DOL took ‘ESG’ out of rule, added new hurdle for 401(k)s

With demand from investors growing, plan sponsors focus on their fiduciary duty.

The Department of Labor’s 148-page final rule issued late last week on environmental, social and governance investing in retirement plans notably excluded some key abbreviations: E, S and G.

The DOL changed the language it had used in the proposed version of the “Financial Factors in Selecting Plan Investments” rule to focus on “pecuniary” and “non-pecuniary” issues, leaving ESG all but out of the discussion.

The rule is still very much about ESG investing, even if it does not call the products out by name. Some changes in the document bode well in the long term for sustainable investing in 401(k)s and other defined-contribution plans, sources said. But at least one change could make it virtually impossible for some fiduciaries to include ESG investments as the default options on plan menus.

[More: DOL releases final rule that could curb ESG in retirement plans]

“Nobody like a rule. Nobody likes being told what to do. But I believe that generally this is a much better rule than the proposed rule,” said John Streur, CEO of Calvert Research and Management. “They obviously took to heart the 8,700 comment letters they received.”

By focusing on the financial materiality of investments, the DOL’s final rule aligns well with standards developed by industry groups such as the Sustainability Accounting Standards Board that ESG managers already follow, Streur said. For investment providers, that is helpful, given the attention they already pay to financially material aspects, he said.

The final rule also shifted from emphasizing what isn’t allowed when evaluating investment options to what should be considered, he noted.

“This says you can use strategies that do include pecuniary factors,” Streuer said. “For plan sponsors, it sets a clear path to conducing due diligence on potential options for their DC plans. And … it makes it to me very clear that investment managers need to be able to document their process analyzing an E, S or G factor from a financial materiality perspective.”

The final rule is a significant improvement over the proposed one, Stephen Saxon, principal at Groom Law Group, said in an email.

“It allows a fiduciary to make a judgment the ESG factors could be ‘pecuniary’ and therefore may be considered in making a prudent judgment regarding a plan’s participation in a particular fund,” Saxon said. That is “a big step in the right direction,” he added.


One of the most striking changes in the final version of the rule is that it does not appear to expressly prohibit employing ESG criteria in a plan’s qualified default investment option, which is usually a target-date fund. However, the language also appears to be engineered in a way that would still prohibit ESG almost altogether in those investments, said Patrick Menasco, partner at Goodwin and co-chair of the firm’s ERISA and executive compensation group.

“This final formulation might be worse than the original,” Menasco said.

The proposed version, for example, contained a safe harbor that would have allowed ESG-themed funds or ones that include such criteria, as long as those investments were selected objectively for their risk and return profiles, he said. The final version scrapped that language, instead stating that fiduciaries must show that investments were chosen for pecuniary factors and that any nonpecuniary factors must also be shown to be in the best interest of retirement savers, he noted.

“There is sort of a circular dynamic going on here. On one hand, you’re not prohibited from including ESG-themed or ESG strategy options under the QDIA. But if you do … you still have to justify those [nonpecuniary factors] as being in the best interests of the retirement savers and the beneficiaries,” Menasco said. “How do you do that?”


The DOL does call out ESG factors in the preamble to the rule. But the fact that those criteria were removed from the rule text itself reflected how troublesome it can be to define ESG, sources said.

“They made the right decision,” said Michael Kozemchak, managing director at Institutional Investment Consulting. “What they came to realize is that [with] ESG or ESG-themed investments, there’s a lack of specificity in that definition, and that is particularly problematic.”

Despite increased interest in general among investors in ESG funds, employers — particularly large companies — have not been seeking them for their retirement plans, he said.

“We have some church plans we work with that wanted socially responsible options,” Kozemchak said. “We included them for the purposes of choice, but [they] have been really challenging” from a performance standpoint.


The final rule could give plan fiduciaries “a little more wiggle room when it comes to incorporating ESG investment products within a QDIA,” said Shawn O’Brien, a senior analyst at Cerulli Associates.

But the regulator’s message has been consistent, even without the ESG language in the final rule, O’Brien said. And plan fiduciaries are ever leery of taking any potential risks, especially without clear benefits.

“In the long term, there is a strong interest from certain plan sponsors, and asset managers still stand behind the financial merits of ESG investing and taking ESG considerations into account,” he said. “In the short term, this makes adoption more difficult.”