New Rule Would Threaten ESG Stewardship
By Frederick Alexander and Holly Ensign-Barstow
On June 30, the U.S. Department of Labor proposed a new rule, innocuously titled “Financial Factors in Selecting Plan Investments.” DOL rules are supposed to ensure that the people who administer retirement plans focus solely on securing adequate retirement benefits under their plan.
This new proposal, however, is not really intended to protect workers and retirees; instead, it seems calculated to score political points. The gist of the proposal is to make it more difficult for retirement plans to incorporate environmental, social, and governance (ESG) factors into their investing philosophy. For example, if a pension plan hires an asset manager that uses environmental measures like carbon emissions or social metrics such as prevalence of human rights abuses in a supply chain, the proposed rule would place a heavy burden on the plan to show that such an analysis is financially relevant. And for a 401(k) plan, the rule would prohibit a mutual fund that used such measures from being a default option.
These rules are clearly based on an animus toward social and environmental responsibility rather than a desire to protect retirement plans. The key “tell” is the complete lack of evidence in the release that explains the new rule. As many correspondents have pointed out, there is a great deal of evidence to the contrary. In fact, more than 1,500 comments were filed in the unusually short time allowed for comment as the administration tries to rush this rule through before Inauguration Day. This comment does an excellent job collecting that evidence.
B Lab and the Shareholder Commons joined together to submit a comment as well, and the full text is available here. Rather than focusing on the ample evidence that analyzing ESG factors is a necessary facet of investment management in the 21st century, we focused on the deleterious effect that the rule will have on the ability of pension plans to use their rights as shareholders to influence corporations to behave more responsibly.
The following is a summary of our comment letter:
The Department of Labor’s proposed new rule on ESG investing will interfere with the obligations of retirement plans with respect to “stewardship,” thereby harming retirement plans. Stewardship includes proxy voting and other methods that shareholders use to influence the social and environmental impact of the companies in their portfolios.
Stewardship allows shareholders, including pension plans, to vote against management at corporations that earn profits by creating social and environmental costs that the rest of the economy must bear. Even though individual companies may benefit financially from such activities, they hurt the securities market overall.
Stewardship of ESG matters by retirement plans is necessary to protect portfolio value from this risk. The DOL should encourage such activity by plans because sound social and environmental systems increase the overall financial returns of investors by creating a healthy economy. Instead, the proposed rule will discourage such stewardship, leading to more degradation of critical social and environmental systems.
This argument is set forth in more detail below.
Diversification and the Importance of Overall Market Return
Sound investing requires diversified portfolios. This principle is reflected in ERISA itself, which requires retirement plans to diversify. The wisdom of a diversified investment strategy can be summarized through the philosophy of the late John Bogle, founder of Vanguard, one of the largest mutual funds companies in the world: “Don’t look for the needle in the haystack; instead, buy the haystack.”
But once a portfolio is diversified, its ability to make money is almost entirely determined by how all companies perform on average, not how the companies in that portfolio perform relative to other companies. As a result, pension funds must focus on raising the return of the entire stock market, and not just individual company performance.
Market Return and ESG
This distinction between individual company return and overall market return is important because an individual company might earn a profit but generate a lot of costs it does not pay. For example, a company does not have to pay the full costs of its harmful emissions, resource depletion, and contribution to inequality. But those costs are paid by others, including consumers, communities and governments, which in turn harms the other companies that are in the portfolios of diversified shareholders. Thus, when companies externalize costs in order to raise their own profits, other companies suffer, which brings down the overall market return of securities. As a result, retirement plans receive a lowered return.
A recent study by a major asset manager showed just how serious this problem is. It discerned external costs attributable to publicly listed companies globally are equal to 55% of their profits. Our global economy is thus less than half as productive as corporate profits would indicate, and as the economy absorbs those costs, growth and productivity will inevitably fall, leading to decreased overall market returns. For example, one recent financial analysis shows a 6% increase in global GDP if the world abides by the Paris Agreement. Inequality perpetuated by corporate conduct also has devastating economic (and human) costs as shown in Heather Boushey’s Unbound: How Inequality Constricts Our Economy and What We Can Do about It.
The Need for ESG Stewardship
Given the critical importance of overall market return, and the danger to that return from corporate activities the damage social and environmental systems, plan beneficiaries clearly need protection from individual companies that improve their own performance with behaviors that damage overall market return. In order to protect themselves, retirement plans must use their power over corporations to end conduct that exploits common resources.
Because investors collectively have the power to vote against management, they have the power — and the responsibility — to steward companies away from abusive activities and towards authentically productive profits. A recent report from PRI, a coalition of asset owners and managers representing $89 trillion of assets under management, reaches this conclusion: Collective investor action to manage social and environmental systems is needed in order to satisfy the fiduciary duties of investment trustees.
For all of the reasons expressed above, we propose that the rule be withdrawn or modified to clarify that ESG actions are not disfavored and that ESG stewardship must be considered by plans in order to fulfill their statutory fiduciary duties. More specifically, we respectfully request that the final rule include assurance that plans will not be penalized for allocating resources to stewardship intended to protect social and environmental systems and to thereby increase the return of the plan on its diversified portfolio.
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B The Change gathers and shares the voices from within the movement of people using business as a force for good and the community of Certified B Corporations. The opinions expressed do not necessarily reflect those of the nonprofit B Lab.
B Lab and The Shareholder Commons Join to Ask the Department of Labor to Withdraw Proposal was originally published in B The Change on Medium, where people are continuing the conversation by highlighting and responding to this story.