Commentary on New Department of Labor Guidance

On April 24^th, the US Department of Labor (DOL) released a Field Assistance Bulletin (FAB), seeking to clarify how environmental, social and corporate governance (ESG) factors should be considered under the Employee Retirement Income Security Act (ERISA).

The essential messages conveyed by the DOL in the new FAB include that fiduciaries must avoid too readily treating ESG issues as being economically relevant to any investment decision, and that fiduciaries may not regularly incur significant costs to fund active ownership efforts, including shareholder resolutions or proxy battles, which are not clearly connected to long-term value creation.

The DOL’s guidance regarding ESG incorporation reflects a shift in stance from its Interpretive Bulletin (IB) provided in 2015, which clarified that plan fiduciaries should appropriately consider ESG factors, as they may have a direct relationship to financial risk and return. The 2015 IB sought to clarify a 2008 ruling, which the DOL feared had “unduly discouraged fiduciaries from considering [economically targeted investing] ETIs and ESG factors”.[i] In speaking with reporters, then Labor Secretary Thomas Perez noted that as reflected in the 2015 IB, ERISA no longer viewed ESG investing to have “the cooties”.[ii]

While the new FAB may be perceived as part of the ebb and flow in guidance that fluctuates with political administrations, importantly, the language does not nullify any sections of the 2015 IB. Thus, the ultimate impact of the FAB may be limited, as the overarching trend in DOL guidance appears to remain in support of the integration of material ESG factors.

Fundamentally, we agree with the DOL’s comments that ESG issues can represent a material business risk or opportunity to a given company, but specific ESG issues are not equally material across all sectors. However, the DOL’s conflation of different responsible investment strategies, and hedging of the financial relevance of ESG factors may lead to some confusion.

Investors can take a wide variety of approaches to responsible investment. Three prevalent approaches are: values-based, ESG integration and impact-focused. An important difference in these approaches is the intent of the strategy. While values-based and impact-focused strategies may not always prioritize financial returns, in lieu of generating positive societal or environmental outcomes, ESG integration strategies are predicated upon delivering superior risk adjusted returns. For example, the CFA Institute broadly supports an approach of ESG integration, as it “encourages the incorporation of ESG data into the investment process so that investors can be more informed about the decisions they are making. This approach sees value in the incorporation of ESG data into the investment process, but it is agnostic on the value-investing argument more pertinent in the [socially responsible investing] SRI community.”[iii]

With intangible assets now representing approximately 85% of the S&P 500’s market value, understanding company performance on a wide range of criteria beyond financial statements is increasingly imperative.[iv]  ESG indicators can also help inform assessments about the capacity of companies to address emerging risks, ranging from water scarcity to human capital and data privacy.[v]

A possible outcome of implementing an ESG integration strategy with a rationale of financial materiality is that the resulting portfolio may be more aligned with positive social or environmental norms. In this sense, there may be some blurring of the lines between the three outlined responsible investment strategies, however ancillary positive environmental/social outcomes should not negate the fiduciary spirit of such strategies. Moreover, many thematic ESG strategies (e.g. Gender Diversity, Low Carbon) may be perceived as being motivated by normative considerations but in truth are built on a financial value proposition.[vi]

Through the new FAB, the DOL recognizes that shareholder engagement can be a component of prudent plan management but cautions that “plan fiduciaries may not increase expenses, sacrifice investment returns, or reduce the security of plan benefits to promote collateral goals”.[vii] Akin to the DOL’s comments regarding ESG integration, this language seems to understate the importance of active ownership in protecting and enhancing value over the long-term. For example, while climate change themed engagements may be perceived by some as the pursuit of a political goal, efforts to understand a company’s climate change risk and related strategies can be a critical component of a thorough and diligent investment process. Research focused on studying abnormal returns following ESG engagements supports the view that engagements on these topics can be effective in generating strong returns.