DOL takes more neutral stance with ESG rule

The Department of Labor's new rule permitting retirement plan fiduciaries to consider climate change and other environmental, social and governance factors when selecting investments and exercising shareholder rights is a regulatory return to normal and takes more of a neutral approach than the proposal on which it was based, industry experts said.

"I think the DOL was looking to place ESG factors within the broader pantheon of investment considerations that fiduciary decision-makers consider all the time," said Julie K. Stapel, Chicago-based partner with Morgan, Lewis & Bockius LLP.

The Labor Department on Nov. 22 finalized its rule — Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights — after unveiling the proposal in October 2021.

The new rule, which will go into effect Jan. 30, is a reversal of two rules promulgated late in the Trump administration that said retirement plan fiduciaries could not invest in "non-pecuniary" vehicles that sacrifice investment returns or take on additional risk and outlined a process a fiduciary must undertake when making decisions on casting a proxy vote.

Lisa M. Gomez, assistant secretary for employee benefits security at the DOL, said in a call with reporters Nov. 22 that the Trump-era ESG rule had a "chilling effect on the integration of ESG factors into the investment selection and asset management process."

The final rule comes after years of stakeholder outreach on the subject and follows an executive order by President Joe Biden in May 2021 directing federal agencies to assess and mitigate financial risks related to climate change.

Will Hansen, Arlington, Va.-based executive director of the Plan Sponsor Council of America and chief government affairs officer at the American Retirement Association, is pleased with the final rule's neutral stance.

"We've had almost 50 years now of ERISA in which the DOL has not stated specifically what types of asset classes should or should not be in a retirement plan investment fund lineup, and it's worked," he said. "So we're happy this (final rule's) neutral approach kind of keeps with that tradition."

The final rule is seen as more neutral because, unlike the October 2021 proposal, it does not include examples of specific ESG factors that fiduciaries could consider and removed language that a prudent fiduciary process "may often require" the consideration of ESG factors.

"The DOL has never taken a position that any other particular investment factor consideration is required, so to say that there could be occasions when ESG is required would have been a deviation from how they've approached it," Ms. Stapel said.

On proxy voting, the final rule eliminates a provision in the Trump-era rule that "the fiduciary duty to manage shareholder rights appurtenant to shares of stock does not require the voting of every proxy or the exercise of every shareholder right."

The final rule eliminates that provision because it may be "misread as suggesting that plan fiduciaries should be indifferent to the exercise of their rights as shareholders, even if the cost is minimal," the Labor Department said in a fact sheet.

Pamela L. Marcogliese, New York-based head of U.S. corporate advisory and governance at Freshfields Bruckhaus Deringer LLP, said the final rule is a reset for both public companies and investors when it comes to proxy voting.

"If you think something is valuable from an ESG perspective, you don't have to twist yourself in a knot to say, 'Oh my gosh this also ties to the bottom line,'" she said.

Whether the final rule leads to further adoption of ESG funds in plan lineups remains to be seen, sources said.

But Lazaro Tiant, New York-based sustainability investment director at Schroders PLC, said with the final rule in place it gives asset managers a greater opportunity to educate and work with plan sponsors on their ESG offerings.

"For us, as asset managers, it allows us to have a much deeper conversation and really talk about what plan sponsors can bring to bear, which I'm excited about because you're not really pigeonholed into having a conversation on ESG-integrated products but really talking about what's changing in the world and why that's relevant and economical from an investment standpoint," Mr. Tiant said.

Further, he expects plan sponsors to "dip their toe" into the ESG pool a bit more once the rule takes effect.

"People have been waiting to look under the hood a bit more (on sustainable funds), not have it be just an educational exercise about what the different options entail, but rather actually start looking at options, looking at track records and see if these options can make it into their plans," Mr. Tiant added.

Mr. Hansen said it will be a "slow process" for plan sponsors to evaluate their plan lineups. "I do think plan sponsors will take a hard look at this rule, listen to what their participants are asking for and then make some decisions on whether to add an ESG fund or not," he said.

One of the major changes the final rule makes is reversing a provision in the Trump-era rule that excluded a fund from being a qualified default investment alternative if its investment objectives, goals or principal investment strategy include or consider the use of one or more non-pecuniary factors.

Under the final rule, standards applied to QDIAs are no different from those applied to other investments, the Labor Department noted in its fact sheet.

While Mr. Hansen said he's pleased with the QDIA changes made in the final rule, he doesn't think plan sponsors are going to "go out there in droves and add an ESG fund as a QDIA."

A survey released in November by Callan LLC found that 35% of institutional investors considered ESG factors in their investment decisions in 2022, down from 49% in 2021 and down from every year since 2016.

"In a vacuum, (the final rule) should give considerable comfort" to plan sponsors weighing ESG options, Ms. Stapel said. "In the political reality we find ourselves in, I'm not sure how much comfort it's really going to give."

Republicans on Capitol Hill are not fans of the final rule.

Specifically, Sen. Tom Cotton, R-Ark., introduced a joint resolution Dec. 1 that would overturn the rule.

The resolution states that Congress "disapproves" of the rule "and such rule shall have no force or effect."

In a separate statement, Rep. Virginia Foxx, R-N.C., ranking member on the House Education and Labor Committee, and Rep. Rick Allen, R-Ga., ranking member on the Health, Employment, Labor and Pensions Subcommittee, said the final rule "overturns the strong protections implemented by the Trump administration, which guarded retirement savers from investment managers seeking to advance social and political objectives unrelated to the financial benefits to workers and retirees. The Biden administration is choosing its climate and social agenda over retirees and workers. This is bad news."

Republicans won control on the House in November and will assume control of the chamber in January, which could lead to more hearings and oversight of the Biden administration's regulatory agenda.

Ms. Stapel noted that the country is less than two years from a presidential election and a change in administration could bring further changes to ESG regulation.

"I think the DOL took some … very strategic and savvy steps to try to make this rule resistant to just being immediately reversed if there were to be a Republican administration," Ms. Stapel said, pointing to the rule's neutrality. "I think that plan sponsors are going to feel more comfort under this rule, but I suspect there will still remain a lingering sense of reticence that maybe two years from now we could be looking at a different landscape."

Mr. Hansen said the "regulatory pingpong is definitely a factor in the decision-making process of a fiduciary when adding an ESG option. But I'm hopeful that the neutrality that this rule took will hopefully dissuade any future administration from continuing that game of pong."