Why we oppose a DoL rule that would limit long-term retirement returns

Register now

At a time when ESG funds have outperformed amidst a pandemic, when Colorado and California wildfires demonstrate the urgency of climate change risks and when business leaders try to define success more broadly than simply short-term shareholder value, the Department of Labor would have us take a step backward and limit the use of forward-looking datasets.

The department has proposed a new rule that would make it more difficult for private sector retirement plans to include funds selected byESG considerations. Why? The proposed rulemaking requires that plan fiduciaries select funds based solely on financial considerations such as liquidity, diversification and return in order to reduce the scope of impact investing.

The proposed rulemaking appears to rely on an argument against the inclusion of ESG data integration because the use of such data would likely cause a rise in fees to investors and lead investors astray from the primary goal to maximize returns.

We take exception to this argument. The consequence of such a measure is that it might bar 401(k) plans from having access to a new breed of investment factors, including ESG funds as an investment vehicle for participants.

The idea has upset asset managers and data providers because behind this effort to de-emphasize ESG funds via the rules that govern private sector retirement plans—the Employee Retirement Income Security Act (ERISA)—comes from a misplaced fear that such investments could actually “subordinate return or lead to increased risk,” putting retirement funds at a disadvantage.

Overwhelming majority

The Labor Department has invited comment. Here's ours:

We argue that independent of any political view on climate change, and the role of government in addressing it, there is observable market data across multiple economic sectors that must be addressed because climate change risk is beginning to be priced into assets. Indeed, companies that are actively working towards carbon mitigation and adaptation (as just one example of the E in ESG), are on average, experiencing less risk and better compounded returns. Conversely, equity investors that ignore climate change (E), fair wages (S) or homogenous boards of directors (G), are at a disadvantage.

Our voice joins those of 95% of respondents who oppose the rule.

Efficacy of ESG

Consider just a few examples of what ESG factors seek to measure: a company’s alignment towards global climate change targets such as the Paris Accord; having diverse, independent boards of directors; and building sustainable supply chains. Given the material impact of these considerations perhaps it’s no surprise that ESG funds increasingly outperform global benchmarks and more conventional investments.

Retirement is a long-term investment. These dollars should be directed at companies who are thinking bigger — considering their societal impact and meeting-higher-governance standards. These are the companies managing for the long run, not the coming quarter.

But don't take my word for it. The efficacy of ESG models can be rigorously back-tested and proven. Here's a case study from our own data.

Consider the performance of a portfolio of stocks with superior climate risk characteristics, as measured by E-scores in the top quartile, compared to the S&P 500. If you had bought into this portfolio in 2010 you would have received 2.3 percentage points of outperformance over the S&P 500. Your investment would have a compound annual growth rate of 16%, compared to 14% for the benchmark.

Creating an ESG-screened portfolio of the S&P 500 yields better returns in a 10-year hypothetical back-test.

Our example illustrates, to the contrary, that ESG scoring is a good thing and that it could well be an indicator for future performance and thus lead to improved returns. If ESG factors succeed in providing predictive power and demonstrate competitive, if not superior, risk-adjusted returns, then limiting their use is a bad thing. The proposed rulemaking, given the evidence, is a solution without a problem.

Perhaps regulators should be asking a different question: when ESG funds outperform, could it be that the signals they are measuring are part-and-parcel to traditional concepts of value and should therefore be encouraged?

If so, providing ESG models can and should be available for long-term investors. Let the market decide which models they want to use.

For reprint and licensing requests for this article, click here.
ESG DoL Retirement planning Portfolio management Portfolio construction