Final DOL Rule Gives 401(k)/403(b) Plans a Green Light for ESG

The U.S. Department of Labor (DOL) recently issued a final rule on “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights.” In a nutshell, this means that 401(k) and 403(b) retirement plan fiduciaries will again be allowed to consider environmental, social and governance (ESG) factors in selecting the plan’s investment options and exercising shareholder rights such as proxy voting.

In our view, this has the potential to be a watershed moment, given the number of participants in and the size and growth of these retirement plans. According to the Investment Company Institute, as of June 30, 2021, 401(k) plans held an estimated $7.3 trillion in assets and represented nearly one-fifth of the $37.2 trillion U.S. retirement market, which also includes individual retirement accounts (IRAs), pensions and annuities. For comparison, in 2011, 401(k) assets totaled $3.1 trillion and represented 17% of the U.S. retirement market. Public sector 403(b) plans are estimated to hold over $1 trillion in assets.¹

Here, we briefly summarize key points of the rule and offer our take on what this means to individuals who participate in these types of employer-sponsored retirement plans.

First, we note that the majority of workers in the U.S. have access to these types of retirement plans. This includes 68% of private industry workers and 92% of state and local government employees.² So, the rule has the potential to impact the investment choices available to many investors. Given that 401(k), 403(b) and thrift savings plans are the most common ways Americans save for retirement, this action by the DOL could have widespread and, in our view, positive implications over time.

Here is a summary of the rule’s key components:

• Retirement plans can now offer investment options that consider the impact of ESG factors. The new rule allows (but does not require) employer-sponsored retirement plans to consider the potential financial impact of ESG risks, as well as the benefits of investing in companies that are committed to positive ESG practices when choosing the plan’s investment options.

• Climate change risk can be viewed as an investment risk. The final rule clarifies that a plan fiduciary’s analysis of an investment’s risk and return profile (whether a fund or an individual stock) may include the economic effects of climate change, as well as other ESG considerations.

• Sustainability is no longer just a “tiebreaker.” The final rule eliminates a tiebreaker test that had stated “collateral benefits,” such as ESG-related impacts, could be used only to break a tie when choosing among investments that were otherwise indistinguishable. Instead, fiduciaries must prudently conclude that competing investments, which may include funds that consider ESG factors, equally serve the financial interest of the plan over an appropriate time horizon.

• More requirements to exercise shareholder rights. The previous DOL rules (which were imposed in 2020) stated that a fiduciary’s duty to manage shareholder rights did not require the plan to vote on every proxy or exercise every shareholder right. The new final rule changes that, holding plan fiduciaries to a higher standard in managing plan participants’ shareholder rights. This also applies to a plan’s holdings of individual shares (if any).

The rules will take effect on Jan. 30, 2023, although certain provisions related to proxy voting will not be applied until Dec. 1, 2023.³

The Impact of the DOL Rule – Our Take

The final DOL rule is clearly a positive for investors who participate in employer-sponsored retirement plans. It allows plan fiduciaries to offer investment choices that consider ESG factors, as long as those factors do not take priority over financial returns.

We were pleased to see that the DOL rule goes beyond climate change, acknowledging that social issues (such as human capital management) and governance factors can have a material impact on an investment’s risk/return characteristics.

However, this does not mean a plan’s investment offerings will change automatically. The rule does not require plans to take any action—plan fiduciaries will have to recognize the benefits of doing so. We believe the best way to expand the use of retirement plan investment options that consider ESG factors is to:

• Increase education among both plan participants and plan fiduciaries.

• Provide better reporting on the key ESG factors in the plan’s investment options.

Fiduciaries continue to streamline their plans’ menus of investment choices. Therefore, it will be important to provide clear, jargon-free education about what it means to incorporate ESG factors into the investment process. That means, among other things, explaining the differences between “ESG integration” versus outcome-oriented strategies used in thematic and impact funds (and what those terms mean!). We also believe asset managers should provide plans with information about key ESG factors in their fund offerings.

It is important to remember that the DOL’s position on these (and other) issues can change. After the 2024 election, a new administration could rewrite the rules. The only way to “permanently” change things would be for Congress to amend the regulations that govern employer-provided retirement plans, known as ERISA. With that in mind, while some plans are already adding investment options that include ESG factors, it is not yet clear how the majority of plans will react to the new rule.

It is also worth noting that certain states prohibit their state retirement plans from considering ESG factors when making investment decisions. These plans are generally not subject to ERISA and, therefore, would not be impacted by this rulemaking.

Bottom line: We believe this is a “win” for plan fiduciaries who can now consider ESG-related risks and opportunities when choosing a plan’s menu of investment options. It is also a win for plan participants, who will be free to choose investments that incorporate ESG considerations along with financial and economic factors, assuming their employer’s plan offers that choice.