US pension rules could slow - but not halt - the use of sustainable investments

There has been exponential growth in global sustainability policy over the past three years. While the majority of it has been favourable for sustainable and ESG investing, the backdrop in the US private pension space has been at odds with much of the rest of the world.

Pecuniary or non-pecuniary, that is the question

In summer 2020 the US Department of Labor proposed two changes to regulations that had the potential to severely limit the use of ESG strategies for private pension, including multi-employer, plans.  These plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA), the US legislation under which savers’ interests are safeguarded.

The first piece of regulation, “Financial Factors in Selecting Plan Investments,” focused on whether it was at odds with a plan sponsor’s fiduciary duty of seeking to maximise returns to incorporate ESG factors and funds into a plan’s portfolio. The proposed rule cited that ESG factors were “non-pecuniary” – meaning not financially material – in nature.

While the public had a short period in which to respond, a study led by US lobby group the Forum for Sustainable and Responsible Investment and Morningstar reported that there were 8,737 comments about the proposed regulation with 95% opposing the rule. Many argued that the Dept of Labor’s definition of ESG reflected an exclusionary approach and disregarded the “financial materiality” of ESG issues.

The second piece of proposed regulation, “Fiduciary Duties Regarding Proxy Voting and Shareholder Rights,” released in August, was centered on insuring that fiduciaries exercise their proxy voting duties prudently and solely for the economic benefit of the plan. The proposed regulation was intended to provide guidance to ERISA fiduciaries in the context of proxy voting and other exercises of shareholder rights, particularly as to whether and when it was appropriate for fiduciaries to vote (or when fiduciaries must not vote) on ESG-focused resolutions.

The outcome

In November, the Dept of Labor issued a final rule on financial factors that was more flexible than anticipated. In response to the overwhelming opposition in the public comments, the final rule struck out any mention of ESG. In fact the Dept of Labor acknowledged in the preamble that ESG factors can be financially material.

The final rule is focused on ensuring that a fiduciary select investments based solely on pecuniary factors and prohibits fiduciaries from sacrificing returns or adding additional risks in order to promote non-pecuniary goals.

“ERISA fiduciaries must evaluate investments and investment courses of action based solely on pecuniary factors – financial considerations that have a material effect on the risk and/or return of an investment based on appropriate investment horizons consistent with the plan’s investment objectives and funding policy.”

The final proxy voting regulation was released in December and the principle is consistent that fiduciaries are prohibited from voting on resolutions focused on environmental and social issues that are not financially material and beneficial to the plan and plan beneficiaries. However, the final rule adopts a more flexible, principles-based approach than the proposed rule.

What does this mean for ESG in private pension plans?

Based on our interpretation, we see a few main implications:

1) There will be a continued focus on understanding and assessing the financial benefits of ESG integration to demonstrate the contribution of such factors to delivering better long-term risk-adjusted returns.

2) Robust ESG integration should be systematic, not outsourced; meaning ESG analysis lives with investment teams and it is not an outsourced ESG function. It needs to be embedded into the investment process in order to maximise long-term risk-adjusted returns.

3) There will be continued focus on using an inclusionary approach to sustainable investing, rather than an exclusionary approach that is focused on negative screening. Thematic, impact and broad screen strategies are likely to be inappropriate.

A question remains as to whether passive solutions would pass the pecuniary test. Many of the indices used in connection with these strategies are constructed using third-party ratings that are a bolt-on to the investment process, rather than the embedded approach taken by active managers that focuses on the material effects on the risk and return of an investment. We believe that this “bolt-on” aspect of passives is unlikely to satisfy the Dept of Labor requirement that the fiduciary focus solely on material financial factors when considering an investment or investment course of action.

Where do we go from here?

The new rule was effective from 12 January 2021, prior to the transfer of power occurring on 20 January.

We expect a more positive stance toward certain aspects of sustainable investing from President Biden, given his campaign pledges to take action on climate change. He has recently named John Kerry to his cabinet as US Special Presidential Envoy for Climate, which will also be a new position on the National Security Council, Brian Deese (formally the Global Head of Sustainable Investing at BlackRock) to lead the National Economic Council and Gina McCarthy, Head of White House Office of Climate Policy.

Even so, reversing the Dept of Labor’s final rule is not straightforward. Although the Congressional Review Act could be used to overturn the rules, that is not assured. The new administration could agree that it will not enforce the new rules until they prepare further guidance, and this guidance could include a broader interpretation of what constitutes pecuniary factors.

Another path to overturning the rules could be private lawsuits – especially given the short comment periods and speed at which the rules were adopted and, in the case of the financial factors rule, in the context of the overwhelming number of negative comments on the initial proposal and potentially negative impact on ESG and passive investment funds.

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