The DOL’s ESG rule survived in court. Does it matter?

It could take a while for ESG to become more widely available in 401(k)s, even if the political focus on it dies down.

Half the states in the country suing the DOL won’t get the agency to budge on its new rule that allows retirement plan fiduciaries to consider ESG factors.

Last Thursday, coincidentally during Climate Week NYC, U.S. District Court Judge Matthew Kacsmaryk granted summary judgment to the Department of Labor, finding that the agency didn’t violate the Employee Retirement Income Security Act. In building and finalizing its rule, Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights, the DOL didn’t go beyond the authority given to it by Congress, nor did it act arbitrarily or capriciously, Kacsmaryk wrote.

Although the court development provides an extra layer of assurance that the DOL’s rule is legitimate, it’s just the latest development in an ongoing partisan feud over what place, if any, environmental, social and governance criteria have within retirement plans. Across administrations, it’s a game of pingpong that has lasted for more than a decade.

Last week’s order marks the end of a legal fight that started in January, when 25 states and several groups filed a lawsuit seeking to stop and reverse the DOL’s rule, which went into effect this year. The agency proposed the rule nearly two years ago as a way to replace a slightly more restrictive version that it had finalized near the end of the Trump administration.

“I’ve been following the DOL back and forth on questions of ESG and sustainability since the mid-90s. I’m not sure this [represents] finality … It is a political football,” said Kirsten Spalding, vice president of the investor network at Ceres.

But the court order puts to bed any doubts about the legality of the Biden DOL rule, Spalding said.

The plaintiffs brought the case in what may be the friendliest U.S. courts for their cause, but the challenge nonetheless was unsuccessful.

“It is a consistent thread now that fiduciary duty does include consideration of financially material ESG factors. There is no mandate to consider them, but there is no prohibition,” Spalding said. “This decision will have far-reaching effects. Others, even if they are not directly covered by ERISA plans, will look to this rule.”

Whether sustainability-themed investment options will see more interest in the 401(k) world is another matter. Plan sponsors tend to be risk-averse, leery of doing anything that’s out of line with their peers, especially being the first to try something new.

Given the political uncertainty around ESG — especially with the focus Republicans have put on the issue — it’s easy to see why some might be hesitant to put sustainable funds on their plan menus. Even so, the DOL has made it clear that evaluating ESG criteria can be part of a fiduciary’s job, and it has even allowed such factors to be part of the selection of the default investment options in plans. The latter was outright banned under the Trump-era version of the rule.

But it’s also worth noting that, even as the prior version of the rule was largely perceived as having a chilling effect, it did not prohibit plans from having ESG-themed investments on their menus. The key is financial materiality, something that the DOL in both instances has made clear that fiduciaries must put before all else.

For years, there have been surveys showing that 401(k) participants want sustainable funds. Yet, such investment options are not the norm in most plans — and even when they are available, few people use them. That is largely because 401(k)s today are powered by inaction — workers get signed up automatically for plans, and their contributions are allocated to whatever the default is. They can change things whenever they want, but most do not.

If ESG is to be incorporated meaningfully into retirement plans, it needs to be a part of the default investment option, usually a target-date series or managed account. There are a handful of sustainable target-date suites on the market, the oldest of which is Natixis — it launched over six years ago.

As of last year, only 12% of large defined-contribution plans included any kind of “ESG fund,” although another 13% indicated they were open to adding one, data from Callan Associates show.

Across a wider range of 401(k) and profit-sharing plans, only about 4% included ESG options as of 2021, according to a separate set of data from the Plan Sponsor Council of America. The top reasons why plan sponsors said they don’t have such options were that they simply didn’t consider them, that there was regulatory uncertainty or that participants didn’t seem interested.

Of course, that doesn’t take into account that many of the mutual funds those plans list ESG factors as data they may consider. Even if products aren’t packaged as “ESG” or “sustainable,” they often weigh social or environmental factors as potential risks or opportunities. Some of the largest actively managed funds on the market, including the $113 billion American Funds Investment Company of America Fund and the $92 billion Dodge & Cox Stock Fund, note that they may consider financially material ESG factors.

Meanwhile, there is currently a host of bills introduced by congressional Republicans seeking to dampen the use of ESG factors, including in retirement plans. That is in addition to efforts by numerous states to pull back on ESG within public funds and pensions.

However, people on both sides of the debate have conceded, or acknowledged, that “financially material” ESG factors might thoughtfully be considered. In some cases, what is or isn’t financially material seems up for interpretation. In others, it isn’t — even those who say they don’t believe climate change is caused by humans might admit that it, along with the shift to a sustainable economy, will result in financially material risks and opportunities.

In comments last week, Treasury Secretary Janet Yellen outlined the department’s new Principles for Net-Zero Financing & Investment, noting that “the physical impacts of climate change are impossible to ignore.”

“It’s really clear that the public wants their investment professionals to have the freedom to consider every important risk and opportunity, and I don’t think that’s a political issue at all,” Ceres’ Spalding said. “Would you ask your doctor not to look at the MRI? … ESG data is just that. It’s an important point to be used in decision-making.”