Late in the afternoon of the Friday before Election Day, the Department of Labor finalized a rule that requires pension and retirement plan fiduciaries to consider only financial interests when investing plan funds. On its face, the rule seems anodyne. Yet it has provoked a strong negative reaction from fund managers and others who advocate for use of Environmental, Social, and Governance (“ESG”) factors in investing.
This negative reaction is puzzling. Advocates for ESG investing, such as the United Nations and BlackRock’s Larry Fink, argue vociferously that ESG investing makes money while also doing good. The rule requires pension and retirement plan fiduciaries to focus on making money when investing plan funds. So what’s the problem? How could a rule that requires pursuit of profit interfere with an avowedly profitable investment strategy?
The final rule does not prohibit use of ESG factors in pursuit of enhanced risk-adjusted returns. Indeed, the operative text of the final rule does not even mention ESG. Instead, the rule requires that in any investment decision, whether based on ESG factors or otherwise, a pension or retirement plan fiduciary must consider only “pecuniary factors,” that is, factors that are “expected to have a material effect on the risk and/or return of an investment.” The fiduciary may not make an investment decision to “promote non-pecuniary benefits or goals.” The rule applies these principles to all investment strategies, ESG or otherwise.
The final rule largely adopts the position we urged in an article recently published in the Stanford Law Review. For clarity, we referred to ESG investing motivated by providing benefits to third parties or otherwise for moral or ethical reasons as collateral benefits ESG, and ESG investing to improve risk-adjusted returns as risk-return ESG. The final rule’s focus on “pecuniary” versus “non-pecuniary” goals aligns with our taxonomy of “risk-return ESG” and “collateral benefits ESG.” We concluded that risk-return ESG investing is permissible if two conditions are satisfied: (1) the trustee reasonably concludes that ESG investing will benefit the beneficiary directly by improving risk-adjusted return, and (2) the trustee’s exclusive motive for ESG investing is to obtain this direct benefit. In light of the current theory and evidence on ESG investing, we showed that these conditions for risk-return ESG could be satisfied under the right circumstances. We also showed that collateral benefits ESG is generally impermissible.
Some of the strong reaction against the rule may reflect a hangover from the rule as originally proposed. In its original form, the proposed rule did indeed single out ESG investing, deeming it inherently suspect and subjecting it to enhanced scrutiny relative to other investment strategies. Singling out ESG investing for enhanced scrutiny was widely and rightly criticized, including in a 12-page comment letter by us. The leadership at the Department of Labor, supported by dedicated career staff members who have served under presidents of both parties, heard the criticisms of the rule as originally proposed and responded accordingly in the final rule. By dropping any mention of ESG and applying the same rule to all investment strategies, whether ESG or otherwise, the final rule is neutral as between investment strategies.
The final rule closely tracks the text of the Employee Retirement Income Security Act, the governing federal statute, which provides that a pension or retirement plan fiduciary must act for the “exclusive benefit” of the beneficiaries, considering “solely” their interests. Under controlling Supreme Court precedent, this means focusing on “financial benefits.” The final rule is also consistent with Department of Labor positions taken under presidents Barack Obama, George W. Bush, and Bill Clinton that ESG factors may be considered only as financial factors.
To know this, however, one would need to read the final rule and appreciate its differences from the earlier proposal. Yet some critics, such as the Forum for Sustainable and Responsible Investment, issued critical press releases almost immediately after the final rule was released. That timing smacks of blind advocacy rather than thoughtful policy analysis.
Another possible explanation for hostility to the final rule is that some advocates for ESG investing don’t actually believe their own rhetoric. Advocates for ESG investing have long claimed to be “doing well while doing good.” But if this claim is true and can be supported with the sort of reasoned analysis that fiduciary law requires, then a fiduciary wishing to make use of ESG strategies has nothing to fear from a rule that requires investment decisions to be based solely on pecuniary factors. What the rule prohibits is consideration of nonpecuniary factors.
Perhaps some worry that ESG strategies are currently profitable but won’t remain so indefinitely as they become more widely adopted. But fiduciary law requires ongoing and attentive stewardship. If an investment strategy stops working, a fiduciary investing other people’s money must adjust accordingly. Nothing exempts ESG investing, or any other investment strategy, from this sound principle.
The final rule and the statute on which it is based reflect a congressional policy choice that pension and retirement plan funds are to secure the retirement of plan participants. Once retired, a participant can take a distribution and spend it on whatever he or she pleases. But until then, the quid pro quo for the extraordinary tax benefits granted to these retirement plans is the imposition of strict fiduciary duties. The fiduciary stewards of these funds hold them subject to a sacred trust for the sole purpose of securing their participants’ retirement—not for present consumption and not for pursuit of environmental or social goals.
This post comes to us from professors Max M. Schanzenbach at Northwestern University Pritzker School of Law and Robert H. Sitkoff at Harvard Law School. It is based on a pair of recent articles about ESG investing, available here and here.