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Background
In November of 2022, the Biden Dept. of Labor issued the “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights” rule (The Rule) which allows employers to consider climate change and other ESG factors (Environmental, Social, Governance) when selecting investment funds for their 401(k) plans.(1) This overturned a Trump-era rule that said that a plan sponsor’s fiduciary obligations required them to use only “pecuniary” criteria – essentially risk-adjusted rates of return – to determine fund choices . (2) The Trump-era rule was in line with the traditional definition of a fiduciary -- codified in The ERISA Act of 1974 -- as a person or entity who, when managing money for investors, has a legal and moral duty to only consider the interests of those investors when making decisions for them.
Within three months, both the House and Senate passed bipartisan resolutions to deep-six The Rule, only to have President Biden veto their legislation.
Republicans and like-minded Democrats insisted that The Rule would allow employers to pursue a destructive left-wing political agenda with their employees’ retirement savings. Democrat Joe Manchin of West Virginia spoke out, saying that the Biden administration was conducting an “unrelenting campaign to advance a radical social and environmental agenda” and “this ESG rule will weaken our energy, national and economic security while jeopardizing the hard-earned retirement savings of 150 million West Virginians and Americans.” (3) The Biden administration countered with a statement that read “It (The Rule) does not require a fiduciary to make investment decisions based solely on ESG factors. The rule simply makes sure that retirement plan fiduciaries must engage in a risk and return analysis of their investment decisions and recognizes that these factors can be relevant to that analysis.” (4)
As it stands now, The Rule is the “law” of the land. (I say “law” because like so many of today’s Federal regulations, this Dept. of Labor rule never received a majority vote in Congress.)
I would like to be able to say that the truth lies somewhere between the Republicans' alarm and the Democrats' bland reassurances, but I don’t believe that is the case. I believe the Republicans' position on The Rule is closer to the truth, but that they are only dimly aware of its insidious nature. It not only invites plan sponsors to put politics before their employees’ right to choose investments which align with their values; it also has the potential to fundamentally alter and radicalize the modern concept of individual investing.
Analysis
Let’s look at the components of the The Rule, the arguments made in favor of it, and how they are likely to interact to harm investors and change the nature of investing.
Corporate Governance – In explaining his veto of Congress’s rejection of his new ESG rule, President Biden argued that one of the factors retirement plan fiduciaries should be able to consider is "poor corporate governance.” (5) This is a red herring. Investment managers have always taken corporate governance into consideration, and there has never been a law that stops them from doing so. Warren Buffett, for example, has been a strong advocate of good corporate governance since the beginning of his investment career, insisting that management treat shareholders as they treat themselves. (6) The Rule unnecessarily gilds the lily of a long-established practice in order to make The Rule seem normal and unthreatening.
Everyone Uses ESG – Senator Chuck Schumer, in a Wall St. Journal opinion piece, argued that The Rule is a good idea because “according to McKinsey, more than 90% of S&P companies publish ESG reports today.” (7) I learned the fallacy of this type of argument as a child, when my mother, of blessed memory, would chastise me with “if all your friends jump in a fire, will you follow along?” Group think rarely starts with logic and seldom ends in righteousness. ln addition, The Rule is aimed at 401(k) plans and investment managers, not the S&P operating companies the Senator references. But even if 90% of investment managers were to jump onboard the ESG band wagon, that does not mean it would be a good idea or that they would have done so willingly. In the last year, I have researched the ESG involvement of over 140 investment management organizations, speaking with their representatives and portfolio managers. Though some of these companies are full-throated ESG advocates, I have received the impression that many others have been dragged into playing the ESG game because of pressure from politicians, the industry and the public. In other words, the same peer pressure my mother warned me about.
The New Rule Simply Gives Investors a Choice – Two quotes from the ubiquitous Senator Schumer capture the essence of this sentiment:
I say let the market work. If that naturally leads to consideration of ESG factors, then Republicans should practice what they’ve long preached and get out of the way.
Nothing in the Labor Department rule imposes a mandate. It simply states that if fiduciaries wish to consider ESG factors—and if their methods are shown to be prudent—they are free to do so. Nothing more, nothing less. (8)
I believe that, in spite of Senator Schumer’s assertions, The Rule creates a climate in which the consideration of ESG will be anything but natural, and that it will lead to less than prudent investment management.
Investors should have the freedom to choose investments that align with their values and beliefs. In fact, we have created Heart of Liberty Portfolios to help give them that freedom. (Learn more about these portfolios here). I would support a rule that said “if a 401(k) sponsor wishes to offer an ESG fund in a particular category, the sponsor must also offer a non-ESG fund in the same category.” For example, if a plan allows a participant to buy “ESG Large Cap Value Fund,” it must also allow him the choice of “Non-ESG Large Cap Value Fund.” The Rule, however, does not offer real choice; in fact, there is a good chance that it will constrain choice and force 410(k) participants down an ESG path to which they are opposed.
Consider the “tiebreaking” feature of The Rule:
The rule formulates a “tie-breaker” standard as allowing plan fiduciaries, who prudently conclude that competing investments “equally serve the financial interests of the plan over the appropriate time horizon,” to consider collateral benefits as “tie-breakers” to make their selection. The rule removes the special documentation requirements imposed under the prior rule. (9)
What does this mean in plain English? “Collateral benefits” are the alleged benefits of ESG. This means that if a fiduciary has a “reasoned decision-making process” (10) that he regularly employs to choose funds in a 401(k) plan, and he applies that to two funds, one of which is ESG-oriented and another is not, and both score equally well, he can use the “collateral benefits” of the ESG fund as a “tiebreaker” and place it in the company plan.
Let’s consider how this might work in the real world. Imagine that I am a plan sponsor who believes in the dire consequences of man-made climate change, and I am hell-bent on doing everything I can to combat this. I want all of my company’s 401(k) plan choices to be ESG funds. I have a normal set of analytics that I apply to funds to determine their suitability for the plan. Previously I had always used past performance, manager tenure, standard deviation and upside/downside capture ratio as my favored metrics. I now find that ESG funds frequently come up short regarding upside/downside capture. So I substitute “performance in down years” and voila, the ESG funds look as good as their non-ESG competitors, and I can use the ESG “tie-breaker” to place them in the plan.
Even if an ESG believer does not have to tinker with his analytics, and is able to find ESG and non-ESG funds that score equally well under his usual criteria, the end result is the same: his employees will be forced to invest in funds which may violate their principles. And according to The Rule, plan sponsors are no longer required to document their selection process. (11) Of course, no employee is forced to invest in his company 401(k), but the government long ago skewed the tax and other benefits of retirement plan investing to overwhelmingly favor 401(k)s over IRAs.
One might argue that this scenario is absurd; no employer would be so irrational as to let his political beliefs influence his business practices, and possibly hurt profits! In answer I give you Target, Anheuser Busch, Disney and the countless locally-owned retail establishments which proudly display MAGA or Black Lives Matter material on their walls.
A final thought on “choice.” The politicians who have attacked The Rule, and the plan participants who oppose it, are probably unaware that most 401(k) plans already contain numerous ESG-influenced funds, because the managers of many funds which are not labeled ESG or “sustainable” employ ESG analytics. We at Capitalist Investment Services have researched and documented this, as has Pension Politics. (12) If you are interested in receiving our research on mutual fund companies' involvement in ESG, please click here.
Radicalizing the Modern Concept of Individual Investing -- The Dutch East India Co. rang the bell on the era of modern investing in 1602 when it offered its equity shares to investors in the world’s first Initial Public Offering. (13) At the time, it went without saying that these investors bought shares to satisfy their own personal needs. Since then, investors have been free to invest for any reason their heart desires. Usually this means for gain or income, but that is not always the case. For centuries, starting with the Quakers, people have invested in what they deem to be a “socially responsible” manner by avoiding gambling, tobacco and liquor companies, even if it means lower rates of return. Back when stock certificates were still issued, grandparents would buy shares of Disney for their grandchildren and gift them the certificates, which were decorated with Walt’s colorful characters, as an introduction to the world of investing. “Many investors” has always equaled “many reasons” for investing.
The “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights” rule (The Rule) threatens to corrupt the long-standing sanctity of personal investment freedom. As I have outlined above, it has the potential to give an employer the ability to funnel his employee’s retirement savings into ESG funds, thereby placing the employer’s support of a cause such as “Net Zero CO2 Emissions” above the employee’s own interests. The name of The Rule itself contains an Orwellian irony. The “loyalty” in the title ostensibly refers to a fiduciary’s duty to be loyal to the interests of those he serves; in reality, The Rule opens the door to give employers the legal right to place their loyalty to their pet causes above the interests of their employees.
Even more alarming, the religious-like fervor over apocalyptic man-made climate change has already begun to sprout a line of reasoning which I believe may end up giving the government license to force all investing to follow ESG dictates.
It is now accepted fact to supporters of The Rule that CO2-induced climate change will soon turn the earth into a cross between Water World and Mad Max. A thirty-three-page letter sent to the head of the SEC from 20 State Attorney Generals last year captures this thinking: (14)
The physical risks and impacts of climate change already threaten registered companies and their operations. Extreme weather events caused or exacerbated by climate change, such as hurricanes, wildfires, extreme heat, and extreme drought, have caused a number of material and costly impacts on company operations. As those events increase in intensity and frequency, their effects on companies will only grow.
I do not believe that so-called “greenhouse gas” emissions represent an existential crisis (an argument for another day), but it is undeniably true to these politicians and many others. And it therefore follows that if you believe this crisis is a scientific fact, then individual choice in investing is a luxury that must be sacrificed, and in order to save mankind and the planet, all investing must march to the ESG drummer. You can already hear, in the statement from the Biden administration that I quoted at the beginning of this piece, the faint intimations of what I believe will become a push to legally mandate “ESG Investing Only” :
The rule simply makes sure that retirement plan fiduciaries must engage in a risk and return analysis of their investment decisions and recognizes that these factors can be relevant to that analysis.
Today “these (ESG) factors can be relevant.” Tomorrow, as the “science” on the apocalypse of man-made climate change becomes “absolutely certain,” that apocalypse will be deemed overwhelmingly relevant to the risk and return analysis that retirement plan fiduciaries “must engage in.” Consequently, I believe there is a strong possibility that ESG investing will become the only choice available, and that all investors will be dragooned into investing their hard-earned money – not according to their own needs and desires – but in the name of a cause supposedly greater than themselves.
Summary
Proponents of “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights” have attempted to gloss over its radicalism by saying that it’s all about good corporate governance, that everyone does it, and that it simply gives investors a choice. I believe that The Rule will be used to restrict real investor freedom, and that it has the potential to radically alter the nature of individual investing itself.
Don Harrison
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(2) https://news.bloomberglaw.com/daily-labor-report/anti-esg-measure-ditching-biden-401k-rule-wins-house-approval
(3) https://www.manchin.senate.gov/newsroom/press-releases/manchin-statement-on-president-bidens-veto-of-bipartisan-challenge-to-esg-rule-politicizing-americans-401ks
(9) https://www.tiaa.org/public/pdf/e/esg_proxy_voting_factsheet.pdf
(10) “Reasoned decision-making process” is part of the duty of prudence under ERISA https://www.capitalgroup.com/advisor/pdf/shareholder/rpgewp-002_dcdolwp.pdf
(11) https://www.capitalgroup.com/advisor/pdf/shareholder/ITGEBR-116-1031260.pdf
(12) https://www.pensionpolitics.com/report/?utm_source=ctup&utm_medium=reportpage
(13) https://www.investopedia.com/ask/answers/08/first-company-issue-stock-dutch-east-india.asp
(14) https://oag.ca.gov/system/files/attachments/press-docs/Comment%20Letter%20ISO%20SEC%20Climate%20Disclosure%20Prop%20Rule%20.pdf