401(k) plans run by money management firms that incorporate environmental, social, and governance (ESG) factors in their investment decisions are under attack.
Earlier this month, a Texas U.S. District Court judge ruled in favor of an American Airlines pilot who sued the airline in a class action lawsuit for hiring an investment manager (BlackRock) that bases its investment decisions for AA’s 401(k) plan on ESG and non-financial factors. The plaintiff argued that American Airlines violated its fiduciary duties by mismanaging the retirement plan when they utilized investment managers pursuing non-financial and nonpecuniary ESG policy goals.
The case, likely to be appealed, is the latest assault on ESG investing, which has come under fierce opposition from conservatives. “This case is special because it is the first such case dealing with ESG,” says Joshua Lichtenstein, an attorney who heads the ERISA fiduciary practice at law firm Ropes & Gray.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
The case against American Airlines
The Spence v. American Airlines case did not involve ESG funds or ESG products. Rather, the lawsuit took aim at the airline for using an investment manager for its $26 billion retirement savings plan with a record of pro-ESG proxy voting practices and shareholder activism in pursuit of ESG goals. American Airlines thus allegedly failed its duty of loyalty to its workers in the plan, but not its fiduciary duty of prudence.
In the ruling, Judge Reed O’Connor of the US District Court for the Northern District of Texas said American Airlines allowed its retirement plan to be influenced by corporate goals “unrelated to workers’ best financial interests.”
“It’s just the first step in the case,” said Aliya Robinson, managing legal counsel for T. Rowe Price’s legislative and regulatory affairs division. “This is probably not the final word on the case. There are a lot of questions out there, still. We’ll continue to follow the case as it evolves.”
Indeed, the judge has yet to decide whether any financial remedies or damages will be awarded. And the legal community expects an appeal at the Fifth Circuit. The impact, at least for now, is unclear, attorneys say.
ESG Funds in 401(k) plans
So, are ESG funds at risk of being removed from 401(k) plans?
That draconian outcome is unlikely, says Lichtenstein. “I don’t think this case will have a material impact on the use of ESG funds (in employer-sponsored retirement accounts) as long as the plan fiduciary can show they selected the fund based only on financial factors.” That said, Lichtenstein says the 401(k) space is extremely litigious and any potential new claim that could be brought against multiple plan sponsors is an important risk to consider. “The biggest impact of this case on ESG funds is likely to be scrutiny of how they vote proxies,” said Lichtenstein.
But the ruling opens the door for ESG funds to be jettisoned from employer-sponsored retirement plans, says Jacob Frenkel, chair of government investigations and securities enforcement practice at law firm Dickinson Wright. “The case stands for the clear proposition that 401(k) plan participants invest their money to make money,” said Frankel. “The investment purpose is not to advance a political or social agenda.”
Whether ESG funds are at risk of being removed from 401(k) plans will depend on the reason a fund was selected for the fund lineup, says Frankel. “Funds that are ESG-friendly, but the ESG concept is not the rationale for the fund’s selection, should be safe. If the (reason) is anything other than ‘financial benefit,’ the plan could have a problem and could start staring at litigation.”
The impact on 401(k) investors
The judge’s ruling does have potential negative consequences for 401(k) investors.
Proponents of ESG investing argue that the ruling limits investment choices for 401(k) savers.
“If left to stand, the Court opinion poses a serious threat to investors’ right to rely on financial advisors and asset managers or make their own informed decisions about how to invest their retirement savings,” said Danielle Fugere, president and chief counsel of As You Sow, a non-profit that promotes corporate social responsibility through shareholder advocacy.
Moreover, the ruling creates a chilling effect that harms 401(k) plan participants. The “fear of lawsuits” could prevent plan fiduciaries from offering participants a wider variety of funds that could allow for better returns and diversification opportunities, Lichtenstein adds.
The risk is if the case becomes a “blueprint for other cases,” says Lichtenstein. “If the Fifth Circuit upholds the opinion, then the Fifth Circuit could become ground zero for copycat cases.”
ESG proponents argue that taking environmental, social and governance factors into consideration is an essential component of the risk analysis for any investment. For example, insurance companies that operate in areas of high fire or flood risk must factor rising climate risk into premium pricing, according to State Street Global Advisors. The court ruling concluded that “just because a financial firm (BlackRock) says (climate change) is ‘financial’ or ‘material’ does not automatically mean that it is.”
“Fiduciaries have an obligation to consider and mitigate long-term climate risk,” said Fugere. “This decision will handcuff them from doing so.”
Expect more scrutiny of ESG in 401(k)s
ESG investments have gained a following among investors. Most 401(k) participants (74%) say having ESG options could inspire them to increase their contribution rate, according to Schroders 2002 U.S. Retirement Survey.
Yet, fewer than 15% of 401(k) plans offer an ESG fund in their investment lineup, according to research by Jane Danyu Zhang, assistant professor of finance at the University of Oregon’s Lundquist College of Business. Zhang’s research found that plans were more likely to offer an ESG option in an employer retirement account if they were in politically liberal jurisdictions.
However, a Gallup poll found that 48% of Americans say retirement fund managers should only take financial factors into account when making investment decisions, vs. 41% who say the managers should also consider ESG factors.
Given the judge’s ruling in Spence v. American Airlines, there’s no doubt employee benefits executives will have to take a close look at the motivations for their investment decisions in 401(k) plans.
“Employee benefits committees and investment managers of 401(k) plans should reevaluate promptly whether the reason for the investments of 401(k) plan assets is solely for financial benefit of plan participants, with social and political considerations being irrelevant to their consideration,” said Frenkel.
Read More
-
UnitedHealth Is the Worst Dow Jones Stock Thursday. Here's WhyUnitedHealth is putting pressure on the 30-stock index Thursday after the insurance giant reported a rare revenue miss. This is what you need to know.
-
Why Bank of America Stock Is Still a Buy After EarningsBank of America stock is trading lower Wednesday after the financial firm reported earnings but Wall Street isn't worried. Here's why.
-
UnitedHealth Is the Worst Dow Jones Stock Thursday. Here's Why
UnitedHealth is putting pressure on the 30-stock index Thursday after the insurance giant reported a rare revenue miss. This is what you need to know.
-
Why Bank of America Stock Is Still a Buy After Earnings
Bank of America stock is trading lower Wednesday after the financial firm reported earnings but Wall Street isn't worried. Here's why.
-
Taiwan Semiconductor Earnings Fuel a Rally in Chip StocksTaiwan Semiconductor stock is higher Thursday after the chip manufacturer beat expectations for its fourth quarter and issued a strong outlook. Here's what you need to know.
-
Asset Protection for Affluent Retirees in 2025Putting together a team of advisers to assist with insurance, taxes and other financial issues can help with security, growth and peace of mind.
-
The Tax Stakes for 2025: Planning for All PossibilitiesIt's unclear whether extending the TCJA provisions for individuals is likely, so what can you do to reduce your overall tax bill either way?
-
A Strategic Way to Address the Tax-Deferred DisconnectWhat you don't know could cost you a fortune. Here's how to make the most of a tax-deferred retirement account and possibly save your heirs a bunch on taxes.
-
Stock Market Today: Dow Pops 703 Points on Cooler InflationA benign reading from the Consumer Price Index report assuaged market fears about the path of borrowing costs.
-
CPI Report Keeps the Fed on Track: What the Experts Are Saying About InflationCPI Disinflation in key areas of consumer prices should help the Federal Reserve stick to its policy path of gradual cuts to interest rates.
