The Department of Labor delivered a final rule on considering environmental, social and governance funds in retirement plan investing choices. The department’s controversial rule suggests that ESG investing comes into conflict with the fiduciary responsibilities of plan sponsors, and it’s feared that the ruling could chill their use in employee retirement plans.

While the rule, issued Friday, doesn’t prohibit ESG investments in retirement plans altogether, plan sponsors are facing down a litigious environment and there’s a lot at stake if they are perceived to be running afoul of their fiduciary obligations. That might give them more reason to steer clear of ESG investments, which advocates say are important vehicles for investors wanting to fight things like climate change and racial injustice. Impact investors further argue that unsustainable business practices will lead to unsustainable companies, and that ESG investing therefore has greater long-term financial benefits, a view that has become so widely accepted that even trillion-dollar blockbuster companies like BlackRock and State Street have vocally backed them.

Snubbing those concerns, the DOL said in its final rule, “when making decisions on investments and investment courses of action, plan fiduciaries must be focused solely on the plan’s financial returns, and the interests of plan participants and beneficiaries in their benefits must be paramount.” According to the department, the Supreme Court’s definition of fiduciary under the ERISA law, means showing “complete and undivided loyalty to the beneficiaries.” ESG investing, doesn’t do that, the department says, because it goes beyond the financial and seeks out “nonpecuniary” benefits.

The department went on to say that providing a secure retirement is a paramount and worthy “social” goal of ERISA plans all by itself, and environmental or social pursuits shouldn’t be pursued “at the expense of ERISA’s fundamental purpose,” which is to give participants a secure retirement.

While the department noted the growing marketplace for ESG products, it also noted ESG critics who have decried “a lack of precision and consistency in the marketplace with respect to defining ESG investments and strategies, as well as shortcomings in the rigor of the prudence and loyalty analysis by some participating in the ESG investment marketplace.”

What’s left for ESG funds is a “tie-breaker” status—plan sponsors can indeed consider them if they match up favorably against other funds, and thus a fund’s pursuit of the greater social good makes it an attractive choice, all else being equal.

Backlash
The backlash to the DOL’s rule was swift and angry when it was proposed in June. Impact investors not only piled on to what they called the department’s shortsighted rules about performance, but also the short comment period.

“In an analysis of more than 8,700 comments submitted in response to the proposal, 95% of commenters opposed the proposal and 94% of comments from investment professionals opposed it,” said US SIF: The Forum for Sustainable and Responsible Investment. 

For years, socially responsible investors have argued that being a bad corporate citizen will cost you dearly in the future—whether it means facing down the expensive burden of regulation, tamping down on the expense of carbon emissions or water use or the inefficiency of your supply chain due to energy mismanagement. Merrill Lynch wrote last year that companies using Thomson Reuters’ environmental and social justice scores would have avoided 90% of the bankruptcies in the S&P since 2005.

'Value, Not Values'
To everyone’s surprise, giant asset managers have started singing the same song. In January, State Street Global Advisors’ president and CEO Cyrus Taraporevala wrote a letter saying that ESG was a matter of “value, not values,” and that shareholders’ stakes were increasingly being affected by companies’ success or failure at addressing climate change, labor practices and consumer product safety.

Last week at Charles Schwab’s IMPACT conference, BlackRock’s Larry Fink made similar comments in a webcast.

“Covid is an existential risk of health, just like climate change is an existential risk of health and property,” Fink said, “and I do believe more and more investors worldwide are starting to see true physical impact on the world from climate change. We are spending a great deal of time building better analytics and data to show that. … And we’re seeing more evidence that climate risk is investment risk.”

Aron Szapiro, the director of policy research at Morningstar, says that the department made a few tweaks to its initial rule, but that the ESG-hostile gravamen has remained. He said the language of the ruling itself now focuses on pecuniary or non-pecuniary factors.

“A plan sponsor can come to a prudent understanding of whether a factor is pecuniary or not pecuniary,” Szapiro said. “That’s the only nice thing I’m going to say about it.”

He points to Morningstar research dispelling the notion that ESG funds underperform funds without environmental-social-governance screens.

“We perceive [ESG] to be an increasingly mainstream way that people invest,” he added. “We don’t see some widespread issue of sustainable funds underperforming conventional funds; we see just the opposite over the last half decade. That’s not to say it will always be so, but it wasn’t an issue that needed immediate solving. … We think [the rule] is out of step. … We don’t think it’s helpful. We don’t think it solves a problem.”