The Department of Labor (DOL) is warning private-sector employee benefit plan fiduciaries not to give too much weight to the environmental, social and governance (ESG) impact and responsibility goals when selecting investments.

In Field Assistance Bulletin (FAB) 2018-01, issued May 7, the DOL instructed fiduciaries not to "too readily treat ESG factors as economically relevant” when selecting investments for clients’ retirement plans. Instead, fiduciaries should consider, “financial factors that have a material effect on […] return and risk."

Investments in strategies that include socially responsible investments have grown substantially in recent years and now comprise more than 25% of global assets under management.

Many interpret the new bulletin as a rebuke of Obama-era DOL guidance that enabled plan fiduciaries to consider ESG factors when evaluating investments. In 2016, the DOL recognized that earlier releases had encouraged, “a misperception that investments in [Environmentally Targeted Investments] are incompatible with ERISA's fiduciary obligations.” 

The Department of Labor’s guidance applies to all retirement plans covered by the Employment Retirement Income Security Act (ERISA). This includes private employer-sponsored defined-benefit (pension) and defined-contribution - 401(k) and IRA plans - as well as union pensions. These assets comprise approximately $20 trillion in assets in the U.S. as of Dec. 31, 2017.

The new guidance has left some ESG experts scratching their heads. Recent studies, including one by KPMG, have shown that ESG-focused investments tend to outperform their non-screened peers and are better able to manage “risks (and opportunities) leading to improved short and long-term value creation.” In a released statement, Abhilash Mudaliar, research director at the Global Impact Investment Network (GIIN), said, “These guidelines unfortunately reflect an outdated view that understands the priority of the investor to be maximization of short-term shareholder profits over everything else.”

Effects on Activist Investing

The new guidance doesn’t just apply to ESG screening. Activist shareholders regularly engage in dialogue with company management and can file a resolution requesting a review of ESG factors and possible change in a firm’s business policies. The updated guidance cautions fiduciaries against ‘routinely’ incurring significant plan expenses to fund such advocacy.  

The effect of this guidance on shareholder coalitions built around specific advocacy objectives, which has been accepted practice for many years in the sustainable and impact investment community, remains to be seen. These coalitions often begin within relatively small shareholder groups, and grow across a network of concerned asset owners. These include large public and private pension plans and foundations, whose boards and trustees act as fiduciaries on behalf of the plans’ income beneficiaries. These ESG-focused shareholder coalitions often pursue a course of advocacy for several years, filing resolutions and actively engaging in dialogue with companies’ senior management.       

The DOL’s interpretation of its updated guidance regarding fiduciaries "routinely" funding such advocacy issues is likely be tested by one or more shareholder resolutions in the future. Prudent investment decision-making by fiduciaries takes into consideration the long-term impact on all affected stakeholders, including all parties in the supply chain. “This includes customers, suppliers, the natural environment and, of course, shareholders," says Mudaliar.

Since 1990, two-thirds of tropical deforestation has been driven by conversion of land for commercial agriculture commodities, such as palm oil, cattle and soy, resulting in the loss of 129 million hectares of forest. Green Century Funds filed the first shareholder proposal on tropical deforestation in 2012, advocating for supply chain accountability. Only five percent of palm oil refineries in Southeast Asia were covered by zero deforestation policies in 2012. By 2017, 74 percent were covered

A coalition of institutional investors representing over $12 trillion in assets under management supported Green Century’s engagement with dozens of companies over a five-year period on deforestation risk in their supply chains. These investors believed that companies like ConAgra Brands, Archer Daniels Midland and Kellogg are less vulnerable to material financial risks and severe reputation damage after agreeing to zero deforestation commitments.

Materiality Matters

The updated DOL guidance does ensure that the primary focus of an ERISA plan fiduciaries will be the financial factors that have a material effect on the risk and return of an investment. This interpretation follows the core principles of the Sustainability Accounting Standards Board (SASB) guidelines for industry and company specific ESG factor consideration. It also supports the investment industry trend to reduce the number of ESG factors that are considered material to performance and risk control.

“The new DOL guidance is correct that, without proper research and resources, it is very possible for investors to swap performance and risk control for ESG exposure,” says Jean-David Larson, director, regulatory and strategic initiatives at Russell Investments. “We agree with the substance of the message: that materiality does indeed matter.”

“In our view, the bulletin affirms the direction that many institutional investors have already been taking in recent years, emphasizing strategies focused on enhancing economic value and differentiating them from ones based primarily on investors’ ethical preferences,” says MSCI’s Linda-Eling Lee. Once again, enhancing economic value has focused investors on models and ratings that reflect only the financially relevant ESG information.

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