ERISA and ESG Investing

The Department of Labor (“DOL”), through its administration of the Employee Retirement Income Security Act of 1974 (ERISA), has a critical role to play in the regulation of employee pension benefit plans. Most importantly, the DOL is tasked with enforcing the fiduciary duties of ERISA plan managers (trustees who retain investment and voting authority or investment managers that receive such authority through delegation by the trustees). Under ERISA, plan managers owe the strictest duties of loyalty and care to their participants and beneficiaries. They are to be constantly guided by the fiduciary principles of acting “solely in the interest of the participants and beneficiaries” and for the exclusive purpose of providing financial benefits to them. The only alternative for a plan manager that wants to be in compliance with its fiduciary duties is to have the sole focus of pursuing the highest risk-adjusted return possible for its participants and beneficiaries. If the pursuit of this maximization does not occur, the plan manager must be in breach of its fiduciary duties.

It is important to recognize and accept that when we talk about ESG investing under ERISA, it is the fiduciary duties of plan managers that direct our discussion. It is not the desires of those who advocate for an increased use of ESG investing. Given this understanding, it is easy for me, as discussed in my recently submitted comment letter, to strongly support the approach taken by the DOL in its proposed rule, Financial Factors in Selecting Plan Investments. I agree with the DOL when it states that “ERISA requires plan fiduciaries to select investments and investment courses of action based solely on financial considerations relevant to the risk-adjusted economic value of a particular investment or investment course of action,” and that “plan assets may not be enlisted in pursuit of other social or environmental objectives,” and “ERISA plan fiduciaries may not invest in ESG [Environmental, Social, and Governance] vehicles when they understand an underlying investment strategy of the vehicle is to subordinate return or increase risk for the purpose of non-pecuniary objectives.” I also find the proposed rule to be consistent with federal court cases that have subsequently interpreted ERISA.

Collateral Benefits ESG versus Risk-Return ESG

I believe the proposed rule would be enhanced if it were to adopt the Max Schanzenbach and Robert Sitkoff approach of dividing ESG investing into two types: “collateral benefits ESG” and “risk-return ESG.”

Collateral benefits ESG is investing based on nonfinancial objectives, including moral or ethical reasons, or to benefit a third party (non-beneficiary or non-participant in a pension fund), such as one or more stakeholders in a public company. For example, focusing on the “G” in ESG, some ESG funds may exclude companies with dual-class shares, such as Alphabet, Facebook, Zoom, Snap, Nike, and Comcast, from their investment portfolios because having such stocks in their portfolios, no matter how financially beneficial, may offend some investors who are strong advocates of shareholder democracy/empowerment. At its worst, collateral benefits ESG results in excluding those investments that would be expected to help maximize the risk-adjusted returns of an ERISA investment portfolio. At its best, it would underweight those investments but still miss out on maximizing risk-adjusted returns that were otherwise available.

Risk-return ESG is investing by utilizing ESG factors only as a means to enhance the manager’s evaluation of the risk-adjusted returns of an investment without regard to collateral benefits. Therefore, I agree with the DOL that this type of ESG investing does not create a legal issue that needs to be addressed in the proposed rule. Nevertheless, the DOL should be on the lookout for collateral benefits ESG being misrepresented as risk-return ESG.

Collateral benefits ESG violates a plan manager’s fiduciary duties when it targets the interests of company stakeholders or any other third party, including the plan manager. There is no win-win. The win can only be for participants and beneficiaries. Moreover, these fiduciary duties do not allow collateral benefits ESG to be used for the pursuit of nonfinancial or nonmonetary benefits even if participants and beneficiaries approve. In sum, investing in collateral benefits ESG, in whatever form, is not compatible with ERISA.

On the other hand, because risk-return ESG focuses only on using ESG factors as a means of optimizing the financial analysis of an investment, it does not conflict with the fiduciary duties of the plan manager. Therefore, I agree with the DOL that risk-return ESG does not create a legal issue that needs to be addressed.

Identifying Collateral Benefits ESG

Even though collateral benefits ESG is easily defined, it still may not be easily recognizable when presented to a plan manager as an investment option. If the DOL does not want plan managers to unknowingly violate their fiduciary duties, the proposed rule should provide guidance on how to recognize collateral benefits ESG. For example, if “portfolio screening” is used in an investment approach or in an investment fund, such as a mutual fund or an Exchange Traded Fund (“ETF”), then you most likely have collateral benefits ESG. Portfolio screening is defined in my comment letter as a process by which a plan manager reduces its universe of eligible investments based on non-pecuniary factors.

Some might argue that adding companies based on positive ESG attributes (inclusionary screen) needs to be distinguished from excluding investments based on moral and ethical grounds (exclusionary screen). I disagree. It is simply another type of portfolio screening—but this time, the screen is based on the requirement of having certain positive ESG attributes. If investments don’t have them, they are excluded from, or underweighted in, the portfolio.

Lower Risk-Adjusted Returns

The use of portfolio screening will necessarily produce lower risk-adjusted returns relative to a well-constructed benchmark index. The first reason is that it leads to an increased probability that the big winners in the stock market will be excluded from, or underweighted in, an investment portfolio.

Hendrik Bessembinder, in his recent pathbreaking article Do Stocks Outperform Treasury Bills?, observed that there is a significant amount of positive skewness in the returns of individual public companies (common stock) that have made up the stock market from July 1926 to December 2016. He found that “in terms of lifetime dollar wealth creation” (“accumulated December 2016 value in excess of the outcome that would have been obtained if the invested capital had earned one‐month Treasury bill returns”), “the best-performing 4% of listed companies explain the net gain for the entire US stock market since 1926, as other stocks collectively matched Treasury bills.” Thus, the returns earned by a relatively small number of big winners were critical to the stock market earning returns above short-term Treasuries.

The understanding that positive skewness exists in stock market returns means that investors are best served if those select few firms that are expected to be the best performers are given the maximum opportunity to show up in an investment fund’s portfolio. If investment funds want to maximize risk-adjusted returns, weeding out investments based on non-pecuniary factors is not the way to accomplish this objective. It is simply an additional constraint on the ability to maximize.

Another reason that portfolio screening may result in lower risk-adjusted returns relates to the unsystematic risk that it can create. ESG funds are currently overweighted in the health-care and technology industries, the two best-performing sectors in the first part of 2020. The result of this recent overweighting has led some advocates of ESG investing to claim that such investing leads to superior financial performance. However, this is not correct. Overweighting in certain sectors can certainly be a good thing, as the short-term performance of ESG funds demonstrates. Of course, depending on the luck of the draw, the opposite is always possible. That is, overweighting can also result in poor financial performance. But the most important thing to understand is that overweighting, and its resulting lack of portfolio diversification, adds extra unsystematic risk to the ex-ante risk-adjusted return calculation. This extra risk cannot be ignored when an ESG fund is being evaluated for its risk-adjusted return.

The Problem with Index Funds that Screen

Moreover, if screening criteria based on non-pecuniary factors are used in the creation of an index, this should create a presumption that those investment funds that use such an index are collateral benefits ESG. For example, by screening out newly issued dual-class shares, which makes no financial sense but is considered good corporate governance by those in the shareholder empowerment movement, investment funds that track some of the most familiar benchmark indexes, such as the S&P 500 index, are now collateral benefits ESG and therefore no longer eligible to be included in an ERISA plan’s investment portfolio. This also means that an investment fund that uses such indexes can no longer serve as a “qualified default investment alternative” (“QDIA”) under the proposed rule. This result is probably a surprise to the DOL, plan managers, participants, and beneficiaries. But it is true.

“All Things Being Equal” or “Tie-Breaker” Standard

Finally, I have great concern about the DOL’s current plan of continuing with its “all things being equal” test or “tie-breaker” standard. This guidance, which essentially creates a safe harbor for collateral benefits ESG to enter the investment portfolio of an ERISA plan, should not be allowed to continue. Even if its occurrence were rare, the tiebreaker is a violation of ERISA because it introduces a non-pecuniary objective into a plan manager’s investment decision-making process.

Alternatively, if the DOL decides to continue with the “tie-breaker” standard, it must do more than just acknowledge that the “test could invite fiduciaries to find ties without a proper analysis, in order to justify the use of non-pecuniary factors in making an investment decision.” My recommendation is to start with the assumption that plan managers will try “to find ties without a proper analysis, in order to justify the use of non-pecuniary factors in making an investment decision.” This simply reflects the reality that when there is money to be made, opportunistic behavior will follow.

If this assumption is accepted, the DOL must determine what procedures and documentation are required to minimize this opportunistic behavior. In sum, if the DOL does not take up-front steps to minimize opportunistic behavior, the DOL should not be surprised to be confronted with numerous claims that economically indistinguishable investments exist.


Despite ERISA being clear in what it requires of its fiduciaries, many commentators will be vigorously opposed to the proposed rule. I view it as a clash between the personal desires of some commentators and what ERISA actually provides (for example, see Martin Lipton’s recent blog post). If these commentators truly want to implement their personal desires, they have but one option – lobby to change the statutory law. But until then, as with the DOL’s proposed rule, they must respect what the current law clearly and unambiguously provides. In sum, I strongly support the DOL’s approach in the proposed rule and hope that my observations and recommendations, as found in my comment letter, will assist in the process of its finalization.


Bernard S. Sharfman is a Senior Corporate Governance Fellow at the RealClearFoundation. The opinions expressed here are the author’s alone and do not represent the official position of RealClearFoundation or any other organization with which he is currently affiliated. This post is adapted from his comment letter to the Department of Labor’s proposed rule, ‘Financial Factors in Selecting Plan Investments.’

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