DOL Opens Door for More ESG Investments in 401(k)s

The U.S. Department of Labor has proposed a new rule that will make it easier for 401(k) plans to choose investments based on environmental, social and governance (ESG) factors.

The rule, Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights, follows an executive order signed by President Joe Biden in late May that, among other things, directed the Labor secretary to reconsider rules enacted under the Trump administration limiting ESG investments in retirement plans.

Biden gave the secretary the option of rescinding, suspending or revising the former administration’s rule. The DOL, led by former Boston mayor Martin Walsh, apparently chose the last option.

Two months before he was confirmed, the department had already decided it would not enforce the standing regulation or pursue any enforcement action against a plan fiduciary based on a failure to comply.

The New DOL Proposal

The new DOL proposal amends the existing rule, which, according to the Labor Department, had the “undesirable effect of discouraging ERISA fiduciaries’ consideration of climate change and other ESG factors in investment decisions even when such consideration might have been in the financial interest of retirement plans and their participants.”

Ali Khawar, acting assistant secretary for the Employee Benefits Security Administration, said the proposed rule “will bolster the resilience of workers’ retirement savings and pensions by removing the artificial impediments — and chilling effect on environmental, social and governance investments — caused by the prior administration’s rules.

“A principal idea underlying the proposal is that climate change and other ESG factors can be financially material and when they are, considering them will inevitably lead to better long-term risk-adjusted returns, protecting the retirement savings of America’s workers.”

The new proposed rule amends the current rule limiting ESG investments in retirement plans in several ways:

1. It clarifies that a plan fiduciary’s duty of prudence can include the evaluation of the economic effects of climate change and other ESG factors on the particular investment or investment course of action.
2. It allows plan fiduciaries to include ESG-oriented fund options as qualified default investment alternatives (QDIAs) in defined contribution plans. QDIAs are the default options fiduciaries use when plan participants do not specify which funds they want to invest in. The 2020 rule essentially banned such considerations.
3. The proposal lets fiduciaries select an investment based on economic or non-economic benefits other than investment returns if the fiduciary can “conclude prudently that competing investments, or competing investment courses of action, equally serve the financial interests of the plan over the appropriate time horizon.” It removes the requirement that fiduciaries produce special documentation when choosing ESG-focused investment over another, under “tie-breaker” rules.
4. The proposal eliminates the multiple restrictions on fiduciary proxy voting under the current rule and directs fiduciaries to apply statutory duties of prudence and loyalty set forth in ERISA legislation governing standards in these areas.

The DOL proposal, which is open to public comment for 60 days, was applauded by representatives of the fund industry, which is managing the hundreds of billions of dollars in ESG-focused investments in the U.S. alone, and by sustainability investing advocates.

Amy O’Brien, Global Head of Responsible Investing at Nuveen, applauded the department “for providing the transparency and clarity the industry has called for in its proposed ESG rule.” She added, “Today’s proposed rule rightfully puts ESG factors on the same playing field as other investment considerations for Americans.”

Jim Roach, senior vice president, head of distribution — ESG Target Date Fund at Natixis Investment Managers, thanked the department for “listening to the investment community about the role of Environmental, Social and Governance (ESG) in investment portfolios, and for creating a proposed rule that is clear and understandable. Fiduciaries should consider all the risks when evaluating investments for clients, and ESG is not a replacement for the fundamentals of sound investing, rather an extra layer of evaluation.”

Lisa Woll, CEO of US SIF: The Forum for Sustainable and Responsible Investment, said the rule “was an important step towards ending the regulatory pendulum that is holding back the inclusion of funds utilizing ESG criteria in retirement plans and complicating proxy voting by plan fiduciaries.”

Woll added that the proposal proposal “significantly removes the artificial barriers created by the 2020 rules for ESG consideration in default plans, or Qualified Default Investment Alternatives (QDIAs)… [and] recognizes the proxy vote as an ownership right and removes provisions that may have discouraged fiduciaries from exercising their ownership rights.”

As for financial advisors, the proposed rule, if enacted, “should make it easier for advisors and plan sponsors to include ESG investments within ERISA plans, but it doesn’t go so far as to require their consideration or inclusion,” said John Faustino, Head of Broadridge Fi360 Solutions.