EXPERT ANALYSIS

President Joe Biden has issued the first veto of his term. He vetoed a Congressional resolution to nullify a Department of Labor regulation on the investment of retirement plan assets.

Dana Muir, a business law professor at University of Michigan’s Ross School of Business with expertise in the fields of investments, pension plan funding and plan investment selection, discusses what led to the veto, where things may go from here and why the issue matters outside Washington.

The background

The Labor Department has modified its guidance on retirement plan investing during each presidential change dating back to the Clinton administration. During Republican administrations, the department put its thumb on the scale against consideration of ESG (environmental, social and governance) factors when making investment-related decisions. In Democratic administrations, it did the opposite.

In late 2020, labor officials issued the first formal final regulation on the topic, which imposed multiple impediments on plans that want to consider ESG factors. In March 2021, the department announced it would not enforce that regulation.

Last December, the department replaced the prior regulation with one that is neutral on ESG investing. The regulation neither encourages nor discourages consideration of ESG factors—it leaves the decision, as with all other investment-related considerations, to the people responsible for managing the plan.

It was this regulation that Congress voted to nullify and that Biden kept in place with his veto. Multiple lawsuits challenging the regulation have been filed.

The big fight

U.S. retirement plans hold approximately $32 trillion. How that money is invested is important to maximizing workers’ retirement accounts and for well-functioning capital
markets.

One of the most serious concerns members of Congress expressed was with the $8.9 trillion held in 401(k)s and specifically with the approximately $3 trillion held in “default” investments. If an employee is automatically enrolled in a plan and does not choose investments, those contributions will be directed to the plan’s default investment. Proponents of the 2020 regulation wanted default investments to exclude all products that considered any factors, such as ESG factors, not intended to maximize financial returns.

The problem with Trump-era regulations

Proponents of the 2020 regulation do not seem to realize the regulation actually prevents plans from choosing some products as default investments even if the products had superior risk and reward characteristics. For example, if the plan determines that Fund XYZ is economically superior to Fund ABC but Fund XYZ’s strategies include consideration of nonpecuniary factors, the plan could not include Fund XYZ in its default investment.

Bottom line: The 2020 regulation departed from the historic requirement that plans must not compromise investment returns for purposes unrelated to providing plan benefits. Instead, it required plans to forgo financial-maximizing investments in order to comply with political hostility to ESG.

This approach combined with a lack of clarity in the regulation could result in litigation against plan sponsors costing millions of dollars. For example, investment funds with trillions of dollars of investments track the S&P 500, one of the most used equity indexes. The S&P 500 excludes companies with dual-class shares. That is a governance factor.

Experts have argued that excluding those companies does not maximize the returns of the S&P 500. If true, arguably the 2020 regulation precluded funds that track the S&P 500 from being part of a plan’s default investment. FTSE Russell has a similar exclusion. If the 2020 regulation remained in force, this type of controversy would have to be decided by the courts.

The prevalence of ESG

Those opposed to the presence of ESG factors in investments may not realize the prevalence of those factors in the current market. Innocent Drinks is a Coca-Cola subsidiary organized as a benefit corporation. That means that Innocent Drinks does not do business “with the narrow mindset of profits above all else.” Instead, the company considers its obligations to employees, customers and the planet.

Would those opposed to ESG investing exclude Coca-Cola stock from 401(k) default investments because employees might not support Innocent Drinks’ ideals? As increasing numbers of companies, investment funds and indices build environmental, social and governance considerations into their business models, it becomes more difficult for plans to ensure they do not fall on the wrong side of the regulatory line.

The veto’s upshot

The Biden veto keeps in effect the 2022 regulation, which does not favor or disfavor ESG factors. Rather, it reinforces the traditional legal principle governing plan investments—plans cannot prioritize anything other than retirement income and financial benefits under the plan.

If those responsible for plan management conclude an investment fund that includes Coca-Cola stock or tracks the S&P 500 index or any other product is the best choice for employees’ retirement income or plan benefits, then that is what they should choose.

Why this matters

I have a study, “Matching Preferences and Access: Sustainable Investing in 401(k) Plans,” forthcoming in the Indiana Law Review. The article explains how 401(k) plans can encourage employees to save more by offering investment options that employees want. Studies show a significant majority of employees want access to sustainable investments, yet fewer than 10% of plans provide that option. The mismatch is due to the regulatory instability and resulting fear by plans of liability.

For the first time, the 2022 regulation explicitly provided that plans can consider employee preferences when establishing investment options. The article explains how plans can do that and comply with their legal obligations.

One interesting finding is that young employees and female employees are most interested in ESG investing. Both groups contribute to plans at lower than average rates. If young people can be encouraged to save early in their careers, they can benefit from the power of compound interest in tax-favored accounts. Women have lower account balances than men but need more retirement savings than men because they have longer life expectancies. Increased savings by women would help offset
this pension gap.

The regulatory instability of the last 30 years is entirely inconsistent with the way retirement plans need to operate: Those plans need to be confident that the next presidential administration will not question their investment-related decisions. The only way to bring stability to this area is to stop treating ESG as some special set of factors that are especially important or especially irrelevant to risk and return considerations and leave those decisions to investment professionals.

The 2022 regulation is the most neutral approach we have seen in the last three decades. Everyone who has the best interests of America’s workers at heart should support it. It is time for both sides of the ESG battle to leave workers’ retirement assets out of their political fight.