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There is a growing interest in including funds that emphasize environmental, social, and governance (ESG) factors in 401(k) plan investment menus, in response (in part at least) to participant interest in these funds and the increased participant engagement they generate. What issues does inclusion of an ESG fund in the plan’s fund menu raise for plan fiduciaries?
In brief
In its most recent guidance – in Field Assistance Bulletin (FAB) 2018-01 (issued in April 2018) – DOL reiterated its position that ERISA’s fiduciary duty of prudence generally applies to the selection of the funds in the plan fund menu. That means that (in DOL’s view) the inclusion of an ESG fund must be “prudent” on an economic basis, without regard to its collateral, non-economic virtues.
In that context, it is probably most useful to think of an ESG fund as implementing a particular style of active management, and to evaluate and monitor its performance and suitability (as an investment option) using the same economic criteria that would be used for any other actively managed fund. In that regard, we note that plaintiffs’ challenges (in 401(k) fee litigation) to the inclusion of actively managed funds in plan fund menus have in some cases been difficult to prove.
With respect to an ESG qualified default investment alternative (QDIA), e.g., a target date fund (TDF), there is an additional requirement: ERISA’s fiduciary duty of loyalty requires that, if the QDIA is ESG-themed, it should reflect the “ESG” views of plan participants, not those of plan fiduciaries.
Finally, courts are likely to apply these rules less strictly to ESG funds included in a brokerage window.
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In what follows we review these issues at length, beginning with a summary of the regulatory framework. We conclude with some general observations on fiduciary practice.
Background – the regulatory framework
Where a defined contribution plan provides participants with a choice of investments from a fund menu, DOL has (generally) identified and defined three different types of investment options: (1) designated investment alternatives (DIAs); (2) qualified default investment alternatives (QDIAs); and (3) brokerage windows/investment platforms. DOL’s ESG guidance provides somewhat different rules for each of these, and it’s useful to distinguish them up front.
DIAs: A DIA is defined as “any investment alternative designated by the plan into which participants and beneficiaries may direct the investment of assets held in, or contributed to, their individual accounts.” These are what are generally thought of as “the funds in the fund menu.”
QDIAs: Participant accounts may, where there is no affirmative instruction, generally be defaulted into a QDIA, most commonly (although not exclusively) a target date fund (TDF). A TDF QDIA is defined in the regulations as “an investment fund product or model portfolio that applies generally accepted investment theories, is diversified so as to minimize the risk of large losses and that is designed to provide varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed income exposures based on the participant’s age, target retirement date (such as normal retirement age under the plan) or life expectancy.”
Brokerage windows: The regulations state that DIAs “shall not include ‘brokerage windows,’ ‘self-directed brokerage accounts,’ or similar plan arrangements that enable participants and beneficiaries to select investments beyond those designated by the plan.” The distinction made in the regulation is between specific funds offered under the plan (DIAs) and brokerage windows (etc.) offering a wide variety of funds that are, in effect, designated by the brokerage window provider, not the plan or plan fiduciaries.
How does DOL guidance address the inclusion of an ESG fund in one of these three types of investment option?
ESG fund as a designated investment alternative
FAB 2018-01 states that, in the case of a DC plan, ERISA’s general fiduciary standards, including the duties of prudence and loyalty, “apply to a fiduciary’s selection of … a designated investment alternative.” In a footnote, DOL explains that:
[I]n deciding whether and to what extent to make a particular fund available as a designated investment alternative, a fiduciary must ordinarily consider only factors relating to the interests of plan participants and beneficiaries in their retirement income. A decision to designate an investment alternative may not be influenced by non-economic factors unless the investment ultimately chosen for the plan, when judged solely on the basis of its economic value, would be equal to or superior to alternative available investments. For example, a plan fiduciary 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 economic factors, and apply that policy to all investment options, including potential ESG-themed funds. [Emphasis added.]
The point that DOL is emphasizing here is that “personal,” non-economic values – even the personal values of participants investing their own accounts – cannot be used to “justify” choosing a particular fund as a designated investment alternative if selection of the fund cannot be defended as prudent on economic grounds.
How problematic is this standard?
The most straightforward reading of DOL’s position is that plan fiduciaries could not (1) determine that a particular investment fund was likely to underperform any reasonably derived benchmark but (2) nevertheless include the fund in the plan’s fund menu “because participants want it.” Let’s note that that standard does not apply just to ESG investment funds: if plan fiduciaries regarded a particularly popular (and well-marketed) fund as imprudently managed, they generally could not include it as a designated investment alternative.
But FAB 2018-01 explicitly recognizes that ESG factors may themselves relate directly to economic value:
[T]here could be instances when otherwise collateral ESG issues present material business risk or opportunities to companies that company officers and directors need to manage as part of the company’s business plan and that qualified investment professionals would treat as economic considerations under generally accepted investment theories. In such situations, these ordinarily collateral issues are themselves appropriate economic considerations… To the extent ESG factors, in fact, involve business risks or opportunities that are properly treated as economic considerations themselves in evaluating alternative investments, the weight given to those factors should also be appropriate to the relative level of risk and return involved compared to other relevant economic factors. [Emphasis added.]
ESG as an active management investment strategy
The course of 401(k) fee litigation has illustrated the difficulty of proving the imprudence of including an actively managed fund in a plan’s fund menu. Most active managers are in a position to argue that their strategy and the personal skill they bring to its implementation are unique. And any underperformance – even over a considerable period of time – may be explained by the vagaries of the market and the unpredictability of the future.
In this regard, funds that bet on a particular ESG investment “story” – e.g., that planning for climate change, or a commitment to diversity or good governance, correlates with superior market performance – may be viewed simply as implementing a particular active management strategy.
Plan fiduciaries will want to consider applying the same sort of performance review standards to ESG funds as they do to non-ESG actively managed funds. The one thing that FAB 2018-01 identifies as clearly problematic would be to excuse the underperformance of an ESG fund on the basis of its “collateral” (non-economic) virtues. Fiduciaries should also consider reviewing plan literature describing the fund in this regard.
Finally, with respect to litigation exposure, there is some evidence that courts may be more lenient in judging the prudence of selecting an actively managed fund where there are other, less expensive funds available in the same asset class. Thus, the availability of efficient, non-ESG investment alternatives (in the same asset class) may be helpful in defending a challenge to the selection of an ESG fund.
ESG QDIAs
Can a QDIA, such as a target date fund, be constructed using one or more ESG funds? Interestingly, FAB 2018-01 does not foreclose this possibility:
In the QDIA context, the decision to favor the fiduciary’s own policy preferences in selecting an ESG-themed investment option for a 401(k)-type plan without regard to possibly different or competing views of plan participants and beneficiaries would raise questions about the fiduciary’s compliance with ERISA’s duty of loyalty. Even if consideration of such factors could be shown to be appropriate in the selection of a QDIA for a particular plan population, however, the plan’s fiduciaries would have to ensure compliance with the guidance in IB 2015-01 [applying ERISA’s general fiduciary rules to ESG designated investment alternatives]. For example, the selection of an ESG-themed target date fund as a QDIA would not be prudent if the fund would provide a lower expected rate of return than available non-ESG alternative target date funds with commensurate degrees of risk, or if the fund would be riskier than non-ESG alternative available target date funds with commensurate rates of return.
Thus, in this context, in addition to passing the “prudence” test discussed above with respect to designated investment alternatives, the fund must pass a “duty of loyalty” test: the ESG factors “thematized” by the fund must be appropriate to the plan’s particular participant population and not simply reflect the views of plan fiduciaries. In this regard, fiduciaries may want to consider a survey of plan participants, rather than assuming a knowledge of their preferences.
We would also note that, per our comments above concerning the importance of the availability of non-ESG funds in the same asset class, courts may be more strict where the only TDF available is “ESG-themed.”
ESG funds in brokerage windows
DOL has had complicated and (at times) shifting views on the status of funds in brokerage windows. FAB 2018-01 does not appear to address the issue of the inclusion of ESG funds in brokerage windows. As a general matter most would argue that so long as a plan has “a prudently selected, well managed, and properly diversified” set of designated investment alternatives, there is some greater degree of latitude as to the funds that may be included in the brokerage window. Thus, a brokerage window may be a good solution for plan fiduciaries who wish to accommodate participants who want to invest in ESG funds but who are concerned about the fiduciary risks.
Good fiduciary practice
Plan fiduciaries will want to keep in mind the following general guidance:
Consult with ERISA counsel, on the plan’s fund menu construction process generally and on the inclusion of ESG funds in particular.
Make sure that the plan’s investment policy statement (IPS) reflects fiduciary practice and that fiduciary practice reflects the IPS. In this regard, general rules, with room for exceptions, may be more useful than detailed procedures.
Document fiduciary deliberations and decisions, with the understanding that this documentation may have to be produced in court.
Focus on process. Courts generally will not punish a fiduciary that used a prudent process that turned out wrong in hindsight. But if the fiduciary does not reach its decision on the basis of a prudent process, its conclusions are likely to be more strictly scrutinized.
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We will continue to follow this issue.