Paul Hodgson: Are the US Department of Labour ESG fund regulations really so bad?

The new rules on ‘pecuniary’ factors in investment choices has the investment world in a tiz. Why?

It doesn’t look good: 95% of respondents who commented are against the new US Department of Labor (DOL) regulations on investment fund choices. You’d think it would give Eugene Scalia, Secretary of Labor, pause for thought. 

But the rules are being rushed through anyway.

In another ‘doesn’t look good’ moment, press reports have revealed that so-called enforcement letters have been sent by the DOL to investment advisors and managers who have merely made passing reference in the press to ESG investing. There are fervid calls to document every investment decision they’ve made in the last two years and get the paperwork to the DOL in two weeks. 

This administration’s opposition to anything good that might come from positive ESG behaviours is well-known, but are these regulations part of that, or are they just prudently nailing down exactly how investment professionals should make their choices?

When you read in the proposal that: “This proposed regulation is designed in part to make clear that ERISA plan fiduciaries may not invest in ESG vehicles when they understand an underlying investment strategy of the vehicle is to subordinate return or increase risk for the purpose of non-pecuniary objectives” you tend to think this is reasonable.

The head of ESG for a large asset management firm thinks this may be the case. “Even my most thoughtful and rational ESG friends,” he told me “seem to be opposed to these rules (though I suspect few have actually read the DOL guidance), but the arguments they use are not very logical. The entire world of ESG is outraged and is hiring lawyers to send in responses, whereas if you just read the guidance, and you know anything about pension plans and ESG, you can only conclude it’s eminently sensible.”

He believes this is a problem of the industry’s own making. “Asset managers couldn't just incorporate ESG issues into their existing funds, focusing on financial materiality,” the manager told me, “(which the DOL is perfectly happy with, as they state very clearly). No, they had to commercialise it and create a new class of funds called ‘ESG funds’, and start making claims that these funds further social goals, (which, though generally doubtful and hard to evidence, has become normal in this fact-free space that is ESG). These funds also typically have higher costs and of course asset managers see a huge commercial opportunity here, especially if these funds become the default option.”

This sounds very much like the proposed rules’ statement that the regulations are designed: “to separate the legitimate use of risk-return factors from inappropriate investments that sacrifice investment return, increase costs, or assume additional investment risk to promote non-pecuniary benefits or objectives.”

“Calling everything ESG seems to have led,” he continued, “to the DOL setting a higher standard for ESG-themed funds, because pension plans should not be used to achieve non-pecuniary goals, and of course many investments that really do have impact in fact involve some sort of concessionary capital or below market returns, so if you’re putting the ESG label on a fund you’re suggesting it has non-pecuniary goals. And so now there’s a burden of proof in demonstrating that it’s still a good selection for a pension plan.”

It makes no difference, he told me, when asset management firms say ESG is just good risk management because the DOL will just reply: “Well, why does it have ESG in the name if you’re just doing what every prudent asset manager ought to be doing?”

The DOL is right to say, he said, that “private employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan”. It should be cracking down on this practice, he affirmed. 

He made three points to me in a second email. First: taking into account ESG considerations where they are financially material is allowed or even required by the regulations.

I have read the regulations and they do say this: “Paragraph (c)(1) is careful to acknowledge, however, that ESG factors and other similar considerations may be economic considerations, but only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories.”

His second point is that pension plans “can add ESG-themed funds as an investment option to beneficiaries, though fiduciaries have to base their decision on objective criteria and need to document their decision.” That’s paragraph (c)(2).

His third point is that the regulations say that pension plans cannot make ESG-themed funds the default. That’s about a third of the way through the proposal where it says: “The Department does not believe that investment funds whose objectives include non-pecuniary goals – even if selected by fiduciaries only on the basis of objective risk-return criteria consistent with paragraph (c)(3) – should be the default investment option in an ERISA plan.”

“This is a bit draconian,” my head of ESG told me, “though I understand the rationale: pension plans should not sacrifice performance in order to achieve ‘non-pecuniary goals’ and by selecting ESG-themed funds retirees’ savings might be directed to funds whose objectives include non-pecuniary goals without their ‘affirmative decision’. ESG people might object but I think most retirees would agree with this. Still, here you could argue that the DOL could just have set an even higher bar than for ESG-themed funds as one of the options, for example, if they can document that ‘all or nearly all beneficiaries of the pension plan agree that their pension savings should be used to pursue non-pecuniary goals’.”

But to me, this is where the DOL has gone too far. Either funds are being selected on the basis of objective risk-return criteria or they are not. If they are, then there is no reason why they shouldn’t be the default option, even if the fund is called ‘Stop Drilling in the Alaskan National Wildlife Refuge All-Share Index’.

Finally, the documentation requirements make ‘draconian’ look like a mild rebuke. In an attempt to avoid prosecution under the Paperwork Reduction Act, the proposal says that producing the required documentation will take a plan fiduciary and a clerical worker about two hours each at a cost of around $380, or approximately €320. As Bob Monks and Nell Minow wrote in a recent Harvard Law School post that tore into the proposed rules to considerable effect: “On what basis? Show your work.”