Putting the “ESG” in Pendulum Swing

Environmental, Social, and Governance (“ESG”) Retirement Investing is a form of socially conscious investing where fiduciaries in a retirement plan review non-financial factors when analyzing investment decisions. (CFA Institute). Though the letters “ESG” may appear novel in the retirement context, “socially conscious” retirement investing is decades old. As early as the 1970s, public pension funds made socially conscious decisions within pension portfolios by divesting from “sin” stocks, like companies affiliated with smoking and gambling. (Jean-Pierre Aubry et. al, Center for Retirement Research). Millennials, the largest segment of the workforce in U.S. history, are now driving interest in ESG investing, putting trillions of dollars at stake for asset managers. (Chris Versage & Mark Abssy, Nasdaq). Workforce retirement plans are most of a non-retiree’s investment savings. (Economic Well-Being of U.S. Households, Federal Reserve). Therefore, because millennials are the largest segment of the work force, millennials increased attention in ESG to retirement investing. Id. The Trump administration issued rules in 2020 to curb ESG retirement investing aimed at concerns that ESG investing (generally) hurts the fossil fuel industry and American retirees. (Saijel Kish & Jeff Green, Bloomberg). In response, the Biden administration reversed the Trump administration’s rules—creating a swinging pendulum leading to uncertainty for the future. (Seyfarth).

The Employee Retirement Income Security Act of 1971 (“ERISA”) governs workplace retirement plan investments, and the Department of Labor (“DOL”) administers ERISA. (DOL). ERISA mandates fiduciary obligations on retirement plan leaders, holding them accountable for their investment decisions. (DOL). The Executive Branch interprets that fiduciary obligation through regulations, which allows administrations to change these regulations from term-to-term. (U.S. Senate).  

Under the Trump administration in 2020, the DOL issued a rule (“Trump rule”) that: (1) limited a retirement plan fiduciary to making investments solely on financial factors and (2) regulated proxy voting by plan fiduciaries to focus on financial performance when voting. (Ted Godbout & Nevin Adams, National Association of Plan Advisors). Only when the financial performance of two investments were substantially similar could a plan fiduciary consider non-financial factors, such as ESG. (Stephen Miller, SHRM). Proponents of the Trump rule believe that financial performance should remain the primary focus of retirement plans and that retirement plans are not appropriate avenues to fight social causes like climate change. (Rachel Koning Beals, MarketWatch).

In response, the Biden administration finalized the “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights” (“Biden rule”) in 2022, reversing course from the Trump rule. (DOL). The Biden rule will allow (but not mandate) plan fiduciaries to consider ESG factors when determining fund choices. (Austin Ramsey, BloombergLaw). The Biden rule also rescinds the proxy voting mandate under the Trump rule. Id. Proponents of the Biden rule assert that plan administrators are fulfilling their fiduciary obligations when they consider non-financial factors, such as ESG factors, and those factors’ impact on financial performance. Id.

The Trump rule overreached as the current fiduciary obligations already require plan fiduciaries to both justify investment decisions and monitor investment performance. (Max Schanzenbach & Robert Sitkoff, Barron’s). Because plan fiduciaries already prioritize investment performance and justify their decisions in selection of the investments, the Trump rule duplicated the fiduciary obligation by requiring extra justification for choosing an equally performing ESG fund.

The Biden rule does not address two critical issues: (1) how to address greenwashing along with ESG rating regularity and (2) the codification of ESG retirement investing into law rather than regulations. Greenwashing is a term used to describe investment funds that choose investments which are less socially conscious than their investments appear. (Kyle Peterdy, CFI Institute). Institutional investors suggest that the Securities and Exchange Commission’s (“SEC”) recently proposed rules under the Biden administration, intended to regulate greenwashing, will instead sow more confusion. (Silla Brush & Lydia Beyoud, BloombergLaw). Companies can still greenwash investments under the new SEC rule by labeling ESG funds as focus, impact, or integration. (Jacob Wolinsky, Forbes). Integration funds use ESG factors in decision making and strategy. Id. Institutional investors are concerned that fund managers “consider myriad other factors,” and as such, labeling any fund as an ESG integration fund may appear—on its face—to overemphasize ESG factors when ESG factors represent a fraction of the factors a fund manager uses in decision making. (Silla Brush & Lydia Beyoud, Bloomberg Law).

In combination with greenwashing, a lack of sufficient regulation for ESG investments makes ESG statements and ratings virtually impossible to compare for investors. (Petrina McDaniel et. al, Bloomberg News). One recent example is Abbott Labs (“Abbott”). Abbott recently suffered a disaster when a lack of quality controls in its manufacturing facilities caused a baby formula shortage in the United States, eventually requiring government intervention. (Saijel Kishan & Anna Edney, Bloomberg Law). Abbott’s ESG score increased two notches after this baby formula disaster. Id. The company that rated Abbott—a major company in the ESG rating space—stated this rating bump occurred because Abbott’s board of directors were less overburdened, and Abbott made changes in leadership. Id. The rating bump demonstrates how ESG is subjective: many people would consider a quality control issue to indicate a lack of corporate governance, yet the ESG score increased (suggesting that these scores are forward-looking). (Jacob Wolinsky, Forbes). This tension leads one to wonder how investors, who seek ESG investments, can rely on rating agencies with such inconsistencies.

Though the Biden rule is imperfect because it does not address greenwashing and ESG irregularity, the Biden rule allows more flexibility compared to the Trump rule. The Trump rule added unnecessary regulation to a highly regulated space. Because plan fiduciaries must adhere to financial performance standards, ESG funds that meet the same financial performance standards as non-ESG funds should not be subject to additional regulations (as the Trump rule suggested). Yet since the Biden administration has failed to codify the Biden rule, even when it had the opportunity as introduced by the 117th Congress, history suggests that the public can expect the ESG retirement investing pendulum to keep swinging. (S.1762; John Judis, The New Republic). While Republicans are in control of the House and Democrats of the Senate, House Republicans’ plans to advance anti-ESG retirement investing legislation remains uncertain. (Andrew Ramonas & Clara Hudson, BloombergLaw). The pendulum will likely continue swinging, and plan fiduciaries—as evidenced from the defunct Trump rules—will exercise caution because of the administrative risk created: a fund choice may be fine for one administration, but not the other. (Ralph Chapoco, BloombergLaw). As such, even though millennial investors seek ESG investments generally and may crave ESG fund choices in their retirement plans, they should not expect to their retirement plans to reflect their wants anytime soon. (Chris Versage & Mark Abssy, Nasdaq).