Key Considerations: DOL’s New Final Regulation on ERISA’s Investment Duties (ESG-Related or Not)

The U.S. Department of Labor (DOL) finalized amendments to the investment duties of a fiduciary subject to the U.S. Employee Retirement Income Security Act of 1974, as amended (ERISA).1 The rule amendments were aimed at ERISA fiduciaries that utilize products and strategies that incorporate environmental, social and/or governance (ESG) factors. Though the DOL opted not to let the final rule get bogged down in the ESG-lexicon quagmire by removing all express references to ‘ESG,’ the final rule clearly and directly applies to fiduciaries that consider ESG factors when investing on behalf of ERISA plans and funds that hold “plan assets.” Indeed, all ERISA fiduciaries that make investment decisions (including the selection of investment funds for participant-directed plan lineups), regardless of whether ESG is even implicated, should review this rule carefully.

The rule becomes effective 60 days after publication in the Federal Register. Plans have until April 30, 2022 to make any changes to their “qualified default investment alternatives” (QDIAs), within the meaning of 29 C.F.R. § 2250.404c-5, as a result of this rule. The rule contemplates a grandfathering mechanism, which will be highly fact-specific.2 The DOL further noted that it “will not pursue enforcement, and does not believe any private action would be viable, pertaining to any action taken or decision made with respect to an investment or investment course of action by a plan fiduciary prior to the effective date of the final rule to the extent that any such enforcement action would necessarily rely on citation to this final rule.”

The final rule builds upon the original investment duties regulation, which provided a safe harbor for fiduciaries in satisfying their duty of prudence under ERISA. The final rule, like the original, compels fiduciaries to give appropriate consideration to numerous factors regarding the composition of the plan portfolio as it relates to diversification, liquidity and current return of the portfolio relative to the anticipated cash flow needs of the plan, and the projected return of the portfolio relative to the funding objectives of the plan. Importantly for 3(38) investment managers, the final rule preserves the aspects of the original regulation that allowed investment managers to rely and act on information provided by the appointing fiduciary in fulfilling these duties with respect to the plan portfolio over which it has discretion.

The final rule withdraws DOL Interpretive Bulletin 2015-01 and supersedes “ESG Investment Considerations” in DOL Field Assistance Bulletin 2018-01.

This final rule does not address an ERISA fiduciary’s responsibilities with respect to proxy voting and the exercise of other shareholder rights. The DOL recently proposed a rule on this topic, though it has yet to move forward with the proposal. Until a final rule emerges, fiduciaries should continue to follow DOL Interpretive Bulletin 2016-01 and DOL Field Assistance Bulletin 2018-01.

Key Considerations

The final rule preserves the essence of the original investment duties regulation (and ERISA) by allowing ERISA fiduciaries considerable leeway in crafting investment portfolios. The DOL thus admitted that, as a general matter, there is total parity between investment strategies and products, whether ESG-related or not. In other words, an ERISA fiduciary may manage plan assets while taking into account ESG risks and opportunities without violating the rule.

The final rule presents five distinct issues worth considering (1) pecuniary factors; (2) comparing investment alternatives; (3) duty of loyalty; (4) special circumstances/non-pecuniary factors/tie-breakers, and (5) QDIAs.

Pecuniary Factors

Whether investing on behalf of an ERISA-covered defined benefit plan or selecting plan investment options for a participant-directed plan, the final rule compels fiduciaries to consider pecuniary factors only, absent special circumstances (discussed below), when evaluating the risk and return profiles of investments. The rule defines a “pecuniary factor” as one “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 and the funding policy….”3 The DOL expressly recognized that ESG factors may be pecuniary factors under the rule.4 The requirement that only pecuniary factors be considered is a legal requirement, not a safe harbor.

The final rule’s definition of pecuniary factors is forward-looking in nature, meaning a fiduciary need not know that a factor will materially affect risk/return at the time of the investment. Instead, the fiduciary must be prudent in coming to that conclusion based on the facts and circumstances. This change by the DOL should give comfort to fiduciaries who are closely tracking the emerging data of various ESG (and other) factors’ impact on investment performance. Fiduciaries should take note that the DOL has repeatedly cautioned fiduciaries against disproportionately weighting the materiality of a factor based on existing data.

The DOL opted to avoid defining the slippery concept of materiality. The DOL said in the preamble to the final rule that it “believes that fiduciaries and investment managers are generally familiar with that concept from its use in connection with both ERISA and the federal securities laws.” This seemingly allows the concept of pecuniary factors to evolve with market consensus on materiality and ultimately on how other regulators define materiality for these purposes. Yet, the DOL acknowledged that the following may be material, and thus, pecuniary factors under the rule: (1) an investment manager’s brand/reputation; (2) proprietary products; and (3) a fund or product’s legal regime that confers greater investor protection and/or improved disclosures.

As with any other evaluation of prospective investments, a fiduciary should first determine that it has sufficient skills and expertise to determine that the ESG (or any other) factor presents economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories (if not, the determination should be made by another fiduciary that has such expertise and skill).5 Moreover, the DOL apparently will look for risk controls in place commensurate with the complexity, nature and size of the investment activity (the implication is that fiduciaries that consider ESG factors should have rigorous controls in place to ensure that they are properly determining factors to be  pecuniary factors under the rule).

In the context of ERISA-covered participant-directed plans, the decision as to which funds populate the plan lineup is subject to ERISA’s fiduciary duties and this new rule, among others. In the preamble to the final rule, the DOL addressed whether a fiduciary could select an ESG investment fund, product or model portfolio based solely on participant request or because of the potential for increased contributions to the plan. In short, these types of considerations are not pecuniary factors and, therefore, the responsible fiduciary may not base its decision to include an ESG fund, product or model portfolio as a designated investment alternative without separately determining that the pecuniary reasons for such inclusion satisfy the rule. As discussed below, however, participant requests and the like may be “tie-breakers” in selecting between alternative investment options.

Comparing Investment Alternatives

Under the final rule, the fiduciary must compare investments or investment courses of action (e.g., selection of designated investment alternative for participant-directed plans) based on factors “that are expected to result in a material difference among reasonably available alternatives with respect to risk and/or return.” This comparison requirement is, therefore, not limitless. Thus, a fiduciary does not need to consider all factors that differentiate investment funds, only ones that are pecuniary. Moreover, fiduciaries are under no obligation to scour the market for the lowest cost investment opportunities, much less select the cheapest available investments.

The DOL further confirmed that the fiduciary need not expend considerable resources on searching for investment opportunities or considering an infinite number of investment alternatives. Instead, the fiduciary’s duty to evaluate alternative investment opportunities is limited to comparing alternatives that are reasonably available under the circumstances. This means that the rule “allow[s] for the possibility that the characteristics and purposes served by a given investment…may be sufficiently rare that a fiduciary could prudently determine, and document, that there were no other reasonably available alternatives for purposes of this comparison requirement.”

Duty of Loyalty

Fiduciaries are already well aware that ERISA imposes a duty of loyalty, in addition to the prudence requirements discussed above. The final rule incorporates this specific fiduciary duty by prohibiting fiduciaries from subordinating the interests of plan participants and beneficiaries in their retirement income to non-pecuniary goals. Though this may seem to be an example of form over function, the DOL opted not to include the duty of loyalty under the rule’s general safe harbor characterization, meaning fiduciaries will likely not only be conservative in satisfying the rule’s requirements but may also opt for even stronger controls/analysis/documentation than the rule technically requires to ensure they do not run afoul of the loyalty concerns the DOL has expressed in the context of ESG.

Special Circumstances/Non-Pecuniary Factors/Tie-Breakers

Prior DOL guidance provided that if, after an evaluation, alternative investments appear economically indistinguishable, a fiduciary may then, in effect, “break the tie” by relying on a non-pecuniary factor. Commenters argued that the proposal effectively required equivalence between investments. The DOL suggested that they did not mean for investment alternatives to have identical characteristics, just equivalent roles in the plan’s investment portfolio. Commenters argued that indistinguishability in liquid markets is all but impossible and are, in turn, never perfectly correlated.

Under the final rule, if a fiduciary is unable to determine which investment is in the best interests of the plan on the basis of pecuniary factors alone, the fiduciary may base the investment decision on non-pecuniary factors, provided the fiduciary documents the following: (1) why pecuniary factors were not sufficient to select the investment; (2) how the investment compares to the alternative investments; and (3) how the chosen non-pecuniary factors are consistent with the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan. This effectively prohibits ERISA fiduciaries from choosing investments with expected reduced returns or enhanced risks in order to secure non-pecuniary benefits.

The third condition is a hemmed-in version of the historical tie-breaker test. Simply, the DOL split the difference from the proposal, which all but eliminated the tie-breaker mechanism, and instead has allowed a tie-breaker but only on the basis of a pecuniary-light factor. Under the final rule, a fiduciary no longer appears able to select an investment fund based on the ethos of the plan sponsor (assuming the other conditions of the rule are met). Instead, the non-pecuniary factor must at least have some nexus to participants’ and beneficiaries’ retirement income or financial benefits. The DOL indicated that responding to participant demand in order to increase retirement plan savings may be consistent with the interests of the participants and interests in their retirement income or financial benefits under the plan. In contrast, selecting an investment option that “would bring greater personal accolades to the chief executive officer of the sponsoring employer, or solely on the basis of a fiduciary’s personal policy preferences, would not.”

The same standards apply to selecting investment funds, products and model portfolios for a participant-directed plan lineup. The DOL admonished fiduciaries to “carefully review the prospectus or other investment disclosures for statements regarding ESG investment policies and investment approaches.” In particular, the DOL stressed that fiduciaries should be “cautious in exercising their diligence obligations under ERISA when disclosures, whether in prospectuses or marketing materials, contain references to non-pecuniary factors or collateral benefits in a fund’s investment objectives or goals or its principal investment strategies.”

The DOL envisions that fiduciaries will evaluate fund prospectuses and other disclosures to determine if the fund uses an ESG or sustainability rating system of index. If the fund uses such a rating system or index, the fiduciary, as part of its due diligence, would need to consider whether the rating system or index “evaluates one or more factors that are not financially material to investments.” If so, the selection of the fund is a special circumstance, thereby requiring the fiduciary to satisfy the aforementioned heightened requirements.

On this point, the DOL indicated that a fiduciary would have to understand how the ratings are actually determined, such as the rating’s methodology, weighting, data sources, performance benchmarks and the underlying assumptions utilized. Moreover, “a fiduciary may not assume that combining [multiple factors] into a single rating, index or score creates an amalgamated factor that is itself pecuniary.”

QDIAs

On QDIAs, DOL stressed that the proposal was never intended to block investment funds, products or model portfolios that treat ESG factors as pecuniary in nature from being QDIAs. The final rule better captures this intent by only prohibiting those QDIAs whose investment objectives, goals or principal investment strategies include, consider or indicate, one or more non-pecuniary factors. Crucially, the tie-breaker mechanism is not available when selecting QDIAs. This means that a fund will no longer qualify as a QDIA if its investment objectives, goals or principal strategies include a non-pecuniary factor, even if including such fund as a QDIA is in response to participants’ request or otherwise increase the desirability of the plan to participants.

The DOL claimed fiduciaries can apply the rule to QDIAs easily and objectively. They indicated, for example, that a plan fiduciary can simply look at the investment fund’s prospectus to determine whether the fund is qualified or disqualified as a QDIA under the final rule. The DOL specifically pointed to Form N-1A to ascertain whether non-pecuniary considerations form a material part of a fund’s investment objectives or principal strategies. The DOL is under the impression that disclosures for other types of investment vehicles, such as collective investment trusts and insurance separate accounts, would provide sufficient information for these purposes.

As noted above, the DOL envisions fiduciaries evaluating fund prospectuses and other disclosures to determine if the fund uses an ESG or sustainability rating system of index. Again, if the fund uses such a rating system or index, the fiduciary, as part of its due diligence, would need to consider whether the rating system or index “evaluates one or more factors that are not financially material to investments.” If so, the fund would no longer qualify as a QDIA under the final rule.

Funds that use positive or negative screening may similarly result in their disqualification as a QDIA, if the screening involves non-pecuniary factors that effectively results in the exclusion of certain sectors or categories of investments, and such exclusions are reflected in the fund’s investment objectives or principal strategies. If these exclusions are not reflected in the investment alternative’s objectives or principal strategies, but they are otherwise disclosed, the fiduciary evaluating such fund is expected to undertake “an economic analysis of the economic consequences to the plan of such an exclusion and determining that such an exclusionary policy would not be economically harmful to the plan.”

The regulation does not apply to investment alternatives that are not designated investment alternatives under the plan (e.g., brokerage windows). However, DOL noted that the rule should not be construed as addressing the application of ERISA’s duties of prudence and loyalty to brokerage windows or other non-designated investment alternatives that grant participants and beneficiaries access to investments that are not designated investment alternatives, and suggests there may be future rulemaking to address this.

Other Considerations

The DOL responded to concerns that the regulation may redirect or stall the development of ESG practices, particularly as the U.S. Securities and Exchange Commission (SEC) continues to monitor ESG developments. Commenters pointed to the SEC’s recent solicited public comment request on the “Names Rule” under the U.S. Investment Company Act of 1940, as amended. The DOL noted in the preamble to the final rule that it did not think it needed to delay a final rule until the SEC decides to take action on the Names Rule. The DOL also recognized that some financial regulators are looking at whether ESG risk presents systemic risk to the financial markets. The DOL responded, “if financial regulators adopt new rules or policies that affect financial market participants, that may create pecuniary or non-pecuniary considerations for plan fiduciaries apart from ERISA.” It isn’t entirely clear what the DOL meant by this. One interpretation is that other regulators’ interpretation of materiality can inform an ERISA fiduciary’s determination as to whether a particular factor is pecuniary or not under the final rule. Yet a contrary interpretation is that the DOL, by using the language “apart from ERISA,” intends to largely wall off the final rule from other regulators’ potentially increasing liberalization over what factors are material to investment return and risk.

The DOL likewise responded to commenters who raised concerns that this rulemaking would interfere with how other federal agencies were addressing ESG risks. For example, the DOL acknowledged that the State Department, Treasury Department, Commerce Department and Department of Homeland Security have taken positions on supply chain links to entities that engage in human rights abuses, including, for example, forced labor in China. Even though supply chain risk is an ESG factor, the DOL took the position that it sees no fundamental conflict between this final rule and positions regarding supply chain risk raised by other government agencies.

Somewhat relatedly, the DOL responded to a comment that the rule would conflict with the position it took regarding the federal Thrift Savings Plan (TSP), namely, to prohibit the plan from investing in Chinese equities. While noting that the TSP is not covered by Title I of ERISA, the DOL added that its “position with respect to investments in China was informed by consideration of specific matters relating to investment risk, including inadequate investor disclosures and legal protections, that are consistent with “pecuniary factors” as used in the final rule.” The DOL further added that “other concerns were raised because the Federal Government matches TSP contributions and investments in China might result in the Federal Government funding activities that are opposed to U.S. national security interest.” Its first explanation, namely that it found disclosures related to Chinese holdings insufficient and legal protections were insufficient, is noteworthy for all ERISA fiduciaries because the final rule states that sufficiency of disclosures and legal protections are pecuniary factors. Thus, a fiduciary may wish to exercise caution in how it evaluates and documents the pecuniary factors in deciding on an investment that has Chinese holdings in light of the DOL’s concern.

The DOL dismissed concerns that the final rule would conflict with international ESG rules and trends by dismissing the sheer relevance of such trends and non-U.S. rules. Specifically, the DOL stated, “international trends in the consideration of ESG factors or other actions of regulators in other countries are not an appropriate gauge for evaluating ERISA’s requirements as they apply to investments of ERISA-covered employee benefit plans.”

The final rule is not immune to rescission or change by Congress or the DOL under a future administration.


1 29 C.F.R. § 2550.404a-1.

2 In a footnote to the preamble of the final rule, the DOL stated, “[t]he Department notes that it may be that a fiduciary could prudently determine that the expected return balanced against the costs and risks of loss associated with divesting an investment made before the effective date of the rule are such that continuing to hold that investment would be appropriate even if the fiduciary as part of its monitoring process determined that the investment, or aspects of the decision-making process, does not comply with the final rule.”

3 The proposal’s language seemingly required that, before an ERISA fiduciary could treat an ESG or other factor as a pecuniary factor, the ESG or other factor would already have had to be determined by other investment professionals as being material to investment performance.

4 In the preamble to the final rule, the DOL noted, for example, that “a company’s improper disposal of hazardous waste would likely implicate business risks and opportunities, litigation exposure, and regulatory obligations” and that “[d]ysfunctional corporate governance can likewise present pecuniary risk that a qualified investment professional would appropriately consider on a fact-specific basis.”

5 The DOL indicated that it does not intend the term “generally accepted investment theories” to freeze the evolution of investment theory or practice, but rather “to establish a regulatory guardrail against situations in which plan investment fiduciaries might be inclined to use…policy-based metrics in their assessment of the pecuniary value of an investment or investment plan that are inherently biased toward inappropriate overestimations of the pecuniary value of policy-infused investment criteria.”

Webcast Available Now – Stradley Ronon’s Diversity and Inclusion Committee Presents: A Candid Conversation with Hispanic Leaders

Stradley Ronon’s panelists of Hispanic leaders share insights into their career journeys and the challenges they’ve overcome along the way. The group discusses ways to combat discrimination and racism, and how the Hispanic community is currently underrepresented in leadership positions, especially in the legal profession.

Presenters:

Gisele Fetterman, Pennsylvania’s Second Lady
Renee Garcia, Managing Senior Counsel, PNC Bank
Sharon R. Lopez, Civil Rights Attorney, Triquetra Law
Rebecca Rodrigues, Associate, Stradley Ronon
Gabriella Leyhane, Associate, Stradley Ronon
Adriel J. Garcia, Associate, Stradley Ronon
Brian P. Seaman, Counsel and Chief Diversity Officer, Stradley Ronon

Replay

NJ Governor Signs Environmental Justice Legislation Placing New Requirements on Facilities Operating in Overburdened Communities

On September 18, 2020, Gov. Phil Murphy signed environmental justice legislation intended to address the disproportionate impacts of pollution on communities by restricting certain industrial operations from entering or expanding in those communities. The law is based on the premise that, and creates a new definition describing, certain communities are “overburdened” because they have historically been impacted, more than other communities within a geographic area, by operations that tend to generate pollution. These “Overburdened Communities” as now defined in the law, share at least one of the following characteristics:

  • at least 35% of all households are low-income households;
  • at least 40% of residents identify as minority or part of a recognized tribal community; or
  • at least 40% of households have limited proficiency with English.

The Department of Environmental Protection is charged with compiling a list of “Overburdened Communities” in the state. However, as described, the definition may be expected to encompass many, if not all, urban areas in the state where residences co-exist with industrial uses, as homes in such areas are typically the least expensive homes in an urban area to rent or own. Often, the housing stock proximate to such facilities was previously known as ‘worker housing’ and in some cases, was constructed by the owners of the industrial facilities and built either at the turn of the 20th century or during the post-World War II manufacturing boom. The current operations which are defined as “Facilities” targeted by the new law are the following: any major source of air pollution, resource recovery facilities, incinerators, sludge processing facilities or combustors, large sewage treatment plants, large transfer stations and solid waste facilities, recycling facilities receiving at least 100 tons of material per day, scrap metal facilities, landfills and some medical waste incinerators.

Under the new law, each of the above-described types of operations will be subject to additional layers of scrutiny whenever an application for a new facility permit, or an application for a major modification of an existing permit, or an application to expand operations is submitted to the Department for approval. The heightened review’s exact extent is not completely clear as the Department is required to promulgate regulations before the new review process commences. Still, there are two specific requirements of that process highlighted in the law. First, no application will be reviewed unless accompanied by an environmental justice impact statement, which does not have a specific definition in the law. That statement must include an assessment of the “potential environmental and public health stressors” that is, all sources of environmental pollution (whether avoidable or unavoidable) which may be expected to arise from the proposed operation, as well as any potential health conditions which the proposed operation may cause in the community. These conditions include asthma, cancer, elevated blood lead levels, cardiovascular disease and developmental problems. It is not known if the Department’s regulations will provide a methodology for determining, on a consistent scientific basis, reproducible evidence of connections between a Facility’s operations and adverse health impacts of nearby residents. The environmental justice impact statement must also contain a description of the environmental and public health stressors already present in the community.

Once the statement is prepared, it will be submitted to the municipality where the Facility is or will be located, and to the Department, who will post it on the Department’s website. The applicant will then hold a public hearing on the application at which the environmental justice impact statement will be presented, and comments will be solicited from the public. Following the hearing, the Department will consider the public’s testimony and determine whether there should be conditions placed on the permit being sought by the applicant in order to “avoid or reduce the adverse environmental or public health stressors affecting the overburdened community.” The law does not describe nor limit the type of conditions that the Department may impose, nor does it appear to limit the Department’s discretion to impose conditions to only address those adverse environmental or public health stressors caused by the Facility at issue.

There are several exceptions from the scope of the new law. Permit applications for remediation activities do not trigger the public hearing requirement and the possibility of additional conditions being imposed, even where minor pollution levels will be allowed to remain in the soil or groundwater. Further, certain provisions of the new law raise significant questions for regulated Facilities. It is not clear if the law’s public disclosures would constitute voluntary disclosures of violations under other state and federal laws. The enforceability of conditions imposed on industrial applicants which are based on the science underlying such a connection may be questionable. Modern science has yet to provide consistent and reproducible evidence of a direct connection between certain conditions and stressors identified in the law and potential health impacts on communities. Likewise, would meeting the conditions imposed by the Department, regardless of scientific foundation, be sufficient to protect the Facility from liability if health impacts are documented in the future? It will be necessary for the Department, charged with administering the law, to provide clarity and reasonableness when bringing the law’s admirable intent into real-world situations.

Webcast Available Now – ESG Regulatory Lens – A Guide for Private Fund Managers

In this webcast, we:

  • Provide an overview of ESG and how the strategies apply to the various types of private fund managers.
  • Give an update on the regulatory climate and legal developments for ESG from the US to Europe and Asia.
  • Provide a framework for approaching the development of an ESG process, including where to access useful tools and resources.

Presenters:

Trysha Daskam, Director & Head of ESG Strategy, Silver Regulatory Associates

John P. Hamilton, Counsel, Stradley Ronon

George Michael Gerstein, Co-Chair, Fiduciary Governance, Stradley Ronon

Replay

Women in ETFs Ring the Bell for Gender Equality

For the sixth consecutive year, a global collaboration across 80 exchanges (the total would be 100 this year but 20 events have been postponed or cancelled due to the Corona Virus as of March 6, 2020) around the world plan to ring opening or closing bells to celebrate International Women’s Day 2020 (Sunday 8 March 2020). The events – which start on Monday 2 March, and will last for two weeks – are a partnership between IFC, Sustainable Stock Exchanges (SSE) Initiative, UN Global Compact, UN Women, the World Federation of Exchanges and Women in ETFs, to raise awareness about the business case for women’s economic empowerment, and the opportunities for the private sector to advance gender equality and sustainable development. Read the full Newsletter here.

DOL releases significant ESG proposal – preliminary analysis

In response to perceived abuses, and acknowledging the rapid growth in environmental, social & governance (ESG) investing, the U.S. Department of Labor (DOL) issued a highly-anticipated notice of proposed rulemaking that would clarify the circumstances under which ESG investing, including the selection of ESG funds in plan lineups, may be conducted in a manner that accords with the fiduciary duties under Section 404 of the U.S. Employee Retirement Income Security Act of 1974, as amended (ERISA). This proposal comes just two years after the DOL issued Field Assistance Bulletin (FAB) 2018-01. It is also part of a continuum of ERISA-ESG guidance over the decades, across both Democrat and Republican administrations, that has sought to address how ERISA’s stringent fiduciary duties may be satisfied when one or more E (e.g., climate change), S (e.g., employee relations) and or/G (e.g., corporate governance) factors are pursued either because they are material to investment performance or because they further some public policy or similar goal.

If the proposal is adopted as-is, plan sponsors, other fiduciaries and the industry, will face a tall order in incorporating ESG factors, especially in furtherance of policy or other non-financial goals (e.g., impact investing), with respect to both the (1) management of plan assets and (2) selection and monitoring of plan investment options available under individual account plans, as the case may be. Here are the initial key takeaways:

  • Integration: ESG strategies, such as integration, that incorporates one or more E, S and/or G factors because of materiality to investment performance, would still be considered consistent with ERISA’s fiduciary duties, provided: (a) there is documentation as to the basis for the materiality determination; (b) other “qualified investment professionals” (i.e., an objective standard) would similarly conclude that the ESG factor is material to investment performance based on “generally accepted investment theories”; (c) the weight given to the ESG factor in the materiality analysis is appropriate (a point the DOL stressed in FAB 2018-01); and (d) the ESG investment is measured against “other available alternative investments” with respect to diversification, liquidity and potential risk-return of the plan portfolio. Point (d) is perhaps the biggest deal because it is arguably de facto the tie-breaker test, which the DOL historically used only when the ESG factor was not material to investment performance, and will raise compliance risk for ERISA fiduciaries (investment managers may be able to mitigate this risk through representations from the appointing fiduciary). The DOL noted in the preamble that this requirement was intended to clarify “that an investment or investment course of action must be compared to available alternatives [and] is an important reminder that fiduciaries must not let non-pecuniary considerations draw them away from an alternative option that would provide better financial results.”
  • Other types of ESG investment strategies: The DOL technically allows an ERISA fiduciary to select an ESG investment, in whole or part, for non-financial/pecuniary reasons, which is in keeping with their long-standing guidance. However, the DOL tightens the screws by requiring that the investments be pursued only if they are “economically indistinguishable” from non-ESG investments, and the fiduciary documents such basis “based on the purposes of the plan, diversification of investments, and interests of plan participants and beneficiaries in receiving benefits from the plan.” There are two immediate considerations: (a) how does “economically indistinguishable” standard differ from the tie-breaker test that the DOL historically used in these contexts? and (b) can these conditions ever be met if the investment is pursued partly for non-pecuniary reasons but, as the DOL acknowledges (referencing Dudenhoeffer), the interests of participants and beneficiaries are in pecuniary benefits? In terms of the former, the DOL’s intent is that there is no difference; in terms of the latter, the DOL acknowledges that this standard would only be met in exceedingly rare circumstances, a position that harkens back to the DOL’s 2008 ESG guidance. Because the DOL believes a fiduciary finding that an ESG investment is economically indistinguishable from a non-ESG investment to be a rare occurrence, it does not believe the aforementioned documentation requirements will be a significant cost to the industry.
  • Individual Account Plans: The plan may offer an ESG investment alternative, including an ESG-themed fund, to participants, subject to these two conditions: (a) “the fiduciary uses (and documents using) only objective risk-return criteria, such as benchmarks, expense ratios, fund size, long-term investment returns, volatility measures, investment manager investment philosophy and experience, and mix of asset types” in selecting and monitoring the fund; and (b) no ESG fund is added as, or as a component of, a QDIA. Consequently, “fiduciaries considering investment alternatives for individual account plans should carefully review the prospectus or other investment disclosures for statements regarding ESG investment policies and investment approaches.” The first condition would eliminate the possibility of adding an ESG fund to a plan lineup for any reason other than those investment-return related criteria, such as to promote a public policy (e.g., climate change, etc.). Commenters should seek clarification from the DOL as to whether this was their intent. The second condition is plain on its face and is equally significant: any ESG-related QDIA, regardless of whether it’s a themed fund, and irrespective that just one component of the QDIA takes ESG into account, is out, even if the ESG fund is selected for the plan solely on the basis of investment performance materiality. It’s unclear if this exclusion is limited to ESG funds whose objectives include non-pecuniary ESG goals or whether it applies to all types of ESG funds.
  • The DOL cautioned that “fiduciaries should also be skeptical of “ESG rating systems” – or any other rating system that seeks to measure, in whole or in part, the potential of an investment to achieve non-pecuniary goals – as a tool to select designated investment alternatives, or investments more generally.”
  • The proposed rule, if adopted, would take effect 60 days after publication in the Federal Register, though the DOL is open to comment on whether transition relief should be available.
  • ESG funds and products that have short track records, low assets under management, and/or are somewhat more expensive than similar non-ESG funds, will be particularly vulnerable under this proposal.
  • As noted above, there is a 30-day comment period for this proposal.