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ESG

ESG Newsletter published on January 6, 2023

ESG Factors Allowed as Fiduciaries Consider Retirement Plan Options

Summary

  • The “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights allows consideration of climate change and other environmental, social and governance (ESG) when selecting investment options for retirement plans and exercising shareholder rights.
  • The rule sets aside the “pecuniary-only” standard at the center of regulations proposed in 2020.
  • After President Joseph Biden won the 2020 election and assumed the Presidency, the DOL blocked the proposed rule that restrained retirement plan fiduciaries, such as 401(k) plan sponsors, from weighing ESG factors when choosing investments.

With publication of a final rule by the U.S. Department of Labor (DOL) in November, considering climate change and other environmental, social and governance (ESG) factors is permitted when selecting investment options for retirement plans and exercising shareholder rights, such as proxy voting for plan-held securities. Allowing retirement plan fiduciaries to consider ESG factors when making decisions for plans was up for debate—and potentially could have been forbidden—under proposed rules from the DOL released in the waning days of the administration of former President Donald Trump.

The rule, “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights,” sets aside the “pecuniary-only” standard at the center of the regulation as proposed in 2020. After President Joseph Biden won the 2020 election and assumed the Presidency, the DOL blocked the proposed rule that restrained retirement plan fiduciaries, such as 401(k) plan sponsors, from weighing ESG factors when choosing investments.

"Today's rule clarifies that retirement plan fiduciaries can take into account the potential financial benefits of investing in companies committed to positive environmental, social and governance actions as they help plan participants make the most of their retirement benefits," said Secretary of Labor Marty Walsh. "Removing the prior administration's restrictions on plan fiduciaries will help America's workers and their families as they save for a secure retirement."

Critics contended that ESG considerations are outside the traditional financial safety and return-on-investment criteria that should be fiduciaries' sole consideration as required by the Employee Retirement Income Security Act (ERISA).

According to the DOL's fact sheet, an important change adopted in the final rule is "the addition of regulatory text clarifying that a fiduciary's duty of prudence must be based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis and that such factors may include the economic effects of climate change and other ESG considerations on the particular investment or investment course of action."

The final rule reverses the 2020 DOL rulemaking and provides fiduciaries with an interpretation of ERISA's fiduciary standards that could allow for the consideration of ESG factors.

The final rule reverses the prior rule's prohibition on using ESG funds as qualified default investment alternatives (QDIAs), which are types of mutual funds that plan sponsors can select as the default option in automatic enrollment 401(k)-type defined contribution plans. Under the rule, standards applied to QDIAs are no different from those applied to other investments.

QDIAs can be target-date retirement funds, which automatically reset their asset mix to become less risky as the specified target retirement year nears. Mutual fund companies have begun marketing target-date funds made up of investments that meet specified ESG criteria.

A second 2020 DOL regulation had aimed to stop what the prior administration viewed as retirement plan fiduciaries casting corporate-shareholder proxy votes in favor of social or political positions that didn't advance the financial interests of retirement plan participants.

Among other changes, the new final rule eliminates the earlier rule's requirement that fiduciaries not participate in proxy votes unless the fiduciary prudently determines that the matter has an economic impact on the plan.

The DOL said the prior regulation created "a misperception that proxy voting and other exercises of shareholder rights are disfavored or carry greater fiduciary obligations than other fiduciary activities."

Breckinridge’s View on the DOL’s Decision

Breckinridge is supportive of the DOL’s decision. As our clients and readers know, ESG analysis plays a key role in helping us carry out our primary objectives of preserving capital while striving to build a reliable source of income and taking advantage of opportunities to improve total return. We believe integrating ESG considerations into traditional financial analysis enables our investment team to gain deeper insight into the underlying risk and value of an investment.

While we are heartened by the decision, we acknowledge that the various DOL ESG guidance interpretations over the past several years have been influenced by politics. As we’ve written, we believe the political discussions related to ESG are misguided. We believe that dismissing or ignoring material ESG risks is a pernicious and compounding risk for investors. With regard to pricing risk, the intent of ESG analysis is to improve security selection with a goal of producing favorable risk-adjusted returns. ESG analysis considers extra-financial factors that may not be included in traditional fundamental security analysis. The goal is not to boycott securities or sectors based on non-financial factors but to identify overlooked investment risks and opportunities. In the end, we hope the DOL’s decision will stand under future administrations. We remain committed to considering material ESG factors as a way to manage investment risk.

 

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