A new executive order signed by President Donald Trump on April 10 to promote energy infrastructure and economic growth could severely limit asset managers’ ability to divest from companies held in retirement plans on the basis of environmental, social and governance considerations, industry watchers said.
While some legal experts, academics and analysts said it’s unlikely that the order would reverse proxy voting trends, several agreed that the administration’s sentiment could deter 401(k) plan participants from demanding ESG options – and therefore, slow fund firms’ product development in the space.
The Executive Order on Promoting Energy Infrastructure and Economic Growth asks the Department of Labor to review data by ERISA-governed retirement plans to evaluate any trends regarding the plans’ energy sector investments. It also requests, within 180 days, a review of existing guidance on fiduciary responsibilities for proxy voting “to determine whether any such guidance should be rescinded, replaced, or modified” to emphasis the focus on returns.
“This is quite an ingenious attack on the ESG movement — the ESG references are cryptic but pointed,” John Grady, partner at law firm DLA Piper, said. “It means that the Trump administration can push back on the ESG movement to the extent that it is pushing money out of oil and energy stocks.”
The directive is going to have a bigger impact in the 401(k) or defined contribution space, according to Jeff Gitterman, co-founding partner at Gitterman Wealth Management. The retirement industry is moving rapidly towards defined contribution, and these plans are ramping up their ESG options to cater to millennials who are saving up for retirement, he said.
Pensions, foundation and endowments have their own ESG directives and move the needle slowly because of their size and focus on the long horizon, Gitterman explained.
Danielle Fugere, president and chief counsel of As You Sow, a nonprofit group focused on shareholder advocacy, agreed. While the order ultimately does not change what the DOL has emphasized through the George W. Bush, Barack Obama and Trump administrations, – that “investors must be concerned with the bottom-line value of their investments,” – she said Trump does not seem to include consideration of ESG factors like climate change as part of this directive.
“Trump threw some chilly water on that and said, ‘Well you need to be careful if you’re going to consider ESG, and you have to justify your participation and shareholder action,’” Fugere said. “Where this plays out more relevantly is in the 401(k) space. We are not seeing a tremendous uptake of ESG considerations in terms of options to employ them…If the DOL now says something slightly more chilling than it has, that may restrict movement towards ESG in the 401(k) arena.”
Despite plan sponsors and participants wanting to align their beliefs with socially responsible investments, they must overcome major headwinds, research from Cerulli Associates shows.
About 56% of plan participants prefer to invest with companies that are socially and environmentally responsible, and 46% of plan sponsors describe ESG factors as very important, according to a recent Cerulli survey. However, only 16% of DC plans offer a dedicated ESG option, and use among plans that have one is below 2% of asset allocations, Callan research shows.
When Cerulli asked plan sponsors to identify their top three most important attributes when selecting 401(k) investments, ESG responsibility came last, 16%, the report found. The most important factors were long-term investment performance (45%) and investment cost (38%).
Jon Hale, global head of sustainability research at Morningstar, argued that the gap between plan participant excitement about ESG investing and the options available to them to do it show that changing signals from the DOL on this topic have curbed development of this corner of the asset management industry.
“It’s unfortunate when DOL muddies the issue because clearly there is widespread interest from plan participants to have ESG options in their retirement plans,” he said. “ESG deepens the connection plan participants have with their investments in that it encourages staying the course during volatile markets and a focus on the long term. ESG investing also helps reduce risk in a portfolio by attending to issues that traditional financial analysis may overlook. Over the long run, these poorly thought out regulatory efforts may slow the trend, but they aren’t good for investors and the trend itself in favor of sustainable investing is unstoppable.”
Change or no change?
Mary Margaret Frank, associate professor of business administration at the University of Virginia Darden School of Business, said she would be surprised if the DOL would rule that ESG factors cannot be considered in proxy voting decisions made by retirement plan providers.
“I would expect that the DOL wants to make sure that the managers of the pension plans are not sacrificing beneficiaries’ financial retirement security unbeknownst to the beneficiaries,” she said. “Financial security is affected by the returns the managers generate as well as the risk they take to achieve those returns. If ESG proxy voting doesn’t hurt the return or increase the risk taken, I would hope the DOL would let proxy voting move forward unregulated.”
Legally speaking, there is little the directive can do to curb ESG from steaming ahead, Brian McCabe, partner at law firm Ropes & Gray, said.
The DOL will be able to collect trend data using schedule H of form 5500s filed by ERISA-governed plans which breaks down all the holdings of the plan. Even so, it would be difficult to discern why a divestment was done as there are several metrics that go into choosing an investment, McCabe said.
Defined contribution plans have a limited menu of mutual funds chosen by plan participants according to their age, knowledge and risk appetite, Gitterman said. And since the funds each contain several underlying stocks, it’s difficult to prove whether ESG leads to underperformance or overperformance, he added.
“Future returns depend on a lot of things, so it will be hard for the DOL to be completely anti-ESG,” McCabe said. “While the tone of the directive is unfavorable [to ESG], it is substantively similar as the Obama-era directive when ESG was considered a tie breaker or differentiator in the selection process.”
Rob Thomas, president of Social(K), a private-label 401(k) record-keeping platform focused on ESG investing, noted that the order only calls for an examination. He also doubted that it would bring about any binding change.
“They’ve already talked about it, they’ve been asked to investigate it, and the narrow piece that they can investigate is, ‘Are they spending too much of the shareholders’ money responding to and doing these proxies?’” he said of the DOL and retirement plans, respectively. “That isn’t going to happen. If you’re a fiduciary, ESG is not an option – it’s an obligation.”
Fugere said this is particularly true of climate change considerations.
“Companies that are not taking climate change into account, that are not reducing their risk, that are not taking opportunities to respond to a changing energy environment, that are not reducing greenhouse gas emissions – these companies are not likely to be successful into the future,” she contended. “We are talking about a fundamental reorientation of the world around climate change, so it’s critical that shareholder ask companies what they’re doing to deal with climate change.”
Nevertheless, difficulty for the DOL in understanding the complete picture behind investments and divestments could lead to increased scrutiny of managers that offer ESG options or weave ESG into product development, according to Jeff Snyder, retirement consultant and founder of The Morning Pulse.
“We will see a layer of evolution not only in how managers choose securities but in their understanding of how it could impact performance,” he said. “There will be a lot more due diligence on their part.”
Thorough reporting about ESG outcomes is going to become table stakes for asset managers, issuers, underlying firms and even advisers, Megan Fielding, senior director of responsible investing at Nuveen, said at an Envestnet forum last week.
“Divestment is an exclusionary approach and can bring underperformance,” Fielding said. “We know fossil fuels don’t meet certain investment criteria, but low carbon is different from a 100% divestment, so we have other options if people don’t want fossil fuel.”
With reporting poised to become more detailed, there is even more of a reason not to go down the divestment route, as more investors are requesting companies to disclose certain climate risk and scenario planning assumptions, she explained.