On November 22, 2022, the U.S. Department of Labor (DOL) introduced new regulations that allow retirement plans to factor in environmental, social, and governance (ESG) considerations when choosing investments and exercising shareholder rights. This update to legislation previously established in 2020 gives 401(k) participants access to climate-friendly funds and other ESG-focused options.

The Department has further specified that fiduciaries should allow participants to invest in projects considering climate change risks. However, they should also weigh the possible risk against expected returns. The revised policy will become effective within 60 days of being published in the Federal Register, with specific proxy voting provisions set to take effect one year later.

Eliminating ESG-Related Restrictions

Previously, the rules didn’t permit ESG investments to be used as QDIAs. A QDIA or Qualified Default Investment Alternative is the default option for employees who have not actively chosen their investments. The new regulations eliminate this restriction, giving retirement plan administrators greater flexibility when selecting investments for their QDIAs.

The 2020 rule also attempted to stop plan administrators from casting proxy votes that, according to the previous administration, were socially or politically influenced and didn’t consider financial performance.

With the new rule, the Department of Labor has clarified that fiduciaries must exercise their voting rights when it is necessary to protect the financial interests of plan participants.

Considerations and New Provisions

ERISA (the Employee Retirement Income Security Act) and the law governing retirement plans require that fiduciaries act in the best interests of plan participants. According to the administration, the new rules abide by those principles, ensuring that ESG investments are consistent with the respective retirement plan’s risk-return objectives.

Furthermore, the new policy includes text that clarifies that an administrator’s duty of prudence must be based on relevant factors, including how climate change and other ESG issues could economically impact certain investments. Duty of prudence refers to the responsibility of a fiduciary to make decisions that are in the best interests of retirement plan participants.

The rule also includes a new provision stating the duty of prudence still applies when fiduciaries consider participant choices in developing fund portfolios for their defined contribution plans. This means that ‘imprudent’ investments cannot be included in the portfolio even if the participants want them, and plan sponsors could face liability should they add ESG funds that don’t benefit the participants.

There are still open questions on how the rule’s consideration of what participants prefer will be applied, such as when there are competing preferences or how important courts will consider the fact that a fiduciary considered participant choices if their investment decisions are considered to be imprudent.

While the DOL has eliminated significant barriers to ESG-focused investments, many plan sponsors aren’t embracing them due to their duty of prudence.

Climate Risks vs. National Security

Fossil fuel investments continue to be a concern, with detractors pointing out that retirement plans focused on these assets are not in line with corporate climate goals.

Others have argued against discouraging investment in oil and gas companies, stating that cutting them off would be irresponsible from a national security perspective. They point out that the U.S. energy infrastructure relies heavily on oil and gas resources and that a sudden push away from these investments could lead to a shortage of energy, forcing the country to rely on imports from “foreign dictators and oligarchs” for its energy needs.

Republicans proposed a new law called the Safeguarding Investment Options for Retirement Act that would limit what non-financial aspects fiduciaries could consider when deciding on investments for defined contribution plans.

ESG Funds: Performance Concerns

Despite growing interest in ESG investment, some are not entirely convinced of its economic benefits. Critics point out that ESG funds have lagged behind other investments in performance, because they focus primarily on non-financial issues such as climate change and social responsibility, and they typically have higher fees.

For example, a study conducted by the Center for Retirement Research (CRR) at Boston College in 2021 found that pension funds incorporating ESG investments did not generate the same returns as those without them. Additionally, these funds tend to come with more expensive fees and poorer performance than comparable index funds.

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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.