What Comes Next With ESG Regulations?

In early May of this year, President Joe Biden signed an expansive executive order aimed at addressing the current and future impacts of climate change.

For the retirement planning industry, perhaps the most directly important part of the order was an instruction to the U.S. Secretary of Labor to consider suspending, revising or rescinding the “Financial Factors in Selecting Plan Investments” final rule that was put in place by the Department of Labor (DOL) under the Trump administration in the summer and fall of 2020. That rule—which is currently final and enforceable—regulates and in some cases restricts the use of environmental, social and governance (ESG) focused investments by participants in employer sponsored retirement plans governed by the Employee Retirement Income Security Act (ERISA).

Biden’s 2021 executive order asked Labor Secretary Marty Walsh to identify what actions the DOL can take under ERISA and the Federal Employees’ Retirement System Act to “protect the life savings and pensions of United States workers and families from the threats of climate-related financial risk.” In stark contrast, the final rule the DOL implemented last year sets forth detailed guidance establishing that retirement plan sponsors should only consider “pecuniary,” or performance-related, factors when selecting investments for their investment lineup.

Although the final 2020 rule did not expressly limit the use of ESG funds, given its framing around the pecuniary concept, experts argued it will still likely have that effect if/when enforced. This is because fiduciaries would seemingly have to comb through an ESG fund’s prospectus and marketing materials for any references to non-pecuniary factors being used in the investment process. Such requirements present potentially significant legal risk to fiduciaries and, therefore, may deter some from considering ESG funds.

Importantly, the Biden administration early on adopted a nonenforcement policy regarding the 2020 final rule, and at this juncture the retirement plan industry is eagerly waiting for new ESG regulations to be proposed. Some sources expect language to emerge as soon as the end of this month or potentially during September.

Given President Biden’s words and actions regarding the importance of fighting climate change, experts say it is almost certain that the current DOL will move in a new direction on this issue compared with the prior administration. That said, the new proposal itself may not have to be radically different from the pecuniary-focused framework already in place, in part because the final version of the rule included important changes relative to the proposal. Chief among these changes is the fact that the text of the final rule no longer refers explicitly to “ESG” as an investment theme that deserves additional scrutiny. Rather, as noted, it presents a framework that emphasizes that retirement plan fiduciaries should only use “pecuniary” factors when assessing investments of any type—which is to say that they should only use factors that have a material, demonstrable impact on performance.

In this sense, the existing rule does seem to leave substantial room for the use of ESG-minded investments, presuming these types of investments are assessed in a purely economic manner and that their financial features make them prudent investments. As such, sources suggest the Biden administration could build on this approach and either develop sub-regulatory guidance that states ESG factors are in general to be considered pecuniary for long-term retirement savings programs, or it could take the more substantial step of proposing a full regulation establishing this concept even more firmly.

Beyond the regulatory outlook, the prospects for ESG investing in the U.S., both inside and outside tax-advantaged retirement plans, appears positive. In addition to the demand building among investors themselves—both individual and institutional—lawmakers are moving on the issue, too. U.S. Senators Tina Smith, D-Minnesota, and Patty Murray, D-Washington, and U.S. Representative Suzan DelBene, D-Washington, have introduced legislation in both chambers of Congress that they say would provide legal certainty to workplace retirement plans that choose to consider ESG factors in their investment decisions or offer ESG investment options.

The bill, called the Financial Factors in Selecting Retirement Plan Investments Act, would amend ERISA directly to make it clear that plans may consider ESG factors in their investment decisions—provided they consider such investments in a prudent manner consistent with their fiduciary obligations. The legislators note that this is the same legal standard that ERISA already applies to non-ESG investment factors.

Elsewhere in Washington, the U.S. Securities and Exchange Commission (SEC) has created a Climate and ESG Task Force in the Division of Enforcement. Consistent with increasing investor focus and reliance on climate and ESG-related disclosure and investment, the Climate and ESG Task Force will develop initiatives to proactively identify ESG-related misconduct. The task force will also coordinate the effective use of division resources, including through the use of sophisticated data analysis to mine and assess information across registrants, to identify potential violations.