The Labor Department proposed a rule Tuesday that will govern how the $10.7 trillion invested in private pension plans should be managed in light of the push to consider the environment, social factors and corporate governance, or ESG, when making investment decisions.
According to Morningstar, from 2018-19 flows into “sustainable” funds increased nearly fourfold, and the number of conventional funds claiming to consider ESG factors rose to 564 from 81. More than 3,100 institutional investors and businesses that provide investor services have signed the United Nations Principles for Responsible Investment.
Many investors understandably want to do good while also doing well. But the standards for ESG investing are often unclear and sometimes contradictory. Researchers at the Massachusetts Institute of Technology’s Sloan School of Management analyzed the methods of six different ESG rating providers and found that their approaches—and results—diverged significantly. In a comparison of two providers’ rating systems, Research Affiliates found a wide gap in the same companies’ scores. Facebook received a top environmental score from one provider and below-average from the other.
Other studies show that when investments are made to further a particular environmental or social cause, returns unsurprisingly suffer. Many managers likely find it challenging to keep their fees low while verifying that an investment offers the ESG benefits its proponents claim. The Securities and Exchange Commission recently solicited public comment on the appropriate treatment of funds that use terms such as “ESG” in their names, and whether these terms are likely to mislead investors.
ESG investing poses particular concerns under the Employee Retirement Income Security Act, or Erisa, the federal law governing private retirement plans. At the heart of Erisa is the requirement that plan fiduciaries act with an “eye single” to funding the retirements of plan participants and beneficiaries. This means investment decisions must be based solely on whether they enhance retirement savings, regardless of the fiduciary’s personal preferences.
The department’s proposed rule reminds plan providers that it is unlawful to sacrifice returns, or accept additional risk, through investments intended to promote a social or political end. Sometimes, ESG factors will bear on an investment’s value. To give an obvious example, if a factory is leaching toxic chemicals into groundwater, lawsuits and regulatory action are likely to follow, sapping profits. A corporation with dysfunctional management will also typically be a poor investment.
But ESG factors often are touted for reasons that are nonpecuniary—to address social welfare more broadly, rather than maximize returns. One prominent firm’s manager has said that its funds may choose investments that offer a below-market rate of return but further the firm’s goal of having a “positive effect on corporate behavior and to promote environmental and social progress.” That trade-off may appeal to some investors, but it is not appropriate for an Erisa fiduciary managing other people’s retirement funds.
What if two potential investments are economically indistinguishable—can nonpecuniary ESG factors be used as a “tiebreaker”? While we are skeptical that such “ties” often occur, the proposed rule would permit consideration of nonpecuniary factors to break a tie, so long as the fiduciary examines the ESG claims carefully and documents the basis for its conclusion. The proposal would also allow a 401(k) plan to include an ESG fund among its investment options, provided it is selected through appropriate diligence based on pecuniary considerations and participants aren’t enrolled in it by default.
ESG investing often marches under the same banner as “stakeholder capitalism,” which maintains that corporations owe obligations to a range of constituencies, not only their shareholders. Erisa requires something different of retirement plans, however: A fiduciary’s duty is to retirees alone, because under Erisa one “social” goal trumps all others—retirement security for American workers.
Mr. Scalia is U.S. labor secretary.
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June 24, 2020 at 06:43AM
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