Author: Steven Grieb
On October 14, 2021 the Department of Labor (the "DOL") proposed a new investment duties regulation under ERISA. The proposed regulations repeal and replace the final regulations issued by the DOL in November 2020, which required ERISA investment fiduciaries to consider only pecuniary (i.e., monetary) factors when selecting investments for an ERISA plan (or when creating an investment line-up for participants to select from). The new proposal also repeals and replaces the December 2020 final regulations addressing a fiduciary's responsibility for voting proxies and other shareholder rights. The new proposed regulations take a much more permissive view of considering environmental, social and governance ("ESG") factors when investing ERISA plan assets.
Not Your Father's Socially Responsible Investing
When the concept of socially responsible investing began decades ago, it focused on excluding certain types of investments. The concept involved screening out companies that were involved in specific prohibited industries, such as tobacco, alcohol or weapons, or companies located in certain countries. But the concept evolved away from excluding certain investments to favoring certain investments based on a company's ESG principles to generate competitive long term returns along with a positive societal impact.
From the perspective of an ERISA fiduciary, this shift creates some breathing room. The idea of excluding a potentially more lucrative investment because of the business they're in runs contrary to the fiduciary's duty of loyalty, which requires the best interest of the participants and beneficiaries to be paramount. But any process that considers how ESG factors might negatively impact the company's bottom line could be complimentary to that duty of loyalty. For example, when a company has engaged in the improper disposal of hazardous waste, that fact could involve business risk, possible litigation and regulatory fines. Considering the negative impact those developments could have on the company's bottom line would appear to make sense from a fiduciary perspective.
The DOL acknowledges the increase in the number of ESG focused investment funds, as well as the amount of money flowing into those funds. The number of ESG metrics, services and ratings offered by third party service providers has also spiraled. The DOL knows that the speed of these trends is increasing. The new proposal gives ERISA fiduciaries much more leeway in taking ESG factors into account and making them part of their decision matrix.
The Regulation's Bottom Line
In March 2021, under new leadership following the 2020 election, the DOL declared a non-enforcement policy regarding the regulations it finalized in late 2020. The DOL also expressed at the time a clear intent to revisit those final rules. As suggested by the non-enforcement policy, the DOL's new proposed regulation creates a much more permissive environment for ESG investments in ERISA plans.
The final rule from 2020 required ERISA fiduciaries to consider only "pecuniary" factors when selecting plan investments. A pecuniary factor is anything that is expected to have a material effect on the risk and/or return of an investment. Anything else would be a "non-pecuniary" factor. The newly proposed regulations take an entirely different perspective. They do not use the term "pecuniary." The new rule starts by reasserting the terms of ERISA fiduciary rules. The duties of prudence and loyalty require ERISA plan fiduciaries to focus solely on material risk-return factors and not subordinate the interests of participants to objectives unrelated to the provision of benefits under the plan. However, compared to the current rules, the proposal takes a very different view of what factors are material to a plan's financial interest.
According to the new regulation, the consideration of all material factors "may often require an evaluation of the economic effects of climate change and other environmental, social, or governance factors on the particular investment." (Emphasis Added.) In other words, ESG factors can be financially material. When they are, fiduciaries have a responsibility to consider them when selecting investments. The preamble to the proposed regulations says that "material climate change and other ESG factors are no different than other 'traditional' material risk-return factors." With the new rule, the DOL is attempting to remove any prejudice to the contrary.
The rule lists three examples where ESG factors are material to the risk-return analysis, including:
- Climate change-related factors, such as a corporation's exposure to the real and potential economic effects of climate change, including the positive or negative effect of government regulations;
- Governance factors, such as those involving board composition, executive compensation, and transparency and accountability in corporate decision-making, as well as a corporation's avoidance of criminal liability and compliance with labor, employment, environmental, tax, and other applicable laws and regulations; and
- Workforce practices, including (i) the corporation's workforce diversity, inclusion, and other drivers of employee hiring, promotion, and retention, (ii) its investment in training to develop its workforce's skill, (iii) equal employment opportunity and (iv) labor relations.
As an example, under this standard, companies without a plan to address climate change may be unprepared to comply with new climate related regulations. Similarly, corporations with diversified leadership might be better able to adapt to the needs of customers in a multi-cultural market place. As a result, the new rule goes farther than saying that ERISA investment fiduciaries may consider ESG factors. It says that ESG factors, especially when thinking about long term investment horizons, are frequently financial in nature and therefore must be considered.
What About the Tie-Breaker Rule?
Under the 2020 regulations, the DOL took the position that ERISA did not prohibit the consideration of non-pecuniary factors if the fiduciary was "unable to distinguish" between the expected rate of return and risk characteristics of two investments. This idea is frequently referred to as the "all things being equal" standard or the "tie-breaker" test. The problem with this standard is that any situation where two investments are indistinguishable is likely hypothetical, and never really happens.
However, the 2020 final rule did allow the fiduciary to rely on non-pecuniary considerations as a tie-breaker if they meet certain documentation requirements. Specifically, the fiduciary must document: (i) why pecuniary factors were not sufficient to select the investment; (ii) how the selected investment compares to the alternative investments with regard to diversification, liquidity and current/projected returns; and (iii) how the chosen non-pecuniary factor or factors are consistent with the interests of participants and beneficiaries in their retirement benefits under the plan.
The new proposed regulation also retains the tie-breaker rule. However, the new rules do not require that two investments be entirely indistinguishable. If a fiduciary prudently concludes that competing investments "equally serve the financial interests of the plan over the appropriate time horizon," the fiduciary is not prohibited from selecting the investment "based on collateral benefits other than investment returns." The new proposal eliminates the extra documentation requirement. Instead, if a defined contribution plan fiduciary relies on non-financial factors to break a tie, they must "prominently display" the non-financial factors considered in disclosure materials provided to participants. The fiduciary could make such a disclosure as part of the annual fee disclosure.
ESG Factors in Qualified Default Investment Alternatives ("QDIAs")?
The 2020 final regulations are clear that no investment fund can be retained as a QDIA (or as a component of a QDIA) if its investment strategies consider non-pecuniary factors. So plans cannot use an ESG fund as their QDIA. The new proposal removes this prohibition. The new rule would instead apply the same standards to QDIAs that other investments are subject to. So a QDIA that considers ESG factors is a much more open possibility under the new rules. From a practical perspective, it's fairly rare that an investment fiduciary selects an ESG fund as a QDIA, even if theoretically permitted by the ERISA fiduciary rules.
What Fiduciary Rules Apply to Proxy Voting and other Shareholder Rights?
Before the 2020 final regulations, many fiduciaries believed that ERISA required them to vote each and every proxy they received relating to a plan asset. The 2020 rule expressly stated that not all proxies must be voted. In fact, the rule allows two safe harbors for proxy voting policies. One safe harbor permits a fiduciary to not vote on any proposal that is not expected to have a material effect on the value of the investment. The other safe harbor permits a policy of not voting on proposals when the plan's investment is too small to have any impact on the outcome.
The proposed regulation removes the explicit statement that not all proxies must be voted, along with the two safe harbors. The new rule instead directs fiduciaries to the generally applicable statutory duties of prudence and loyalty. The preamble to the regulation makes clear that the DOL still takes the position that fiduciaries don't have to vote every proxy. However, the DOL expressed concern that such an express statement in the regulations might cause ERISA fiduciaries to abdicate their duty to vote a proxy when the vote might have an impact on the investment's bottom line. So fiduciaries still must consider whether a proxy vote might have an impact on the investment's risk or return. As a rule, fiduciaries should vote a proxy unless they determine that there's a prudent reason for not doing so.
Gallagher Insight
Interest in socially responsible investments – both by retirement plans and individual investors – has grown significantly in recent years. For many years, Gallagher's Investment Monitoring Reports have contained information on your fund's Morningstar sustainability rating, which is the fund's Morningstar ESG rating.
The DOL's proposed regulations might serve to give retirement plan fiduciaries some encouragement in using these investments going forward. The new rules are not final and effective at this point. Nevertheless, they do provide a window into the DOL's thinking on the subject. Decisions allowing funds that consider ESG factors will require careful deliberation and documentation. But under these rules, there may be some circumstances where the DOL considers use of ESG factors as a requirement. Gallagher will continue to monitor developments in the DOL's position relating to socially responsible investing.
