With publication of a final rule by the U.S. Department of Labor (DOL) in November, considering climate change and other environmental, social and governance (ESG) factors is permitted when selecting investment options for retirement plans and exercising shareholder rights, such as proxy voting for plan-held securities. Allowing retirement plan fiduciaries to consider ESG factors when making decisions for plans was up for debate—and potentially could have been forbidden—under proposed rules from the DOL released in the waning days of the administration of former President Donald Trump.

The rule, “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights,” sets aside the “pecuniary-only” standard at the center of the regulation as proposed in 2020. After President Joseph Biden won the 2020 election and assumed the Presidency, the DOL blocked the proposed rule that restrained retirement plan fiduciaries, such as 401(k) plan sponsors, from weighing ESG factors when choosing investments.

"Today's rule clarifies that retirement plan fiduciaries can take into account the potential financial benefits of investing in companies committed to positive environmental, social and governance actions as they help plan participants make the most of their retirement benefits," said Secretary of Labor Marty Walsh. "Removing the prior administration's restrictions on plan fiduciaries will help America's workers and their families as they save for a secure retirement."

Critics contended that ESG considerations are outside the traditional financial safety and return-on-investment criteria that should be fiduciaries' sole consideration as required by the Employee Retirement Income Security Act (ERISA).

According to the DOL's fact sheet, an important change adopted in the final rule is "the addition of regulatory text clarifying that a fiduciary's duty of prudence must be based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis and that such factors may include the economic effects of climate change and other ESG considerations on the particular investment or investment course of action."

The final rule reverses the 2020 DOL rulemaking and provides fiduciaries with an interpretation of ERISA's fiduciary standards that could allow for the consideration of ESG factors.

The final rule reverses the prior rule's prohibition on using ESG funds as qualified default investment alternatives (QDIAs), which are types of mutual funds that plan sponsors can select as the default option in automatic enrollment 401(k)-type defined contribution plans. Under the rule, standards applied to QDIAs are no different from those applied to other investments.

QDIAs can be target-date retirement funds, which automatically reset their asset mix to become less risky as the specified target retirement year nears. Mutual fund companies have begun marketing target-date funds made up of investments that meet specified ESG criteria.

A second 2020 DOL regulation had aimed to stop what the prior administration viewed as retirement plan fiduciaries casting corporate-shareholder proxy votes in favor of social or political positions that didn't advance the financial interests of retirement plan participants.

Among other changes, the new final rule eliminates the earlier rule's requirement that fiduciaries not participate in proxy votes unless the fiduciary prudently determines that the matter has an economic impact on the plan.

The DOL said the prior regulation created "a misperception that proxy voting and other exercises of shareholder rights are disfavored or carry greater fiduciary obligations than other fiduciary activities."

Breckinridge’s View on the DOL’s Decision

Breckinridge is supportive of the DOL’s decision. As our clients and readers know, ESG analysis plays a key role in helping us carry out our primary objectives of preserving capital while striving to build a reliable source of income and taking advantage of opportunities to improve total return. We believe integrating ESG considerations into traditional financial analysis enables our investment team to gain deeper insight into the underlying risk and value of an investment.

While we are heartened by the decision, we acknowledge that the various DOL ESG guidance interpretations over the past several years have been influenced by politics. As we’ve written, we believe the political discussions related to ESG are misguided. We believe that dismissing or ignoring material ESG risks is a pernicious and compounding risk for investors. With regard to pricing risk, the intent of ESG analysis is to improve security selection with a goal of producing favorable risk-adjusted returns. ESG analysis considers extra-financial factors that may not be included in traditional fundamental security analysis. The goal is not to boycott securities or sectors based on non-financial factors but to identify overlooked investment risks and opportunities. In the end, we hope the DOL’s decision will stand under future administrations. We remain committed to considering material ESG factors as a way to manage investment risk.

Disclaimers:

This material provides general and/or educational information and should not be construed as a solicitation or offer of Breckinridge services or products or as legal, tax or investment advice. The content is current as of the time of writing or as designated within the material. All information, including the opinions and views of Breckinridge, is subject to change without notice.

Any estimates, targets, and projections are based on Breckinridge research, analysis, and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.

Past performance is not a guarantee of future results. Breckinridge makes no assurances, warranties or representations that any strategies described herein will meet their investment objectives or incur any profits. Any index results shown are for illustrative purposes and do not represent the performance of any specific investment. Indices are unmanaged and investors cannot directly invest in them. They do not reflect any management, custody, transaction or other expenses, and generally assume reinvestment of dividends, income and capital gains. Performance of indices may be more or less volatile than any investment strategy.

Performance results for Breckinridge’s investment strategies include the reinvestment of interest and any other earnings, but do not reflect any brokerage or trading costs a client would have paid. Results may not reflect the impact that any material market or economic factors would have had on the accounts during the time period. Due to differences in client restrictions, objectives, cash flows, and other such factors, individual client account performance may differ substantially from the performance presented.

All investments involve risk, including loss of principal. Diversification cannot assure a profit or protect against loss. Fixed income investments have varying degrees of credit risk, interest rate risk, default risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. Income from municipal bonds can be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the IRS or state tax authorities, or noncompliant conduct of a bond issuer.

Breckinridge believes that the assessment of ESG risks, including those associated with climate change, can improve overall risk analysis. When integrating ESG analysis with traditional financial analysis, Breckinridge’s investment team will consider ESG factors but may conclude that other attributes outweigh the ESG considerations when making investment decisions.

There is no guarantee that integrating ESG analysis will improve risk-adjusted returns, lower portfolio volatility over any specific time period, or outperform the broader market or other strategies that do not utilize ESG analysis when selecting investments. The consideration of ESG factors may limit investment opportunities available to a portfolio. In addition, ESG data often lacks standardization, consistency and transparency and for certain companies such data may not be available, complete or accurate.

Breckinridge’s ESG analysis is based on third party data and Breckinridge analysts’ internal analysis. Analysts will review a variety of sources such as corporate sustainability reports, data subscriptions, and research reports to obtain available metrics for internally developed ESG frameworks. Qualitative ESG information is obtained from corporate sustainability reports, engagement discussion with corporate management teams, among others. A high sustainability rating does not mean it will be included in a portfolio, nor does it mean that a bond will provide profits or avoid losses.

Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.

The effectiveness of any tax management strategy is largely dependent on each client’s entire tax and investment profile, including investments made outside of Breckinridge’s advisory services. As such, there is a risk that the strategy used to reduce the tax liability of the client is not the most effective for every client. Breckinridge is not a tax advisor and does not provide personal tax advice. Investors should consult with their tax professionals regarding tax strategies and associated consequences.

Federal and local tax laws can change at any time. These changes can impact tax consequences for investors, who should consult with a tax professional before making any decisions.

The content may contain information taken from unaffiliated third-party sources. Breckinridge believes the data provided by unaffiliated third parties to be reliable but investors should conduct their own independent verification prior to use. Some economic and market conditions contained herein have been obtained from published sources and/or prepared by third parties, and in certain cases have not been updated through the date hereof. All information contained herein is subject to revision. Any third-party websites included in the content has been provided for reference only. Please see the Terms & Conditions page for third party licensing disclaimers.