Wall Street Lobbies to Bring More ESG Funds Into 401(k)s

That means 401(k) overseers and managers need to show that environmental, social and governance strategies can boost financial returns—a challenge for the nascent industry. ESG-focused funds are a growing profit center for asset managers.

Lobbyists representing managers, pensions and retirees began making calls to the Biden transition team in the weeks after the rule was announced. Some lobbyists urged the incoming administration to agree not to enforce the rule and place it under review, said people familiar with the matter.

The rule was slated to be rolled out starting January. That month, the Biden administration flagged it for review.

Wall Street’s lobbying has pushed money managers into a debate over whether easier access to ESG funds helps or harms small investors. Many asset managers argue that being attentive to climate risks or workplace diversity reduces losses and boosts returns.

Some investors say they worry about what they say is Wall Street’s overreach into political causes and whether ESG funds can deliver on financial promises, including returns.

The Trump administration’s Labor Department said that investors shouldn’t assume ESG funds deliver better returns. It warned that the definition of ESG remains unclear, ESG funds can pursue goals with no bearing on returns and they can charge high fees.

The rule makes clear plan overseers can’t sacrifice worker 401(k) returns for nonfinancial reasons. They can only consider those reasons if they determine competing investment options would have equal financial merits.

“It doesn’t flatly rule out all plan investment in ESG funds, but it imposes strict conditions under which plans may select ESG funds,” said

Mark Iwry,

who oversaw national retirement policy while a senior official in the U.S. Treasury Department during past Democratic administrations.

U.S. ESG funds attracted a record $51.1 billion of new money in 2020, more than double from the previous year, according to Morningstar. But they are a tiny part of 401(k)s.

Only 2.6% of U.S. corporate plans offered ESG funds as investment options in employee-benefit plans in 2019, according to the survey data by Plan Sponsor Council of America.

Asset managers want clearer language on when 401(k)s can include ESG funds.

“We don’t want to have people being deterred from looking at investment options where clearly there is a lot of investor demand,” said

Eric Pan,

chief executive of the asset-management industry’s main lobby group, Investment Company Institute.

The initial rule already was toned down after pressure from Wall Street. The Labor Department altered the language last year from a version proposed in June so that several restrictions no longer explicitly apply to ESG funds. The department deleted a section that said plans could deem ESG factors financially material only if qualified investment professionals would say so.

BlackRock Inc.

and others argued that the requirement would add costly burdens.

The debate over the rule has been good for asset managers, said

Jose Minaya,

chief executive of Nuveen, Teachers Insurance and Annuity Association of America’s $1.2 trillion investment-management arm. “It will push the industry to get more sophisticated in terms of how it looks at ESG factors,” he said. The firm plans to keep discussing the rule with the Biden administration.

Mr. Minaya hopes the next iteration will be clearer on how 401(k) plans can account for ESG in investments.

Some executives have expressed concern that the rule penalizes attempts to nudge companies on carbon emissions or other ESG issues that affect shareholder returns.

The risk is that even index funds or active managers that account for ESG factors could be seen as pursuing nonfinancial goals and locked out of 401(k)s.

“It’s a slippery slope,” said

Lori Heinel,

deputy global chief investment officer for $3.5 trillion money manager State Street Global Advisors.

Write to Dawn Lim at dawn.lim@wsj.com