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ARA Pushes Back on Chilling Effect of DOL's ESG Proposal

Regulatory Compliance

In a comment letter on the Department of Labor’s proposed rule on environmental, social and governance (ESG) factors in selecting plan investments, the American Retirement Association cautions that the proposal "could stifle investment selection, decrease participant savings rates and diminish portfolio diversification."

In its July 30 letter, the organization argues, among other things, that the guidance should not discourage ERISA fiduciaries from considering (ESG) factors and that otherwise-appropriate investments should not be prohibited from qualifying as Qualified Default Investment Alternatives (QDIAs) simply because they also consider ESG factors. 

“The ARA shares the DOL’s goal of safeguarding the interests of participants and beneficiaries, but we believe those interests are best served by providing plan fiduciaries as a matter of prudence the opportunity to consider the impact that factors such as ESG could serve—or impede—long-term performance,” the letter states.  

The DOL’s June 23 proposed regulation purports to clarify the investment duties of ERISA plan fiduciaries in relation to using ESG criteria to make investment decision concerning private employer-sponsored retirement plans. The DOL had stated that it was “concerned that some investment products may be marketed to ERISA fiduciaries on the basis of purported benefits and goals unrelated to financial performance” and that “ESG investing raises heightened concerns under ERISA.” 

The ARA states, however, that it does not believe that DOL guidance should promote or prohibit a fiduciary from considering an otherwise prudent investment simply because it includes ESG factors. To the contrary, the ARA believes ESG factors are worthwhile and important elements of a prudent investment. “We are far from alone in this belief. Throughout financial markets worldwide, an appropriate corporate governance policy is recognized as beneficial,” the letter observes.  

Moreover, if the DOL believes that marketplace factors may inappropriately “prompt” ERISA fiduciaries’ evaluation of plan investments, the ARA suggests that the appropriate remediation lies with the marketplace information that ERISA fiduciaries receive and that regulators of investment marketing and related standards, not the DOL, may be better positioned to address the concerns.

Non-economic Elements

The ARA further explains that DOL guidance over the years has been consistent in stipulating that ERISA fiduciaries may not sacrifice financial returns in pursuit of “collateral” non-financial benefits, but has allowed that non-economic elements may be considered if an investment has an expected rate of return equal to other investments with similar risk characteristics and it is an otherwise appropriate investment for the plan.   

“In a departure from this foundation, the proposal would largely, if not nearly completely, constrain a fiduciary from considering ESG factors as part of a prudent process even those deemed to have a substantive impact on long-term investment returns,” the letter contends. More specifically, it notes, in removing the “all things equal” standard, the proposal allows the fiduciary to select an ESG fund only if doing so does not mean the plan gives up other non-ESG investment options and the fiduciary uses only “objective” risk and return criteria to select investments.  

The ARA further observes that the preamble, at the same time, notes that there is not a uniform definition of “ESG” or what constitutes an investment product or process that is based upon factors related to ESG considerations. Given this lack of consensus, the ARA says that it is concerned that even the most prudent investment option could be excluded by a plan simply because of an ESG label in marketing materials or because ESG factors are invoked in an investment disclosure. 

What’s more, without clarity on the definition of what “ESG factors” are, plan sponsors may be challenged to ensure they are meeting the proposal’s additional diligence and documentation requirements, the letter notes. In addition, fiduciaries might feel pressed to overlook such an option, even if it were deemed to be “prudent and a superior investment choice” simply because ESG is incorporated in its construction and maintenance.

The scope of these additional requirements needs to be clarified but may also simply be impracticable, the ARA advises. The organization notes that it is not clear whether the proposal would extend only, for example, to a fund that invests as an ESG investor or relies on ESG investment strategies. Another issue is whether it would apply if any underlying investments—such as in a target date fund (TDF), mutual fund or collective investment trust—applies either ESG principles in their investment “assessment, judgments or mandates.”

QDIA Exclusion

The ARA further states that it strongly disagrees with the proposal’s prohibition on including ESG investments as QDIAs or as a component of a QDIA. 

Under the proposal, according to the letter, even if a fiduciary can prove that ESG investments are superior on the basis of objective risk/return criteria consistent with the proposal’s other requirements, they may not be included as, or as part of, a QDIA. “This rule plainly excludes otherwise-qualifying investment options solely because their objectives include ESG factors,” the letter states. 

For example, assuming that evaluating and validating the governance process of a potential corporate investment is part of a prudent investment process, the proposal would seem to mean that if a TDF incorporates such prudent processes in its investment management, it would be precluded from being a QDIA, the letter explains. In other words, a TDF could be excluded from being a QDIA merely by following a prudent process incorporating an evaluation of corporate governance.  

“Such a result would be entirely incongruous with the underlying objective of the proposal, which is to promote prudent investing of plan assets in the best of interests of participants,” the ARA states.