Author: Steven Grieb
On November 22, 2022, the Department of Labor (DOL) finalized its investment duties regulation under the Employee Retirement Income Security Act (ERISA). The final regulations repeal and replace the prior 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 lineup for participants to select from).
The purpose of the final rule is to clarify the application of ERISA's fiduciary duties of prudence and loyalty to selecting investments and investment courses of action — including selecting Qualified Default Investment Alternatives (QDIAs) — and exercising shareholder rights such as proxy voting.
The final regulations take a much more permissive view of considering environmental, social and governance (ESG) factors when investing ERISA plan assets, compared to the 2020 final regulations.
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 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 DOL also understands that ESG investing has become controversial from a political perspective. The new final rule 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. In October of 2021, the DOL issued proposed regulations that significantly amended the 2020 final rules. As suggested by the non-enforcement policy and the proposed regulations, the DOL's newly finalized guidance creates a much more permissive environment for ESG investments in ERISA plans. Generally, the new final regulations become effective 60 days after their formal publication in the federal register on December 1, 2022.
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 new final regulations take an entirely different perspective. They do not use the term "pecuniary." The final rule starts by reasserting the terms of ERISA fiduciary rules. The duties of prudence and loyalty require ERISA plan fiduciaries to focus solely on relevant 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 new final regulations take a very different view of what factors are relevant to a plan's financial interest.
Under the 2021 proposed regulations, the consideration of all relevant 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.) Using the term "require" led many fiduciaries to conclude that considering ESG factors might be mandatory in some circumstances. As a result, the final regulations do not use the phrase "may often require".
Instead, the new final regulations simply state that "Risk and return factors may include the economic effects of climate change and other environmental, social, or governance factors on the particular investment or investment course of action. Whether any particular consideration is a risk-return factor depends on the individual facts and circumstances."
In other words, ESG factors can be financially relevant* in certain circumstances. When they are, fiduciaries "may" consider them when selecting investments. The preamble to the proposed regulations says that the DOL's intent is to clarify that ESG factors are no different from other non-ESG relevant risk-return factors. With the new rule, the DOL is attempting to remove any prejudice to the contrary.
Under the terms of the final rule, fiduciary investment decisions must be based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis. Those risk and return factors may include the economic effects of climate change and other ESG factors on the particular investment. Whether any specific consideration is a risk or return factor depends on the individual facts and circumstances. Finally, the weight given to any factor by a fiduciary should appropriately reflect an assessment of its impact on risk or return.
Additionally, the preamble to the 2020 regulations made clear that ERISA fiduciaries could not consider participant preferences when assembling an investment line up for participants to select from. Many fiduciaries believe that having ESG focused investments available under the plan will encourage more employees to actively participate in the plan and/or contribute more savings. The 2020 regulations did not allow fiduciaries to consider that factor. Conversely, the new final regulations expressly acknowledge that giving consideration to whether an investment option aligns with participants' preferences can be relevant to furthering the purposes of the plan. Still, fiduciaries may not add imprudent investment options to menus based on participant preferences or requests.
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 tiebreaker if they meet certain documentation requirements.
The new final 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 final regulation eliminates the extra documentation requirement from the 2020 rule. That doesn't mean that fiduciaries shouldn't document how the investments equally serve the plan's financial interests and the collateral factors considered. The DOL simply intends for the same standards of documentation to apply to tie-breaker decisions as any other fiduciary matter.
Additionally, under the 2021 proposed regulations, if a defined contribution plan fiduciary relies on non-financial factors to break a tie, they would have been required to "prominently display" the non-financial factors considered in disclosure materials provided to participants. This requirement would have been a new disclosure requirement under ERISA. The final regulations do not contain the proposed participant disclosure requirement.
ESG factors in Qualified Default Investment Alternatives (QDIAs)
The 2020 final regulations were 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 under that rule, plans could not use an ESG fund as their QDIA.
The new final regulation removes this prohibition. The new final rule would instead apply the same standards to QDIAs that other investments are subject to. Consequently, 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 allowed two safe harbors for proxy voting policies. One safe harbor permitted 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 permitted a policy of not voting on proposals when the plan's investment is too small to have any impact on the outcome.
The 2022 final 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 final 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.
As a result, when an ERISA fiduciary receives a proxy vote relating to a plan asset, they must take affirmative steps to consider whether a proxy vote might have an impact on the investment's risk or return. Fiduciaries should vote a proxy unless they affirmatively determine that there's a prudent reason for not doing so. Any actions relating to a proxy vote — including the decision not to vote — should be documented, including the relevant factors considered, and why the fiduciary ultimately selected a given course of action.
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 final regulations might serve to give retirement plan fiduciaries some encouragement in using these investments going forward. Fiduciaries should understand that ESG investments have recently become a political hot potato, and the final regulations could be challenged in the courts.
As a result, decisions allowing funds that consider ESG factors will require careful deliberation and documentation in accordance with a prudent process. ERISA fiduciaries should carefully document when ESG factors are considered and how those factors impact the investment's risk and return characteristics. Gallagher will continue to monitor developments in the DOL's position relating to socially responsible investing.
* In some places, the 2021 proposed regulations referred to "material" factors when making investment decisions. The final 2022 regulations use the term "relevant" as opposed to "material".