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Is Mandatory Fossil-Fuel Divestment Coming For Your 401(k) And IRA? And How Much Will It Cost You?

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Should pensions and retirement savings plans divest from fossil fuel companies? That practice is becoming increasingly prevalent globally. Over the past several years, pension funds in Scandinavia have announced divestment from oil and gas companies, and the NEST retirement savings fund in the UK, that is, the government-managed IRA-like fund into which workers are defaulted if their employers don’t otherwise provide benefits, has said it will likewise pull its assets from coal mining, tar sand oil production, or arctic drilling. In the United States, in 2020, a pair of representatives proposed legislation that the Thrift Savings Plan, the 401(k)-like plan for government employees, likewise “decarbonize.” And various state pension funds have announced divestment plans, most notably the state of New York, where back last December I observed that this plan did not appear to conform with that state’s constitutional requirement that fund investments be solely focused on maximizing fund returns for pension participants.

With respect to individual retirement savings in the United States, in contrast, the Department of Labor had ruled during the Trump administration that the fiduciary duty to maximize returns for investors precluded such divestment actions in ERISA-regulated retirement savings (that is, 401(k) plans for private-sector employers), though they did leave a loophole that fund managers could take into account climate change as one factor in determining how to maximize returns. At the time, I had voiced a preference for more worker choice, observing that there are many choices of providers when it comes to IRAs, from those with an environmentalist approach to those with a religious approach, such as the Catholic Ave Maria Mutual Funds, and that equalizing IRA and 401(k) benefits would allow savers greater choice in their retirement savings, sacrificing some return as a trade-off for investments in keeping with their ethics.

Which brings me to the proposed rule change from the Department of Labor, on October 14. As described by the New York Times,

“The Labor Department proposed rule changes on Wednesday that would make it easier for retirement plans to add investment options based on environmental and social considerations — and make it possible for such options to be the default setting upon enrollment.

“In a reversal of a Trump-era policy, the Biden administration’s proposal makes clear that not only are retirement plan administrators permitted to consider such factors, it may be their duty to do so — particularly as the economic consequences of climate change continue to emerge. . . .

“The new regulations would also make it possible for funds with environmental and other focuses to become the default investment option in retirement plans like 401(k)s, which the previous administration’s rules had prohibited.”

The Times insists that, despite this change, fund managers would still not be permitted to sacrifice returns for the sake of favoring ESG [environmental, social, governance] factors.

However, despite this generic description, other sources make the Biden administration’s objectives clearer. The Financial Times reports that “The labour department said that retirement savings plans might also be actively required to consider climate change in their investments.”

The Society for Human Resources Management provided insight by R. Sterling Perkinson, a partner at the law office Kilpatrick Townsend: “It remains to be seen whether the DOL will go a step further in final regulations by mandating consideration of certain ESG factors, or whether they will maintain a more neutral position that they are no different than other traditional investment criteria.”

Is there any real harm in ESG investing? Clearly, many people are on-board with this change. But here are three areas of concern:

First of all, “ESG” is not a single one-size-fits-all set of decisions. To take one example, in a September 2021 report, the group Hong Kong Watch accused Western pension funds who proclaim themselves to be following the principles of ESG/environmental, social and governance-based investing, to be focusing narrowly on environmental causes and turning a “blind eye” to human rights abuses in China.

What’s more, the rush to divest from fossil fuel companies may be having harsh unintended consequences. As reported at Bloomberg today, in an article titled, “Shunning Fossil Fuels Too Soon May Prove Catastrophic,” Oil and gas exploration investment almost halved between 2015 and 2020, according to the IEA. . . . Current investment is woefully inadequate to keep pace with likely global energy demand in coming years. . . . Without a sensible, realistic investment strategy — and timetable — for producing renewable energy, the effects of shunning investment in traditional energy sources are likely to be little short of catastrophic if I’m only half right. . . . Governments and ESG investors can feel as virtuous as they like. But willfully-blind ignorance about the consequences of their actions — deep recessions, broken societies and millions more going hungry — doesn’t make them any less immoral. The road to hell, after all, is paved with good intentions.”

And here’s a more practical concern: ESG investing, even taking its supporters at their word that returns are on par with traditional investing, is more costly. According to a September 2021 Wall Street Journal commentary:

“ESG funds tend to be more expensive than other funds. According to another Morningstar study, the asset-weighted average expense ratio of U.S. ESG funds was 0.61% in 2020, compared with 0.41% for all U.S. open-end mutual funds and ETFs.

“Even small differences in expense ratios can add up over time. For example, according to my calculations, a $100,000 investment portfolio with an 8% annual return would increase to about $898,000 over 30 years with an expense ratio of 0.41%, versus about $849,000 if the expense ratio was 0.61% — a difference of $49,000.”

This might seem small. But as awareness has increased, 401(k) fund managers have been under substantial pressure to reduce their fees. It will no doubt be very appealing for them to boost their revenues by convincing employers that they are obliged to select for their employees the ESG fund options, despite the higher fund expense charges. And, of course, it’ll be employees who will be paying the price.

As always, you’re invited to comment at JaneTheActuary.com!

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