On Tuesday, the Biden administration finalized a series of rules that will make it easier for employers to include so-called impact investment funds in their retirement plans. Specifically, the Department of Labor will no longer ban employers and advisors from considering extraneous factors such as social impact when they evaluate investment assets for an employer-sponsored retirement plan. This is being hailed as a win for environmental and social movements, but employers may need to pay attention to a rule that can change hands with every new administration in Washington.
For help navigating how this helps your own retirement investment options, consider working with a financial advisor.
What Is the DOL ESG Rule?
The new rule is written broadly, which means that it may let employers explore several different categories of investing. But it specifically aims to create more opportunities for ESG, or “Environmental, Social and Governance,” investing. Otherwise known as impact investing, these are portfolios that invest around specific social and political goals. For example, a portfolio may explicitly choose not to invest in fossil fuels and dirty industries, or it may proactively invest in renewable energy companies.
ESG investing has grown aggressively in recent years. A September study by Dow Jones called this “the number one growth opportunity for investment professionals,” expecting the sector to more than double between 2022 and 2025.
However employer-sponsored retirement funds have recently avoided this category of investing due to a rule passed by the Trump administration.
The Trump-era rule amended ERISA to specifically ban employers and advisors from considering factors other than risk, return and financial performance indicators when selecting assets for a retirement portfolio. Specifically, it required employer-sponsored retirement plan “fiduciaries to select investments and investment courses of action based solely on financial considerations relevant to the risk-adjusted economic value of a particular investment or investment course of action.”
Employers who appeared to consider extraneous factors could be subject to legal scrutiny by the Department of Labor. Failure to abide by this rule was considered a breach of fiduciary duty, a serious charge that can merit enforcement actions up to and including loss of license for any financial professionals involved.
Although these rules did not mention ESG funds specifically, in external statements the Trump administration made clear that they intended to chill impact investing. It appears to have worked. While hard data is scarce, anecdotal reporting suggests that employers avoided ESG funds in their 401(k)s and related plans to avoid drawing investigations from the Trump Department of Labor.
This rule received significant criticism not just from social activists but also the financial community at large. As MarketWatch reported in 2020, approximately 96% of all public comments opposed this change to ERISA, and professional investors noted that in 2020 ESG funds actually tended to outperform the market at large. This rule forced employers not only to avoid funds that their employees might prefer on a personal level, potentially harming an employer’s ability to recruit younger talent, but which also may have been the better investment at the time.
The Biden administration rule rolls back these requirements in three specific ways.
First, employers are no longer required to consider only raw performance when considering a retirement investment. Instead, “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 [such] factors may include the economic effects of climate change and other ESG considerations on the particular investment or investment course of action.”
Second, an employer may use ESG funds as their retirement plan’s default investment options. They can’t subordinate financial performance to unrelated goals, meaning that they cannot select an under-performing impact fund. However, as long as the fund’s returns are strong, an employer can make ESG funds their first choice.
Finally, employers can use impact issues as a “tie breaker” when choosing between equally competitive funds. The Trump-era rule required that competing investments be “economically indistinguishable” before an employer could pick based on impact-related issues. Given the range of data available for any investment product this was a functionally impossible standard to meet, and one which invited scrutiny from an openly hostile regulatory authority.
What Does the Biden ESG Rule Mean For Fiduciary Duty And Your Investments?
The new rule reiterates “the longstanding principle that the fiduciary may not accept reduced returns or greater risks to secure collateral benefits.” Within that context, though, an employer can choose investments based on impact issues so long as the fiduciary can “prudently conclude that competing investments or investment courses of action equally serve the financial interests of the plan over the appropriate time horizon.” In other words, as long as competing investments are substantially similar, they don’t have to be identical.
The upshot is a mixed result for employers seeking ESG investment opportunities. This is a field that can have both financial and employee culture benefits for many employers. Impact-related investments tend to post competitive results, and they’re very popular with younger workers. Employers that want to seek those returns or those employees can now do so.
However, there is also a significant risk of whiplash going forward. Republican politicians have emerged as openly hostile to ESG, and many national figures have made opposition to impact investment a campaign issue. The result is that employers may need to anticipate rules that change every time a new party wins the presidency, a potential headache for plan administrators who would like to think in terms of decades rather than presidential administrations.
The Biden administration has rolled back a Trump-era rule that restricted investment in funds that focus on environmental, social and governance issues. While employers can now freely pursue these investments, they should be careful of an issue that has grown increasingly politicized in recent years.
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