Retirement plans: Why PE is in and ESG is out under new DoL guidance

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When it comes to retirement plans, private equity's in and ESG is out.

At least, that's where the Department of Labor's latest regulatory guidance is trending. The agency recently expanded the availability of private equity in 401(k)s and then proposed this week to tighten regulation on ESG funds in retirement plans.

In the more recent of the two moves, on June 23, the department’s Employee Benefits Security Administration issued a proposed rule amendment “establishing clear regulatory guideposts” for plan fiduciaries regarding ESG in ERISA plans.

“Private employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan,” Secretary of Labor Eugene Scalia said in a statement released the same day.

Under the proposed amendment, the DoL would codify that plan sponsors must first consider risk-adjusted pecuniary goals when making investment selections. In the case of a “tiebreaker” between two funds, the sponsor would be required to follow investment analysis and documentation requirements.

In an op-ed in the Wall Street Journal published June 23, Scalia raised questions about the reliability and performance of ESG investments.

“Many investors understandably want to do good while also doing well, but the standards for ESG investing are often unclear and sometimes contradictory,” wrote Secretary of Labor Eugene Scalia.

“Many investors understandably want to do good while also doing well, but the standards for ESG investing are often unclear and sometimes contradictory,” he wrote. Referring to “other studies” later in the column, Scalia also asserted that when investments are made with the intention of furthering a particular environmental or social cause, returns “unsurprisingly suffer.”

The vast majority of asset managers are working ESG into their strategies, according to Harvard Business School. Approximately 80% consider ESG criteria when making investment decisions, its research shows.

The Labor Department’s proposed amendment follows a June 3 information letter allowing 401(k) plans to invest in buyout firms when such firms are included in diversified funds — making 401(k)s more akin to pension plans.

The latest guidance on ESG is “intellectually inconsistent” with the information letter, according to Micah Hauptman, financial services counsel at the Consumer Federation of America. While it expresses skepticism of ESG, “the DoL is now saying that private equity — which is opaque, costly, risky, illiquid and hard to value — is fine to include in 401(k)s,” Hauptman says.

"[Plan fiduciaries] need to keep their eyes focused on participants’ financial interest in a secure retirement," a Labor Department spokeswoman said in an emailed statement. "These principles apply equally to private equity and to ESG funds, and the Department has said just that."

The spokeswoman said that the Department’s information letter on private equity "simply makes clear that professional money managers, charged with obligations of prudence and loyalty, can take full advantage of the full range of market options, which include private equity."

In a letter sent to Scalia, a group of 19 consumer advocate organizations, including Hauptman's, criticized the department's guidance around private equity investments. They argued that the Labor Department’s decision discounted how private equity funds “can and do manipulate” their investment performance and often have high fees.

It isn’t just consumer advocates who are concerned about retail investors and private equity.

On June 23, the SEC issued a risk alert regarding private equity, which laid out deficiencies in the private equity sector and said that clients were not aware of conflicts of interest and, in some cases, were paying more in fees and expenses than they should have. The regulator caps open-end fund asset allocation to illiquid securities at 15%.

An SEC spokesman declined to comment on the Labor Department’s guidance regarding private equity.

“The Department of Labor doesn't seem concerned when plans include extremely high-cost investments,” Hauptman says, later adding: “They're just singling ESG out.”

A new Reg BI compliance wrinkle?
As the industry pushed to comply with the fiduciary rule, new issues emerged.

Since 1994, the Labor Department has issued three interpretive bulletins regarding ESG, all of them emphasizing plan sponsors’ fiduciary responsibility to consider financial returns above all other factors, according to background information on the proposal published by the Labor Department.

Meanwhile, ESG funds seem to be holding their own. In 2019, sustainable funds outperformed conventional peers, according to Morningstar data.

A Morningstar article noted that even while many funds don’t market themselves as sustainable, almost 500 funds added ESG language to their prospectuses.

The Labor Department’s proposal includes a 30-day comment period.

Editor's note: This story has been updated with additional comment from a Labor Department spokeswoman.

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