The US Department of Labor’s New “Investment Duties” rule: When implemented, proposal could limit the growth of ESG investment.
By Rick Pasquier, Partner at Practus, LLP
The U.S. Department of Labor (the “DOL” or the “Department”) issued a release dated June 30, 2020 in which it proposes amendments to the “Investment duties” rule under Title I of the Employee Retirement Income Security Act of 1974 (ERISA). Many early commentators believe that the practical effect of the proposed changes will likely be to discourage pension fund managers and advisors to those funds from selecting investments using criteria that that incorporate express environmental, social and governance (commonly known as “ESG”) considerations. The DOL states that it is taking action to uphold “bedrock principles” under ERISA that require fiduciaries to act with “complete and undivided loyalty to the beneficiaries,” a formulation of the fiduciary duty that is the “highest known to the law.”
The Department’s actions will likely slow the growth of ESG investing, which it acknowledges currently is growing rapidly. According to the proposing release (the “Release”), the DOL is taking these steps to protect retirees and prospective retirees from fiduciaries who might be tempted to use ESG as a screen behind which to make decisions that could harm them.The Department does not cite any evidence that ESG investing strategies underperform traditional investing strategies as a justification for their action tightening constraints on the decisions of fiduciaries. The most generous view would say that with this proposal the Department of Labor is telling fiduciaries to take special care before committing beneficiary’s retirement savings to thinly justified “do-good” schemes to increase their own prestige. The least generous view is that the Department is choosing to act now to slow ESG in order to gain credit with the Administration’s backers with close ties to traditional industries reliant on fossil fuels.
Well-advised fund managers will be able find ways to continue to invest in ESG vehicles despite the new rule’s requirements. Including ESG investments in pensions governed under ERISA are not forbidden by the proposed rule. Investment managers and advisers will need to defend their choice of ESG investment strategies as being driven solely by “pecuniary factors” and on “material economic considerations.” Fiduciaries in the pension and self-directed retirement plan arena will need to carefully weigh the risks of ESG investing and take steps to improve record-keeping to document more thoroughly the methods by which they decide on such investments.
Comments on the proposal are due by July 30, 2020.
Brief Summary of the New Rule
The DOL explains in the Release that the new rule is essentially designed to “restate” existing law and clear up inconsistencies in sub-regulatory guidance offered from time-to-time and published in the Federal Register.
Subparagraph a of the proposed rule simply restates the statutory language of the “exclusive purpose” requirements in Section 404(a)(1)A) of ERISA and the “prudence duty” in Section 404(a)(1)(B) of ERISA. Subparagraph b of the proposed rule provides additional gloss on the “core principles” behind the sole purpose requirement that fiduciaries not act to subordinate the interests of participants or beneficiaries to their own or another’s interests. Investments and investment courses of action need to be evaluated solely on the basis of “pecuniary factors and not on the basis of any non-pecuniary factor.” Furthermore, the fiduciary must not:
“subordinat[e] the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to unrelated objectives, or sacrifice[e] investment return or tak[e] additional risk to promote goals unrelated to those financial interests of the plan’s participants and beneficiaries or the purposes of the plan.”
The proposed rule defines what it means to give “appropriate consideration” to the various facts and circumstances. The proposed definition makes clear, consistent with past guidance, that “appropriate consideration” must weigh how a particular investment fits into the purposes of the plan, including how the level of diversification, degree of liquidity, potential risk and return and assessments of “how an investment course of action compares to available alternative investments or investment courses of action” related to these factors.
Subparagraph c of the proposed rule contains new language that specifically addresses ESG factors. Use of ESG factors cannot result in selecting an investment which does not offer “pecuniary” advantages to the participant or beneficiary, either in the sense of having worse prospects for financial returns or involving additional risks above those of similar investments where ESG factors are not considered. The Release explains that “a fiduciary’s evaluation of an investment must be focused only on pecuniary factors.” Further, the proposed rule states that:
“Plan fiduciaries are not permitted to sacrifice investment return or take on additional investment risk to promote non-pecuniary benefits or any other non-pecuniary goals. Environmental, social corporate governance, or other similarly oriented considerations are pecuniary factors only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories.”
The DOL does not propose to repeal past guidance to the effect that ESG factors can be used to “break a tie” between investment options that have otherwise “like” prospects for financial returns and risk profiles. The Release nevertheless contains language expressing doubt as to whether these “ties” actually exist and seeking comments from the public that could help the DOL evaluate whether this hypothesized “tie-breaking” scenarios actually come to pass in the real world. The proposed rule imposes additional record-keeping requirements in cases where “non-pecuniary” factors are used to break ties to document why investments were determined to be “indistinguishable” and why the investment was chosen based on the “appropriate consideration” criteria in Subsection b(2) of the rule.
Section c(2) of the proposed rule provides revised guidance on fiduciary standards for individual account plans like the typical defined contribution 401k plans where the participant picks among a select group of investment funds. Fiduciaries must use only “objective” risk-return criteria in selecting and monitoring investment alternatives for the plan including any ESG-oriented investment alternatives. The rule requires that individual account plan fiduciaries adequately document their selecting and monitoring of investment alternatives and prohibits ESG funds or strategies from being used as component of any default investment alternative (i.e. QDIAs) offered to those participants who make no affirmative selection.
The New Rule in Context: Will it reduce innovation?
It is impossible to predict with precision the extent to which the DOL’s proposed rule will slow the growth of ESG investing. On the one hand, it increases record-keeping requirements and would appear to exclude entirely the inclusion of funds that expressly pursue “non-pecuniary” goals such as “impact” funds. ESG factors can still be used if they are related to material economic factors that directly affect risk-return measures that are “pecuniary.” One expected result might be that managers of ESG funds stop adding disclosure warning investors that a selection based on ESG factors might come at the expense of future return prospects or raise additional risks. More effort might be spent by these managers to explain how the choice of ESG factors directly impacts expected returns and likely risks. Other fund managers may simply shun ESG funds or cease use of “negative screens” based on ESG criteria entirely to avoid violating the new “Investment duties” rule.
The impact of the “clarifications” of past guidance offered in the rule could have a significant impact on ESG investing. The Department nevertheless is proceeding despite the fact that it cannot cite any evidence that the interests of pension beneficiaries or participants have been adversely affected by use of ESG criteria in conformity with past Department guidance. This is likely because no such evidence exists. Indeed, there were reports in the media that ESG or “sustainable” themed funds outperformed the market during the post-COVID-19 market turmoil. There is no reliable or consistent evidence that ESG investments consistently outperform or underperform the market. In its Global Financial Stability Report published in October 2019, the IMF found the performance of “sustainable” funds is comparable to that of conventional equity funds. The timing of this proposal raises questions about the nature of the Department’s goals. Is it to protect the interests of pension beneficiaries and participants, or to serve other goals? Clues towards answering this question might be found in the Department’s decision to define the duties of the fiduciary in terms of new regulatory concepts: “pecuniary factors,” “material economic considerations” and “generally accepted investment theories.” These terms deserve to be analyzed critically.
The DOL’s proposal is premised on notions that “pecuniary factors” are self-evident and can be separated from “non-pecuniary factors” in a neat and tidy way. On the one side, “pecuniary factors” are presumably based on “the numbers” and “objective” criteria recognized under “generally accepted investment theories.” On the other side, according to this reasoning are merely qualitative judgments based on “other factors” such as ESG factors which the authors of the proposal apparently believe typically are “non-pecuniary” or “non-economic” in nature. The language of Subsection c(1) of the rule quoted above makes clear that the Department thinks that there is a clear dividing line between “pecuniary” and “economic” factors and “non-pecuniary and non-economic” factors on the other. The Release also refers to “objective” criteria which are linked closely to “pecuniary factors.” Presumably “other factors” are “non-objective” and hence “subjective.” This clean distinction does not survive close scrutiny.
The language of the rule related to “material economic considerations and generally accepted investment theories” would appear to reference the standard capital asset pricing models (CAPM) like those popularized in the wake of the work of Jack Traynor, John Lintner and William Sharpe. The Department itself posts a link to a memo written by Stan Panis and Josh Schaeffer of Deloitte Financial Advisory Services to Joseph Piacentini of the Employee Benefits Security Administration dated July 11, 2007 outlining a suggested definition“Generally Accepted Investment Theories.” . standard CAPM, the value of an investment is determined by calculating the discounted present value of the stream of income the investment will generate, adjusted by its market risk or beta. The basic valuation based on discounted present value assumes that the investment will be held for its life, which is hardly ever the case with respect to assets held in most retirement plans. The value of an investments over any relevant horizon also must also relate to the price at which the investments trade in the market over a much shorter time horizon. The strong version of the efficient market hypothesis (EMH) holds that this difference in time horizon doesn’t matter, because the “price is always right” (i.e., in liquid markets the price of an individual reflects its risk-adjusted long-term value). According to EMH the price of a financial asset reflects all of the information known and that price is “best” in the sense of being a distillation of all informed observers’ best estimate of the underlying value of the investment. Any new information that arises is instantly factored into the price as opportunistic traders pursue any mispricing and by their trades make it go away.
The classical “strong” version of EMH has come under withering, and some would argue devastating, critique by academics coming out of the empirical or “behavioral” schools of economics. A useful popular summary of the case made by behavioral economics on EMH is contained in Richard Thaler’s 2015 memoir Misbehaving: The Making of Behavioral Economics. The best academic reference point for the debate are the proceedings of the famous 1986 Conference on Psychology and Economics held at the University of Chicago. CAPM itself has come under sustained critique as well. Information is not free. Beliefs about the state of the present and especially the likely shape of the future are not infallible. Market participants can cling to incorrect beliefs for extended periods of time, such as during pricing bubbles that pop when beliefs about the state of the world and the future change suddenly. Thus, behavioral economics teaches that prices of financial assets are not always “right.” In fact, systematic mispricing can exist and not be corrected by arbitrage. Sometimes the same investment can carry two different prices. This has been found to be true in the case of corporate spin-offs and closed-end mutual funds.
Because information is not free and beliefs can be incorrect, there is a role for market regulation. To make sound investment decisions, market actors need good information about the present and the future. Future prospects are not always accurately reflected in current stock prices. The SEC’s integrated disclosure system is a good example of how regulation can fill the information deficit. Investment analysts digest historic financial- and non-financial information and company guidance on future prospects and risk. The SEC has encouraged issuers to provide forward-looking non-financial information to help investors assess future opportunities and risks. Guidance on future financial results is always built on assumptions. Assumptions about future markets. Assumptions about future costs. Assumptions about the future legal, regulatory and political environments. These assumptions cannot be evaluated without reference to broad considerations which go beyond the “numbers” which the naïve believe drive economics. The growth of ESG investing is driving a demand for better information on the drivers of future value: environmental impact; long-term trends in energy usage; political trends; and the role of corporate culture in building value. Better information and more standardization and disciplined scrutiny of non-financial data hold the promise of improving investment returns.
There is also a time-horizon issue. Again, EMH says that today’s stock price reflects the state of actual knowledge of the future of the company. But such future is unknowable and there is a good reason to want it that way. Theorists of innovation like Vijay Govindarajan believe that the fastest-growing companies are those that devote a significant share of management and financial resources to the tasks of clearing out the old and building the new. This requires that the Company not abandon the every-day tasks of managing the current business; but, over time, a company must devote significant resources and management attention to anticipating and capitalizing on discontinuous change. This means placing small but decisive bets on future businesses very different than the existing business (sometimes even that cannibalize the existing business) and continuing to update those bets as better information is available. This paradox has implications for the sharp distinction between hard “numbers” of economics (“pecuniary factors”) and supposedly “non-objective” “non-pecuniary” “other factors” such as ESG.
The funds flowing into ESG investment strategies are demanding better information about more factors than those that drive current returns, the quality of which will only improve with the maturation of the voluntary initiatives such as Global Reporting Initiative (GRI), Integrated Reporting Council (IIRC), Sustainable Accounting Standards Board (SASB) and CDP (formerly known as the Carbon Disclosure Project). The Investor-as-Owner Subcommittee to the SEC Investor Advisory Committee has recommended that the SEC amend its disclosure rules to promote better standards for ESG disclosure. This proposal moves in the opposite direction. To the degree that the DOL’s amended rule on “Investment duties” reinforces a defensive focus on current results and short-term horizons, it could have the paradoxical result of chilling innovation and in the long run hurt the workers and retirees that the DOL is supposed to protect.