A new ESG rule’s coming, but is there investor demand for these 401(k) funds?

As we count down these last few days before the Biden Labor Department finalizes its new rule on environmental, social, & governance (“ESG”) investments, the big question is: when will fiduciaries be permitted to take ESG values into account when making investment decisions for 401(k) plans?  The Department of Labor, which sent its final version of the rule to the White House for approval, has wrestled with when and how fiduciaries can consider non-economic ESG factors for over 30 years, and it has issued guidance in each of the Clinton, Bush, Obama, and Trump administrations. If the regulatory instability has you worried, we’re here to help.

What’s the big disagreement?

Administrations have generally agreed that ESG factors can be taken into account if their consideration boosts investment return or reduces investment risk. Where Republicans and Democrats have disagreed is when ESG factors can be considered where those considerations do not boost investment performance. Republicans have suggested never, unless there is a tie. Democrats have suggested whenever there is a tie. Both Democrats and Republicans have used the “tie-breaker” phrasing, but both parties have meant different things.

An easy way to think about the disagreement is by drawing a line down the middle of a piece of paper. Things to the left and right of that line are not ties, traditionally Republicans and Democrats have agreed. Where the disagreement comes in is how to draw the line. Do you draw the line using a very narrow laser or do you draw the line using a thick sharpie marker?  Using the Republican “laser” approach, you could argue that there really aren’t ever ties. Democrats would counter that comparing two investments is more of an art than a science, and that given the number of factors that go into whether an investment is going to be economically successful, ties can occur with some frequency.

Another key disagreement has been how to determine what specific values plan fiduciaries may consider, and what exactly “ESG” actually means.

What do we expect in the Biden ESG rule?

The Biden rulemaking comes just two years after the Trump Administration enacted its own ESG rule. In 2020, the Trump Administration suggested not only that ties rarely occur, but it also required additional documentation when ESG factors were used to break ties. Further, it limited the use of ESG factors as a tiebreaker at all in-plan default investments. The Trump rules were viewed by many as chilling the consideration of ESG factors.

At a minimum, we expect the new rulemaking to undo the Trump Administration rules and to suggest that ties do in fact occur. We also expect the recordkeeping requirements and default investment restrictions to be eliminated. In the United Kingdom, for example, some retirement plans are required to analyze how global warming could impact the plan; while it would be a surprise to see a similar requirement in the Biden rule, it is a possibility.

What are the arguments for and against ESG in 401(k) plans?

While ESG has been a contentious topic, it is important to recognize that there are arguments on both sides of the debate that resonate.

ESG advocates highlight the size of the retirement investment marketplace and suggest that it is too big a pool of money to force to the sidelines given the issues that the world is facing. ESG advocates also suggest that telling fiduciaries that they cannot take non-financial ESG factors into account is confusing, and that it will lead to fiduciaries avoiding considering ESG factors even when those factors are important economically. ESG advocates also argue that retirement savers may have more money in retirement even if returns are sacrificed because participants are more likely to contribute money to their 401(k) plans if there are investment options that align with their social views.

Related: Do employees really want ESG options in their retirement plans?

ESG opponents argue that our retirement system already serves an ESG purpose. 401(k) plans seek to achieve the social goal of providing workers with a dignified retirement. Additionally, opponents argue that consideration of non-economic ESG factors in a non-tie situation means that retirement savers are either sacrificing investment performance or taking on additional risk. They argue that this potentially decreased return or increased risk is at odds with the purpose of the tax advantages and strict rules for fiduciary conduct. Further, they argue that not all individuals will want to invest in a manner that promotes the identified ESG aims which could lead to decreased participation.

So what should benefits pros do?

Benefits professionals will want to understand the Biden Administration rule. If your company has significant participant demand for ESG investing, it could provide an opportunity for a fresh review of whether ESG considerations can be included without increasing the risk of litigation.

ESG investing is, however, likely to remain a hot topic, and there is real risk that a future administration will write its own ESG rules. Republicans in Congress have already signaled that there will be efforts to undo the Biden Administration rule.

As a result, benefits professionals will want to be nimble in complying with rules that are likely to continue to evolve.

Kevin Walsh and Jacob Eigner are both attorneys at Groom Law Group, Chartered. They advise plan sponsors and other ERISA fiduciaries on how to comply with evolving ESG guidance as well as other issues related to 401(k) plan investing.