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Historical Article Re-Print ESG DC Tipping Point: Why the Time Might Be Now

A number of forces are coming together which may influence more defined contribution (DC) plan sponsors to consider environmental, social, and governance (ESG) factors and funds. Regulatory developments in Europe are encouraging or mandating the consideration or inclusion of ESG funds in retirement plans; for multinational companies, these regulations may be influencing companies to consider expanding their offerings in the United States as well. And, with millennials and Gen Zers now in the workforce with a socially conscious mindset, participant interest in ESG is increasing. Finally, with the Biden administration’s focus on climate change, the Department of Labor (DOL) is considering guidance related to the inclusion of ESG funds in retirement plans.

Retirement Public Policy Strategist

Over the past 27 years, the DOL has released several guidance documents on the subject of ESG investing. In 1994 the department released Interpretive Bulletin (IB) 94-1 in order to correct misperceptions that investments in ESG funds are incompatible with fiduciary obligations outlined in the Employee Retirement Income Security Act of 1974 (ERISA). In that guidance the DOL stated that ERISA does not prevent fiduciaries from investing in economically targeted investments if the expected rate of return is commensurate with alternative investments and if other fiduciary considerations, including diversification and the plan’s investment policy, are met. The DOL went on to say, however, that the focus on the plan’s financial returns and risks must be paramount and fiduciaries may not accept lower expected returns or take on greater risks in order to secure “collateral benefits.” However, the department stated the following with respect to collateral benefits: " ... the Department has consistently recognized that fiduciaries may consider such collateral goals as tie-breakers when choosing between investment alternatives that are otherwise equal with respect to return and risk over the appropriate time horizon. ERISA does not direct an investment choice in circumstances where investment alternatives are equivalent, and the economic interests of the plan’s participants and beneficiaries are protected if the selected investment is, in fact, economically equivalent to competing investments.”1

Although the underlying tenets of ERISA — the duties of prudence and loyalty, were prominent in both the 1994 and 2008 guidance documents, the continual issuance of new guidance under different administrations, which provided different interpretations of and reliance on the "tie breaker" test, has led to uncertainty for plan sponsors, resulting in a reluctance to include ESG funds in retirement plans. The ping-ponging of guidance continued through the Obama administration, which issued IB 2015-01, withdrawing IB 2008-1, and most recently resulting in, first, sub-regulatory guidance and then a regulation from the Trump administration.

The regulation issued by the Trump administration put additional documentation requirements on funds that include “non-pecuniary” factors2 in order to demonstrate their financial impact and deemed “non-pecuniary” funds to be per se unacceptable as qualified default investment alternatives (QDIAs). Finally, although the “tie-breaker” test was retained in the final regulation, the preamble stated that those situations would be rare.

Where we are now

On October 13, 2021 the DOL issued a proposed regulation clarifying the Biden Administration’s views on the use of ESG funds in retirement plans. In a departure from the Trump Administration rule, the new regulation, at its core, treats ESG funds no differently than any other investment fund. Although the core tenets underlying ERISA, the duties of prudence and loyalty, remain paramount, the proposed regulation recognizes that ESG factors in investment selection can be “financially material” and clarifies that the impact of an ESG factor may be an appropriate consideration when evaluating particular investment options. In a change from the 2020 regulation, the terms “pecuniary” and “non-pecuniary” have been deleted from the proposed rule.

The rule also makes changes to both the tie-breaker and QDIA provisions in the Trump Administration regulation in an attempt to address concerns raised regarding those issues.

There is a 60-day period in which to send comments, ending on December 13.

Why is this time different?

In addition to the new DOL regulation, there are a number of forces coming together that may encourage plan sponsors to move forward with incorporating ESG funds into their DC plans. For multinational companies, regulations in Europe and the United Kingdom are not only encouraging the incorporation of ESG factors into plans’ investment lineups but requiring it. In the US, participant interest in ESG funds, particularly sustainability funds, is increasing. A new Schroders study found that incorporating ESG investments into retirement plans may lead to greater contribution rates. The “2021 U.S. Retirement Survey,3” conducted in late January 2021 among 1,000 US consumers ages 45 to 75 and 230 workers with employer-sponsored DC plans, reported that of those participants who were aware that their plan had ESG options, nine out of 10 said they invest in them. The Schroder survey further found that 69 percent of retirement plan participants said they would or might increase their overall contribution rate if their plan offered ESG options.

In addition, ESG integration is gaining prevalence as a value-driving factor for traditional investment analysis and decision-making. Under such strategies, the thoughtful assessment of material ESG factors — used, for example, as a complement to traditional research such as analyzing financial statements, industry trends, and company growth strategies — is integral to identifying opportunities, mitigating risks, and creating long-term shareholder value for investors. As the quality and consistency of ESG data and analytics increase, we expect such ESG integration to increasingly become a mainstream, if not standard, element of long-term, value-driven investing.

Finally, with the Biden administration issuing a new regulation early in its term, rather than days or months before the end of the administration, plan fiduciaries may be able to take comfort in the fact that the legal environment will be in place for years prior to a possible change in policy. As ESG integration becomes more the “norm” in fund construction, we believe these factors will become one of the primary bases upon which investment managers rely.