On Nov. 22, 2022,the Department of Labor issued a final rule that permitsplan fiduciaries to take into account ESG factors and other ancillary factors if the fiduciary concludes that the investment“equally serve[s] the financial interests of the plan over the appropriate time horizon” without creating “expected reduced returnsor greaterrisk” (Final Rule). The Final Rule also eliminated a recordkeeping requirement that the prior rule had imposed.
This article provides an overview of the interplay between ESGfactors and fiduciary duties in plan investments,background of the dichotomy in guidance issued during previous administrations, and a summary of key provisions in the Final Rule applicable to ESG factors in plan investments.
Overview
For the most part, the DOL has been consistent on when a plan fiduciary can take ESG factors into account. In general, a plan fiduciary can take into account any factor that a fiduciary prudently determines is expected to have a material effect on the risk and/or return of an investment based on appropriate investment horizons consistent with the plan's investment objectives.
If an ESG factor is expected tohave a material effect on the risk or return, the DOL has repeatedly encouraged fiduciaries to take those factors into account. For example, if an investment fiduciary thinks that investments in companies that sell tobacco products are likely to perform poorly economically, the DOL has not restricted the fiduciary's ability to avoid tobacco-related investments.
The DOL has consistently said that a fiduciary cannot sacrifice return or increase risk to take any factor into account. For example, if an investment fiduciary thinks that oil and gas production are harmful to the environment,but the fiduciary also thinks that an investment that includes companies that profit from oil and gas production is the best possible option for plan participants, the DOL has said that the fiduciary should not let the possible environmental harm taint the fiduciary's focus on the economic performance of the retirement plan.
Where prior guidance had been somewhat inconsistent has been what to do where a fiduciary thinks that consideration of a factor could generate a social good,but where that factor is not expected tohave any impact on investment performance. While DOL guidance throughout presidential administrations has suggested that ESG factors can be considered in these circumstances as a “tie-breaker,” some administrations have expressed skepticism about the frequency of ties.
Background
Section 404 of ERISA requires that plan fiduciaries discharge their duties “solely in the interest of the participants and beneficiaries, for the exclusive purpose of providing benefits to participants and beneficiaries.” How this language can be reconciled with ESG investing has now been the focus of five presidential administrations.
The DOL under President Bill Clinton issued Interpretive Bulletin (IB) 94-1, which clarified that ERISA requirementsdo not prevent plan fiduciaries from investing plan assets in economically targeted investments (ETIs)—defined by the bulletin as investments selected for the economic benefits in addition to the investment return to the participant of the employee benefit plan—so long as the ETI has an expected rate of return that is commensurate to rates of return of alternative investmentswith similar risk characteristics.
The Bush administration cautioned fiduciaries that investments rarely meet the criteria of IB 94-1. It issued Interpretive Bulletin 2008-01, stating that fiduciariesmay only take factors otherthan the economic interests of the plan into account in rare and limited circumstances, specifically where “analysis showed that the investment alternatives were of equal value.” The DOL suggested that there is a risk that the DOL or a plaintiff could challenge the analysis and that a fiduciary would likely need a written record to demonstrate compliance.
The Obama administration subsequently promulgated Interpretive Bulletin 2015-01 which withdrew IB 2008-01 and reinstated IB 94-1. IB 2015-01 stated that ESG factors “may have a direct relationship to the economic value of the plan's investment” and consideration of ETIs or ESG criteria does not require additional documentation beyond that required by fiduciary standards applicable to plan investmentsgenerally.
The Trump administration also issued itsown regulation,“Financial Factors in Selecting Plan Investments” (Financial Factors Rule). The Financial Factors Rule divided factors into those that were expected to have a pecuniary impact and those that were not. The Financial Factors Rule indicated that non-pecuniary factors could only be considered where a fiduciary faced a tie afterexhausting consideration of pecuniary factors. It also stated that the DOL “continues tobelieve that the likelihood that a plan fiduciary will be unable to distinguish between two investment options based on pecuniary factors is rare” and prohibited consideration of non-pecuniary factors in default plan investments. The Financial Factors Rule also contained a documentation requirement that applied whenever a fiduciary used a non-pecuniary factor to break a tie.
The Final Rule
In the preamble to the Final Rule, the DOL states that it is seeking “regulatory neutrality.” It suggests that the Financial Factor Rule may have had a chilling effect on ESG consideration, “even in cases where it is in the financial interestsof plans to take such considerations into account.” The preamble reinforces the DOL's message of neutrality by stating that “[a] fiduciary … remains free underthe Final Rule to determine that an ESG-focused investment isnot in fact prudent.”
The Final Rule suggests, however, that ESG factors can be beneficial to plans in several ways—some of which may be controversial. For example, the preamble suggests that “labor-relations factors, such as reduced turnover and increased productivity associated with collective bargaining, may be relevant to a risk and return analysis.” The preamble suggests that plan fiduciaries that take participant preferences into account in selecting investments for a plan's menu could see greater participation and higher deferralrates, which could help lead to larger participant retirement savings
This is the first time the DOL has expressly identified participation ordeferralrates as factors that a fiduciary could take into account.
The Final Rule makes a handful of significant changes by:
- Rejecting the “non-pecuniary” terminology from the Financial Factors Rule and instead pivoting terminology to whether factors are “material” and “relevant”;
- Suggesting that consideration of any factor in making an investment decision should be based on three elements;
- Removing ESG specific rules related to default investments and documentation; and
- Clarifying that participant preferences can be taken into account.
These changes are largely consistent with the guidance issued by the Clinton and Obama administrations.
The Final Rule provides a clear framework for considering ESG factors that may have an economic impact. It provides that a fiduciary's decision should:
- Be based on factors that the fiduciary believes are relevant to the investment's risk and return;
- Recognize that risk and return can include things like the economic effects of climate change and other factors on the particular investment or investment course of action; and
- When giving weight to any factor, appropriately reflect an assessment of that factor's impact on risk and return.
Where a fiduciary identifiesESGfactors that do not give rise to an economic impact,the DOL suggests that a fiduciary can incorporate an ancillary factor if the fiduciary concludes that competing investments “equally serve the financial interests of the plan over the appropriate time horizon.”
Outlook
ESG investing is going to remain an area where future administrations are likely to seek to revise rules. Practitioners and plan fiduciaries can find some comfort though in the relative consistency of the “tie-breaker” test. The DOL has remained consistent that plan fiduciaries ought to consider factors that the fiduciary believes to be relevant to investment risk and return—regardless of whether those factors are ESG factors or not. Similarly, the DOL has suggested that fiduciaries shouldn't sacrifice returns or take on additional risk to pursue ancillary goals—regardless of how noble those other goals may be.
Where fiduciaries and practitioners may see evolution as a result of the Final Rule is around investments related to participant savings. The DOL's Final Rule hints that some ESG goals may be more likely to lead to better retirement outcomes. For example,the DOL suggests that plan fiduciaries may seek to evaluate whether incorporation of ESG factors would increase contribution rates or plan participation. The Final Rule invites the question about whether investments that support participant jobs could lead to increased plan funding. While the DOL is careful to remind fiduciaries that they cannot sacrifice returns, the Final Rule may trigger some analysis by plan fiduciaries to determine if there are ways to comply with the guidance while responding to plan participant investment requests.
There are likely to be efforts to revise the Final Rule. On the one side, some membersof Congress have signaled that they have concerns that the Final Rule may promote ESG investing in a manner that is inconsistent with ERISA. On the other side, other membersof Congress may seek further regulatory changes or changes to ERISA's text to require plans to take certain ESG factors into account or to document that certain ESG risks are periodically evaluated.
Over the coming months, plan fiduciaries are likely to hear from participants and investment consultants about the Final Rule. While it does provide for a less stringent regulatory landscape than the Financial Factors Rule, individuals should rememberthat while DOL has given a green light to considering the pursuit of ancillary good, it has only done so where participant returns aren't sacrificed and risks aren't increased.
Originally Published by Bloomberg Law
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
