The Department of Labor’s (DOL) new rule on “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights,” which allows for consideration of environmental, social, and governance (ESG) factors when making investment decisions, has come under fire from multiple fronts.

What Is the New ESG DOL Rule?

In late 2022, the DOL under President Biden promulgated the new rule to allow retirement plan fiduciaries to consider the potential financial benefits of investing in companies that consider ESG factors. This standard allows fiduciaries to make an investment decision based on the collateral benefits of ESG factors if two conditions are met:

1. The fiduciary must determine that such considerations are economically relevant to its investment objectives.
2. The fiduciary must not sacrifice investment return or take on additional risk due to such considerations.

Criticisms of the ESG DOL Rule

This rule has been met with strong opposition from 49 Republican lawmakers and Democratic Senator Joe Manchin of West Virginia, who have filed a joint Congressional Review Act (CRA) measure to nullify it. The CRA enables Congress to repeal recent federal regulations with a simple majority vote. If the measure is successful, the CRA says that “no substantially similar rule” could be issued in the future.

In addition, 25 states, including Utah, Texas, Louisiana, and Virginia, have filed a lawsuit against this rule. They claim it violates ERISA law by allowing fiduciaries to prioritize non-financial interests over financial interests when making investments.

Opponents of the new ESG DOL rule argue that the rule “politicizes 401(k)s” during a time when Americans are already suffering due to record-high inflation and market downturns. According to Senator Manchin, it is “irresponsible of the Biden Administration to jeopardize retirement savings for more than 150 million Americans for purely political purposes.”

Critics argue that this rule will lead to higher costs for retirement plans due to the increased complexity associated with incorporating ESG criteria into their investments. They also believe this could lead to lower returns since many ESG investments may not be as profitable as traditional investments.

Statistics show that funds with the best Morningstar sustainability scores had the worst returns in the first half of 2022, losing 13% on average compared to those with lower scores that lost 4%. In addition, a Bloomberg analysis revealed that global ESG funds have “underperformed the broader market in the past five years.”

Furthermore, detractors argue that this rule could open up retirement plans to litigation risks since there is no clear definition of what constitutes an ESG factor or how much weight it should be given when making investment decisions.

Some states have already taken measures against the DOL’s new rule. For example, in August, Governor Ron DeSantis backed a resolution prohibiting state pension funds in Florida from incorporating ESG factors into their decision-making. Other states, such as Arkansas, Missouri, and Oklahoma, have introduced similar bills.

What Do Supporters Say?

Despite these efforts by critics of the DOL’s new rule, proponents argue that retirement plans must keep up with changing investor preferences and remain competitive in today’s market. They claim that many investors now prefer companies with strong sustainability practices and are willing to pay a premium because they perceive long-term value-creation potential.

For this reason, they believe incorporating ESG criteria into retirement plan investments can help reduce risk and achieve competitive returns in the long run.

They also argue that the new DOL rule does not require retirement plan fiduciaries to prioritize non-financial interests over financial interests. Instead, it allows them to consider ESG factors when making investment decisions without sacrificing financial objectives.

The new DOL rule is a controversial measure that has sparked debate among investors, lawmakers, and other stakeholders. Supporters argue that retirement plans should be allowed to invest in companies with solid sustainability practices.

At the same time, opponents claim that the rule could lead to higher costs and lower returns while enabling fiduciaries to make politically and socially driven decisions instead of prioritizing financial interests.

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This is not intended to be exhaustive nor should any discussion or opinions be construed as legal advice. Readers should contact legal counsel or an insurance professional for appropriate advice.