Last week, the Department of Labor (the “DOL”) on June 23, 2020 proposed a new rule (the “Proposed Regulation”) relating to the consideration of non-pecuniary factors that would have a pointed impact on the use of environmental, social and governance (“ESG”) factors in the context of investment decisions by fiduciaries of employee benefit plans (“Plans”) subject to the Employee Retirement Income Security Act of 1974 (“ERISA”). While the DOL has, under successive presidential administrations, put forth its own gloss on basic principles governing economically targeted investments (“ETIs”) first outlined by the DOL in 1994, the DOL has never before sought to enshrine the proper treatment of ESG considerations in actual regulatory language. In this sense alone, the DOL’s latest proposal is highly significant. Our recent OnPoint, ERISA’s Social Goals? ESG Considerations Under ERISA (May 15, 2020), issued before the DOL’s release of the Proposed Regulation, traces the development of the DOL’s ETI/ESG-related authority over the years and generally discusses ESG considerations under ERISA.
But it is not just the apparent effort to create greater permanence on questions concerning ERISA and ESG that is striking; it is also the arguably skeptical tone more generally adopted by the DOL about the merits of taking ESG (and other similar non-pecuniary) considerations into account when investing retirement assets. Although it is difficult to predict precisely what form any final rule may take, it is perhaps noteworthy that the DOL has provided a limited 30-day comment period for the Proposed Regulation. The seriousness with which the DOL views this matter is also reflected by an op-ed written by the Secretary of Labor in support of the regulation.1 We also note our understanding that there is anecdotal evidence that, in recent months, various DOL offices have been investigating ESG-related practices.
The DOL refers to the ESG initiative as a “New Investment Duties Rule.” The Proposed Regulation essentially seeks to anchor a position that has seen subtle shifts in tone over the course of the last 30 years from administration to administration in what the Preamble to the Proposed Regulation (the “Preamble”) refers to as “sub-regulatory” guidance. As the News Release accompanying the Proposed Regulation notes, the successive iterations over these years “may have created confusion” with respect to “investments selected because of non-financial objectives, such as environment, social and public policy goals, that the investments may further.”2
According to the DOL’s News Release accompanying the proposal, the proposal is designed, in part, to make clear that ERISA Plan fiduciaries “may not invest in ESG vehicles when they understand an underlying investment strategy of the vehicle is to subordinate return or increase risk for the purpose of non-financial objectives.” In this regard, the DOL stated that its intent was to “reiterate and codify long-established principles of fiduciary standards for selecting and monitoring investments, and thus to provide clarity and certainty regarding the scope of fiduciary duties surrounding non-pecuniary issues.”
In proposing the Proposed Regulation, the DOL expressly wished to make it clear that the “fundamental principle is that an ERISA fiduciary’s evaluation of plan investments must be focused solely on economic considerations that have a material effect on the risk and return of an investment based on appropriate investment horizons, consistent with the Plan’s funding policy and investment policy objectives.” The DOL was fairly clear in its intent in this regard, citing to the United States Supreme Court’s 2014 decision in Fifth Third Bancorp v. Dudenhoeffer for the proposition that, in the context of ERISA retirement Plans, the “interests” of Plan participants and beneficiaries “must be understood to refer to ‘financial’ rather than ‘non-pecuniary’ benefits.”3 Indeed, according to the DOL in the Proposed Regulation, the only appropriate “social” goal for ERISA Plans is that of providing sufficient retirement savings for participants and beneficiaries, with the Proposed Regulation stating that “[p]roviding a secure retirement for American workers is the paramount, and eminently-worthy, ‘social’ goal of ERISA Plans” and that “[p]lan assets may not be enlisted in pursuit of other social or environmental objectives.”
In pursuing this goal, however, the Proposed Regulation would not specifically prohibit a Plan fiduciary’s consideration of ESG. The DOL recognizes that “there may be instances where factors that sometimes are considered without regard to their pecuniary import…will present an economic business risk or opportunity that corporate officers, directors, and qualified investment professionals would appropriately treat as material economic considerations under generally accepted investment theories,” identifying “environmental considerations” as an example. Thus, a stated purpose of the Proposed Regulation is to differentiate between the “legitimate use of risk-return factors” from “inappropriate investments that sacrifice investment return, increase costs, or assume additional investment risk to promote non-pecuniary benefits or objectives.”
Ultimately, however, the Proposed Regulation may make it more challenging for a Plan fiduciary to conclude that the selection of ESG products meets its prudence and “exclusive purpose” obligations under ERISA than under any preceding DOL guidance.4 To accomplish the DOL’s desired change in approach, the Proposed Rule contains some considerations of general applicability, and also various specific considerations for individual account (participant-directed) Plans, such as “401(k)” Plans. In both cases, the DOL offers a roadmap as to how Plan fiduciaries should consider ESG factors in light of their fiduciary duties as well as with regard to choosing investment options more generally.
In considering an investment for a Plan, a Plan fiduciary would need to:
- Select investment options based solely on pecuniary factors. In order to satisfy certain ERISA loyalty and prudence requirements, a Plan fiduciary must select “investments and/or investment courses of action based solely on their pecuniary factors and not on the basis of any non-pecuniary factor.”
- “Pecuniary” here means a material effect on the risk and/or return of an investment based on appropriate investment horizons consistent with the plan’s articulated funding policy and the investment objectives.
- Not put others’ interests ahead of plan participants’ economic interest. The Proposed Regulation contains a new express regulatory provision stating that compliance with the “exclusive-purpose” duty in ERISA prohibits fiduciaries from “subordinating the interests of Plan participants.” A fiduciary cannot “subordinate the interests of the participants and beneficiaries to the fiduciary’s or another’s interests.”
- Consider ESG (and other similar non-pecuniary) factors only where investment returns won’t suffer and where the Plan won’t take on additional risks or higher fees. As the Preamble notes, fiduciaries “must never sacrifice investment returns, take on additional investment risk, or pay higher fees to promote non-pecuniary benefits or goals.”
- Determine that ESG (and other similar non-pecuniary) factors present appropriate pecuniary risks and rewards under general investment theories. The DOL stated in the Preamble that: “ESG factors and other similar considerations may be [valid] economic considerations, but only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories.”
- The DOL also noted that "[t]he weight given to pecuniary ESG factors should reflect a prudent assessment of their impact on risk and return—that is, they cannot be dispropotionately weighted."
Rules for Plans that Are Not Participant-Directed
In the case of Plans that are not participant-directed Plans, the Proposed Regulation would require fiduciaries to:
- Compare alternatives—and conclude they compare favorably (or are “indistinguishable”) on economic merits. A Plan fiduciary must “compare investments or investment courses of action to other available investments or investment courses of action with regard to . . . the level of diversification, degree of liquidity, and potential risk and return in comparison to available alternative investments.”
- The DOL in the Preamble noted that “[c]larifying that an investment or investment course of action must be compared to available alternatives 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.”
- Apply a “rare” tie breaker, but only if the ESG option is “indistinguishable” economically from other alternatives. In Interpretive Bulletin 2008-01 (issued under a Republican administration), the DOL adopted an “all things being equal” or “tie-breaker” rule, stating that a Plan fiduciary must have “first concluded that the alternative options are truly equal, taking into account a quantitative and qualitative analysis of the economic impact on the Plan.”5
- The Proposed Regulation would retain the “all things being equal” or “tie” rule from this prior DOL guidance, noting that, “if … alternative investments appear economically indistinguishable, a fiduciary may then, in effect, ‘break the tie’ by relying on a non-pecuniary factor.” However, the DOL specifically stated that it “expects that true ties rarely, if ever, occur. To be sure, there are highly correlated investments and otherwise very similar ones [but no real ties].” Elsewhere in the Preamble, the DOL refers to the possibility of a tie being “theoretical” and again mentions that it “believes that truly economically indistinguishable alternatives are rare.”
- In this regard, it is potentially interesting that the DOL also noted in the Preamble that it believes that ESG funds “often come with higher fees, because additional investigation and monitoring are necessary to assess an investment from an ESG perspective.”
- Appropriately document why a chosen ESG strategy is “indistinguishable” economically from other alternatives and why it met other criteria. The DOL stated that “the fiduciary should document specifically why the investments were determined to be indistinguishable and document why the selected investment was chosen based on the purposes of the plan, diversification of investments, and the interests of plan participants and beneficiaries in receiving benefits from the plan.”
Special Rules for Participant-Directed Plans
Many 401(k) and similar participant-directed individual account Plans have a number of investment options from which participants may choose. The Proposed Regulation does not apply the “economically indistinguishable alternative investment” test noted above to these participant-directed plans. Instead, it notes that “a prudently selected, well managed, and properly diversified fund with ESG investment mandates could be added to the available investment options on a 401(k) Plan platform” if the Plan utilizes consistently applied economic risk-return measures across the Plan. This would apply to investment options that “include one or more environmental, social, and corporate governance-oriented assessments or judgments in their investment mandates (e.g., ‘ESG investment mandates’) or that include these parameters in the fund name (‘ESG-themed funds’).”
Specifically, in the case of similar participant-directed Plans, the Proposed Regulation would require a fiduciary to:
- Select ESG-themed or ESG investment mandate options only if employing objective risk-return measures for all investment options in the Plan. A Plan fiduciary may consider a “prudently selected, well managed, and properly diversified [investment option] with ESG investment mandates” as an option under an individual account Plan provided that the Plan fiduciary considers “benchmarks, expense ratios, fund size, long-term investment returns, volatility measures, investment manager tenure, and mix of asset types (e.g., equity, fixed income, money market funds, diversification of investment alternatives, which might include target date funds, value and growth styles, indexed and actively managed funds, balanced and equity segment funds, non-US equity and fixed income funds) in selecting and monitoring all investment alternatives for the Plan including any environmental, social, corporate governance, or similarly oriented investment alternatives.”
- Document the findings under the above objective risk-return measures.The Plan fiduciary must document its conclusions based on the objective metrics prescribed by the Proposed Regulation (or otherwise) and as applied more holistically to the Plan.
- Confirm methodology consistently applied in an applicable investment policy statement. The DOL noted that a Plan could adopt an “investment policy statement with prudent criteria for selection and retention of designated investment alternatives for an individual account plan that were based solely on pecuniary factors, and apply the criteria to all investment options in similar asset classes or funds in the same category, including potential ESG-themed funds” (i.e., funds that use the term “ESG” or a similar term).
In addition, there are separate proscriptions relating to the use of ESG considerations in connection with a qualified default investment alternative (a “QDIA”). Generally, QDIAs are default investments that are used for where participants do not make affirmative investment choices from among investment alternatives available under a Plan. According to the Preamble, QDIAs are somewhat special in that a “selection of an investment fund as a QDIA is not analogous to merely offering participants an additional investment alternative as part of a prudently constructed lineup of investment alternatives from which participants may choose.”
The DOL notes in the Preamble that it “does not believe that investment funds whose objectives include non-pecuniary goals—even if selected by fiduciaries only on the basis of objective risk-return criteria consistent with [the objective risk-return analysis]—should be the default investment option in an ERISA plan.” The DOL was concerned that “a fiduciary’s decision to favor a particular environmental, social, corporate governance, or similarly oriented investment preference—and especially a decision to favor the fiduciary’s own personal policy preferences—would raise questions about the fiduciary’s compliance with ERISA’s duty of loyalty.” We note that the text of the Proposed Regulation applies this approach to an “environmental, social, corporate governance, or similarly oriented investment mandate[s],” and, under that regulatory language, it seems possible that an investment alternative could be a QDIA if ESG factors are considered purely as a pecuniary matter.
The Proposed Regulation in large measure seems to rise from the DOL’s skepticism about the value of ESG itself. It notes that “ESG investing raises heightened concerns,” that ESG methodology is prone to “inconsistencies” and that there is “a lack of precision and rigor, in the ESG investment marketplace.”
That said, the Proposed Regulation is clear that ESG factors may be considered to the extent they deliver on pecuniary objectives. If it can be shown empirically that considering ESG factors can actually deliver better returns for Plans, the arguments in favor of considering ESG factors would seem naturally to improve. Under that paradigm, ESG factors could be viewed as positive considerations that are permissibly taken into account. And in the case of 401(k) plans, the use of ESG-themed or ESG mandate investment options may be acceptable (other than for QDIAs, it seems) where they satisfy the objective risk-reward parameters noted above for the option under consideration when those metrics are used more broadly across the Plan. In all cases, the Plan fiduciary will need to reach the appropriate conclusions and document them. It is ultimately the DOL’s intention to be clear that a Plan fiduciary “must never sacrifice investment returns, take on additional investment risk, or pay higher fees to promote non-pecuniary benefits or goals” or “subordinate the interests of participants or beneficiaries to the fiduciary’s or another’s interests.”
While the paths to considering ESG factors under ERISA are not entirely closed, the regulatory environment as indicated by the Proposed Regulation seem clearly not to be ESG-friendly. Objective economic analysis and consistency would seem to be guiding principles under the Proposed Rule, and the avenues for legitimately considering ESG factors may continue to be open. However, if the Proposed Regulation is finalized in its current form, the gauntlet to be run by those pursuing ESG goals will become more challenging.
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If you would like to discuss the Proposed Regulation or other ESG considerations under ERISA, or any aspect of ERISA’s fiduciary rules, please contact any of the Dechert attorneys listed below or any Dechert attorney with whom you regularly work.
The authors gratefully acknowledge the assistance of Devon Roberson, a law clerk with Dechert LLP, for his assistance in the preparation of this update.
1) Eugene Scalia, Retirees’ Security Trumps Other Social Goals, The Wall Street Journal (June 23, 2020) (available at: https://www.wsj.com/articles/retirees-security-trumps-other-social-goals-11592953329).
2) U.S. Dep’t of Labor News Release, U.S. Department of Labor Proposes New Investment Duties Rule (available at: https://www.dol.gov/newsroom/releases/ebsa/ebsa20200623-0).
3) See Proposed Regulation (citing Fifth Third Bancorp v. Dudenhoeffer, 573 U.S. 409, 421 (2014)) (emphasis in original).
4) Section 404 of ERISA provides for certain fiduciary duties of conduct, including a duty of prudence and a duty to diversify Plan investments so as to minimize the risk of large losses (unless under the circumstances it is clearly prudent not to do so). While the Preamble focuses primarily on the former, it also notes that the latter is still relevant to the analysis.
5) DOL Interpretive Bulletin 2008-01, 29 CFR 2509.08-1 (2008).