Public, Private Pensions Set to Collide Over ESG Investing (1)

A US Labor Department plan to ease restrictions on green private-sector retirement investing is on track for release later this year amid a new wave of red-state anti-ESG policies clouding what was supposed to be a victory for socially-conscious investors.

The political environment in which DOL’s Employee Benefits Security Administration will likely issue the new final environmental, social, and corporate governance investing rule is starkly different from a year ago when the proposed version was made public.

More than a dozen Republican state legislatures have passed or proposed bills that blacklist ESG-friendly money managers or ban ESG investing altogether. Almost an equal number of blue states have implemented or are weighing legislation that encourages the consideration of environmental factors in pension investments or restricts public funds from investing in gun companies or polluters.

Those disparate approaches are setting the stage for a retirement industry deeply divided on how best to—or even whether to—account for climate change, social justice, and workers’ rights movements in their investment decision making, while the accounts of millions of US workers and retirees hang in the balance.

The Labor Department doesn’t directly exercise any regulatory authority over public pension plans, the retirement accounts covering state employees like police officers, teachers, and firefighters. State pension plans conversely don’t set policy for private-sector workers who are usually subject to strict fiduciary standards of care under federal control.

But the public and private wings of the retirement industry do influence each other and have worked in near perfect harmony for decades, observers said. “Do-good” retirement investing, they say, could put them on a collision path like never before.

“States don’t just look to the Department of Labor for guidance, they basically all copy Labor Department fiduciary standards word-for-word,” said Josh Lichtenstein, a partner at Ropes & Gray LLP in New York. “When you start being more divergent in the interpretations of the same fiduciary standards under federal and state laws, it raises legitimate questions about what happens next.”

ESG Showdown

The EBSA rule, in its final review at the White House, reverses a Trump administration policy limiting investment strategies to financial interests. The Biden administration’s proposal would make it clear that the way a potential investment helps or harms the environment, workers, or social causes can be and sometimes is strictly an economic consideration.

“ESG risks are financial risks,” said Steven Rothstein, managing director of the Ceres Accelerator for Sustainable Capital Markets. “It’s not politics. If you believe in a free market, let the market speak.”

Environmental nonprofits praised the Labor Department’s October 2021 proposed rule for striking a careful balance between fiduciary constraints and environmental interests.

ESG investment criteria have since come under fire from Republican politicians who claim the department is thumbing the scale in favor of such investments.

As states ban these ESG criteria for their own pension plans, they’re cutting ties with federal regulations they’ve closely followed on other investment-related questions for years. The Employee Retirement Income Security Act of 1974 defines a strict fiduciary standard of care almost all pension plan professionals have long followed.

Not only do states tend to mirror DOL fiduciary policies on paper, but many of the third-party practitioners who advise them don’t make any real distinctions between the state- and federally-regulated plans for which they work.

As the Labor Department seems poised to make ESG a permissible part of the investment decision-making process, and certain states are banning this type of investing altogether, attorneys and companies that do work for both types of plans could be left choosing one or the other.

“Many lawyers who work in this space treat ERISA and the DOL as offering best practices,” said David Webber, a professor at the Boston University School of Law.

Sustainable investment strategies account for nearly a third, or $17 trillion, of professionally managed US investments, according to the Forum for Sustainable and Responsible Investment (US SIF).

“The markets are saying that E, S, and G are already in the mix of investment decisionmaking, said Bryan McGannon, US SIF director of policy and programs. “These state-led attacks on ESG retirement investing are politically motivated, not financially motivated or in the best interest of retirement beneficiaries.”

While ESG retirement investing has been more popular in private- and public-sector pension plans, only about 3% of US 401(k) plans offer an ESG fund, and less than 1% of retirement assets under management are sustainably invested. The Biden administration’s proposed ESG rule, combined with state anti-ESG rhetoric, could flip that dynamic, McGannon said.

Companies such as BlackRock Inc. and UBS Group AG that have made ESG investing a priority are among states’ primary targets. They’re set to lose millions of dollars in public-sector pension business as right-leaning states steer their money elsewhere.

ESG also held up Biden’s nominee to lead EBSA, as Republican lawmakers in Congress who failed to probe New Jersey attorney Lisa Gomez on the ESG rule during her first round of committee questioning sought answers from her on the issue later.

She said in written responses to the Republican questions that it was appropriate for the department to issue its updated ESG regulation because the Trump-era rules “chilled the use of ESG factors, even when they were directly relevant to the merits of the financial decision or simply broke the tie” between otherwise equal investment options.

The timing even suggests that ESG retirement investment criteria played a role in delaying the implementation of the rule until Gomez had been confirmed by the Senate, said Kathleen Wechter, counsel at Arnold & Porter Kaye Scholer LLP.

The Senate confirmed Gomez to the assistant secretary post Sept. 29 by a vote of 49-36. The department forwarded the final rule to the White House for review less than a week later.

Labor Department officials say there wasn’t a delay in the movement of the ESG rule, despite the yearlong wait.

“Given the range of competing views, the requirements of the Administrative Procedure Act, and the Department’s commitment to thoughtfully addressing comments, the regulation has moved with appropriate speed through the process,” said Principal Deputy Assistant Secretary Ali Khawar.