How a proposed Labor Department rule would help protect retirement savings from climate risk
(This article was co-authored by Alex Song of the Institute for Policy Integrity at NYU School of Law. You can also read it here.)
Should pension plan managers be able to consider climate change and other financially relevant environmental, social and governance (ESG) factors in their decisions? A recent analysis of public comments found overwhelming support for a proposed rule by the Department of Labor (DOL) affirming their ability to take these factors into account.
ESG factors, including climate change, can affect the risk and return of all types of investments, not just ESG labeled funds. For example, a company may have critical assets that are particularly vulnerable to physical risks from climate-amplified extreme weather or may face transition risks due to climate-related political or technological changes.
The Trump administration, however, has limited the ability of pension plan managers to consider ESG factors when selecting plan offerings and making other decisions. The DOL’s proposal would remove these irrational constraints, allowing plan managers to better protect Americans’ savings.
The DOL administers the Employee Retirement Income Security Act (ERISA), which sets out fiduciary duties of care and loyalty for employers who sponsor retirement plans. and anyone with whom they contract to help manage or advise these plans (collectively, “pension plan managers”). Prudence requires pension plan managers to perform their duties with care, skill and diligence. Loyalty requires that they act only for the benefit of the participants (the people invested in the scheme). The DOL proposal does not change or conflict with these fundamental fiduciary duties, as some have erroneously claimed. Rather, it ensures that trustees can effectively discharge their obligations in the context of the widespread financial impacts of climate change. The DOL proposal explains why pension plan managers may often need to consider climate risk and other ESG factors and affirms their ability and responsibility to do so.
Environmental Defense Fund, NYU School of Law’s Institute for Policy Integrity, and Initiative on Climate Risk and Resilience Law jointly submitted comments supporting the proposal, as did the overwhelming majority of more than 100 other institutions and 20,000 people who commented.
Here’s why DOL’s proposal is so important:
- Climate change is a risk-reward factor for retirement investments.
Climate change is already affecting business results and its effects on business operations are expected to accelerate over the coming decades. The National Oceanic and Atmospheric Administration reports that in 2021 alone, there were 20 separate billion-dollar weather and climate disasters in the United States, causing $145 billion in damage. A wide range of industries will experience significant climate-related losses. For example, climate change is expected to reduce labor productivity and agricultural yields, particularly in the South West, and real estate brokerage site Redfin estimates that climate-intensified wildfires could wipe out up to $2 trillion. dollars in land value in California alone.
These effects are relevant for financial risk-return analyses, especially for retirement investments. Given that many pension funds invest in a diversified portfolio representative of a large part of the economy, the overall impact of climate change on the economy is relevant to the interests of plan participants, particularly in light of long-term horizons inherent in retirement investing. A systematic review of the economic literature on sustainable investing and climate finance found an “encouraging relationship between ESG and financial performance”, observing that ESG funds often outperform mainstream funds over longer time horizons and provide downside protection during social or economic crises.
- Trump administration rules are hampering the consideration of climate risk by pension plan managers.
In 2020, under the Trump administration, the DOL issued new rules targeting ESG investment strategies and deviating from established ERISA practices. These rules changed long-standing regulations under ERISA Section 404(a) and imposed new procedural and documentation requirements that have, in practice, limited the ability of pension plan managers to take consider climate-related risks and other ESG factors in their decisions. As we noted in our July 2020 comment letter to the DOL, such interference in the prudent decision-making processes of trustees ultimately harms plan participants whose savings are at stake. In 2021, the DOL of l The Biden administration has announced it won’t enforce the Trump administration’s rules, but plan managers still need the clarity and certainty of a new rule.
- The DOL proposal says pension plan managers should consider all factors relevant to investment risk and return, including climate impacts.
If finalized, the proposal would eliminate the Trump administration’s harmful limitations on the ability of trustees to consider climate impacts when making investment decisions. The proposal asserts that fiduciaries should treat climate and other ESG factors like any other risk-return factor, where applicable. Trustees “still cannot subordinate the interests of members and beneficiaries in their retirement income or financial benefits under the plan to other objectives”. In other words, fiduciaries should consider the financial impacts of climate and other ESG factors, but not their personal political preferences. Pension plan managers must always work in the best interests of their clients, and current and future retirees can be assured that their financial security is the only goal.
- The DOL proposal applies the same rational principles to default investments as to investment options in general.
The proposal also reverses a Trump-era hurdle on designating funds that consider climate or other ESG factors as default investments for plan participants who don’t otherwise specify how to allocate their contributions. About 80% of new contributions to the ERISA plan are invested in such default funds, known as qualified default investment alternatives (QDIA), which only underscores the importance of allowing trustees to take into account all relevant risk-return factors when selecting them. By restoring the discretion of trustees to consider climate and ESG factors in the selection of QDIA where relevant to the risk-return analysis, the proposal will ensure that participants are not unnecessarily deprived of access to options financially prudent investments.
- The DOL proposal reminds pension plan managers of the potential value of exercising shareholder rights.
Finally, the proposal corrects distortions in fiduciary decision-making that were introduced by the Trump administration’s proxy voting rule, which included several provisions that discouraged fiduciaries from exercising shareholder rights. Specifically, this rule included a statement that fiduciary duty “does not require every proxy to be voted or every shareholder right to be exercised”, and a “safe harbor” provision for voting on matters “essentially related to the business activities of the issuer or . . . is expected to have a significant effect on the value of the investment. This wording has encouraged trustees to err on the side of waiving their right to vote on shareholder proposals and board elections.In other words, pension plans would have less say in the management of the companies they invest in, despite the fact that shareholder voting can be an important risk management tool. The proposal properly recognizes the value of shareholder rights and removes statements that would have discouraged trustees from exercising those rights to the most beneficial extent. her.
In summary, the DOL proposal would protect Americans’ retirement savings by:
- emphasize the financial relevance of climate change
- roll back the Trump administration’s harmful rules
- affirming that fiduciaries should consider ESG factors such as climate change where relevant to the risk-return analysis of investments
- apply the same rational principles to the selection of default investments
- recognize the value of exercising shareholder rights