category quartile ranks:
Get the full analysis here:
