What to watch for in the DOL’s upcoming ESG ruling
next issue no. 8: Fiduciary perspective
The more things change, the more they stay the same. This adage may come to mind when thinking about Washington’s guidance on the factors an Employee Retirement Income Security Act of 1974 (ERISA) retirement plan fiduciary may consider when selecting investments for plan menus over the years. At the risk of oversimplifying, the guidance over the years is usually less about WHAT the critical factors are and more about HOW to consider factors as investment innovations continue to occur. This is especially true in terms of considering environmental, social and governance (ESG) factors.1
Over the past 30 years (since the Clinton Administration), views on how fiduciaries should consider investments using ESG factors for inclusion in their plans have fluctuated with each new Administration. Regardless of advancements and innovation in ESG reporting, the guidance typically toes the party line. Republican administrations have typically used language that is more skeptical in their guidance while language from the Democrats’ positions have been more accepting of ESG factors.
The status quo of ESG rulings
The newly proposed version of the ESG rule, anticipated to be released by the Department of Labor (DOL) as early as this summer, would make changes to the current version, which was finalized in 2020 during the Trump Administration. Specifically, it’s expected to provide guidance on the various factors a plan sponsor may consider when choosing investment options for plan menus, and seeks to roll back some of the language in the current rule that may be interpreted to have a chilling effect on plan fiduciaries’ willingness to include ESG investments, forgoing the potential value those investments can bring to participants. There is general agreement across much of the retirement plan and investment management industries that the current proposal addresses many of the outstanding issues from the 2020 rule and would open up many more options for plan fiduciaries to include pertinent ESG factors when determining investment options.
Up until the Trump Administration, Washington’s views were expressed as less binding “regulatory guidance” as opposed to the formal rules we’ve seen in 2020 and 2021, which are more binding and therefore more onerous to reverse or change. The hope is that the new version of the rule, when finalized, will contain sufficiently neutral language as to give it longevity across future presidential administrations; but there is still some risk that a future Republican administration could attempt to change the rule again if it is seen as too accepting of ESG.
For context, the DOL’s 2020 rule (Financial Factors in Selecting Plan Investments) was actually less extreme than the proposed version of that rule. While the proposal did not outright prohibit plan fiduciaries from considering ESG factors, it included language that seemed to question whether such factors could be financially material. However, all references to “ESG” specifically were removed from the 2020 rule. The remaining language was much more neutral. It is encouraging that the final rule that emerged from the DOL under the Trump Administration was relatively balanced and aligned with prior DOL guidance regardless of administration. Perhaps this is an indicator that the new rule will be similarly evenhanded, which will make it more likely to have a long shelf life.
Key points to look for
The new proposed rule included specific examples of factors that could be considered by plan sponsors when selecting investments for plan menus. Of note, all of the examples cited by the DOL were ESG-related, causing some commenters to wonder if the new rule might be too focused on ESG. We will be interested to see whether the final rule removes these ESG examples, adds additional examples that are not ESG-related or maintains the originally proposed examples.
Qualified Default Investment Alternative (QDIA)
As we stated in our comment letter, the DOL’s proposal to remove the current prohibition on using ESG investment options as QDIAs, or as part of a QDIA, is one that we enthusiastically support. Removal of the QDIA provision was supported by many others in the industry as well. We expect to see it included as part of the final rule.
The new proposal seeks to amend the so-called “tie-breaker test,” which plan fiduciaries can use to guide their selection of an investment option when they deem two investments to have identical financial benefits for the plan and its participants. Under the new proposal, a plan fiduciary can break the tie by considering “collateral benefits other than investment returns,” so long as those collateral benefits “equally serve the financial interests of the plan over the appropriate time horizon.” This may give plan fiduciaries another opportunity to incorporate ESG factors into their investment selection process, to the extent they are faced with a tie between two investment options where ESG considerations are in play. However, some commenters argued that the tie-breaker test is rarely if ever used in practice, and questioned the wisdom of including it in the new version of the rule at all. We will be watching closely to see how the DOL decides to address this issue in the final rule.
From the fans (or increasing participant interest)
It also must be said that we know plan participants want a broader range of options in their retirement planning, especially with relation to ESG and responsible investing (RI) factors having a place on the menu.
Nuveen’s 2021 RI survey2 shows that 75% of employees believe that an employer that offers RI investment options cares about retirement outcomes. This goes across both millennials and non-millennial respondents. Our RI survey shows that 92% of millennials and 69% of non-millennials hold this view.
Further, investors currently investing in RI are more likely to agree that employers who have RI on their retirement menu care about their retirement outcome, compared to those not currently participating in RI (94% and 57%). Just as importantly, our survey shows that 68% of employees agree with the statement that they feel better about contributing to a workplace retirement plan if it has RI options available. The survey finds that RI options also increase employee loyalty and overall sentiment. RI options in retirement planning therefore have implications beyond just the fiduciary, and could aid employee retention and overall firm morale.
However, the U.S. Supreme Court has made it clear that participant desires are not necessarily a shield against a fiduciary failing to review and monitor investments — i.e., a plan fiduciary cannot add an inferior investment just because participants want the investment.
The wishes of plan participants are only part of the slew of considerations when it comes to investment menu construction and the overall regulatory and legislative environment around retirement planning. But it should still be a factor.
For many, the new proposed rule is generally a welcome update to the current version. Compared to the 2020 ESG Rule, the newly proposed version takes a more accepting approach to ESG investments, and should give plan fiduciaries greater confidence and clarity when selecting investments for plan menus. We hope the new rule will broaden participants’ access to ESG investments, as it is clear that plan participants want these options to be available within their retirement options as well. The final version of the DOL’s ESG Rule will hopefully strike an appropriate balance between taking an ESG-friendly approach and using sufficiently neutral language, so that the rule can survive throughout political changes in coming years. We also expect that the final rule will provide much-needed assurance that ESG investments can be included in QDIAs. We look forward to reviewing the final rule when it is issued.
In this issue
1 Responsible investing incorporates Environmental Social Governance (ESG) factors that may affect exposure to issuers, sectors, industries, limiting the type and number of investment opportunities available, which could result in excluding investments that perform well.
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