On June 24, 2020, the Department of Labor released a proposed amendment to regulations under ERISA section 404(a) (which describes general fiduciary standards), providing regulatory guidance with respect to fiduciary decisions to invest plan assets based on environmental, social, and corporate governance (ESG) factors or in ESG-themed funds.
In this article, we review the proposal. We begin with a brief set of takeaways.
Takeaways for plan sponsors
The proposal would apply the following rules to defined benefit plans and to designated investment alternatives in participant-directed defined contribution plans:
A general prohibition on consideration of “non-pecuniary” issues in fiduciary plan investment decisions. For this purpose, “pecuniary” is defined as a factor that has a material effect on the investment’s risk/return. So, if, e.g., the difference between two different funds’ approach to governance does not have a material effect on risk/return, then that factor is non-pecuniary and generally may not be considered.
Explicit rules on what constitutes “appropriate consideration” by fiduciaries of investment decisions.
Tighter rules for the documentation of consideration of ESG factors as part of a “tie-breaker/all things similar” analysis.
The proposal would prohibit the use of ESG funds in a qualified default investment alternative (QDIA), e.g., a 401(k) plan’s default target date fund. This feature of the proposal is likely to generate a lot of comment.
The proposal provides a more relaxed set of rules (e.g., with respect to the documentation of a “tie-breaker” analysis) for non-designated investment alternatives on investment platforms in participant-directed defined contribution plans.
DOL’s guidance with respect to these issues has, to date, been “sub-regulatory” – generally in the form of Interpretive Bulletins and Field Assistance Bulletins – and therefore less formal. A feature of this less-formal guidance has been a sort of “duel of interpretations” – with Democratic administrations providing (marginally) more relaxed guidance and Republican administrations providing (marginally) stricter guidance. In this context, DOL’s new regulatory project can be understood as an effort to bring some stability to this situation, with a fully vetted (through the regulatory notice-and-comment process), more formal process culminating in regulation.
How effective these rules will be in limiting ESG investment will depend very much on how these rules are enforced. Probably the biggest concern for sponsors in this regard is the possibility of litigation based on the rules articulated in this proposal.
The new rules would be effective 60 days after finalization. Comments must be submitted by 30 days from the publication of the proposal in the Federal Register.
ERISA’s general fiduciary standards – loyalty and prudence
Under ERISA, fiduciaries must discharge their duties “solely in the interests of the participants … for the exclusive purpose of providing benefits to participants … and defraying reasonable expenses” and “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.” These are generally referred to as the fiduciary duties of loyalty and prudence.
The proposed regulation undertakes to articulate and explain the extent of these duties, particularly in the ESG context. Under the proposal, a fiduciary satisfies in duties of prudence and loyalty if it:
Has given appropriate consideration to the relevant facts and circumstances.
Has evaluated the investment based solely on pecuniary factors that have a material effect on the return and risk of an investment.
Has not subordinated the interests of the participants to unrelated objectives, or sacrificed return or taken additional risk to promote goals unrelated to participant interests.
Has not otherwise acted to subordinate the interests of the participants to the fiduciary’s or another’s interests.
What is “appropriate consideration?”
Under the proposal, “appropriate consideration” requires a determination by the fiduciary that a particular investment/fund “is reasonably designed … to further the purposes of the plan, taking into consideration the risk of loss and the opportunity for gain (or other return).”
To satisfy the “appropriate consideration” standard, the fiduciary must consider: (i) diversification/portfolio composition; (ii) portfolio liquidity relative to anticipated cash flow; (iii) projected portfolio return relative to plan funding objectives; (iv) with regard to factors (i)-(iii) how the investment compares to alternative available investments.
To connect some dots here, the last requirement – that the fiduciary consider how the investment compares to available alternative investments – is intended to require an explicit analysis of whether a particular ESG investment provides a competitive risk return. Without objective guidance, this requirement may lead plan some sponsors to be more conservative in their evaluation of this issue.
Consideration of pecuniary vs. non-pecuniary factors
DOL proposes defining a “pecuniary factor” as “a factor that has a material effect on the risk and/or return of an investment.” One obvious point to make here, if an ESG factor (e.g., governance) does not have a materialeffect on an investment’s return, then it’s not pecuniary.
DOL’s treatment of when and how non-pecuniary factors may be taken into account is one of the critical elements of the proposal. We quote it at length:
A fiduciary’s evaluation of an investment must be focused only on pecuniary factors. Plan fiduciaries are not permitted to sacrifice investment return or take on additional investment risk to promote non-pecuniary benefits or any other non-pecuniary goals. Environmental, social, corporate governance, or other similarly oriented considerations are pecuniary factors only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories. The weight given to those factors should appropriately reflect a prudent assessment of their impact on risk and return. Fiduciaries considering environmental, social, corporate governance, or other similarly oriented factors as pecuniary factors are also required to examine the level of diversification, degree of liquidity, and the potential risk-return in comparison with other available alternative investments that would play a similar role in their plans’ portfolios. [Emphasis added.]
Economically indistinguishable alternative investments
The Clinton DOL introduced the idea that non-pecuniary ESG factors might, without violating ERISA, be used as “tie-breakers … all things being equal.” In the preamble to the proposal, DOL expressed skepticism about this theory: “The Department expects that true ties rarely, if ever, occur.” One possibility, in this regard, may be adoption (by the plan fiduciary) of a formal scoring approach that would occasionally, but rarely, result in a tie.
Nevertheless, the proposal allows this sort of tie-breaker approach, subject to a requirement that the fiduciary “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.”
Depending on how this rule it enforced, it may significantly limit fiduciaries’ ability to choose an ESG investment based on a “tie-breaker” rationale.
Special rules for DC plans
These rules apply to the selection of any “designated investment alternative” (DIA) in a DC plan. Under ERISA section 404(c), a designated investment alternative is “a specific investment identified by a plan fiduciary as an available investment alternative under the plan.” (For a discussion of some of the complexities of defining/identifying designated investment alternatives, see our recent article Fiduciary obligations with respect to a brokerage window.)
With respect to DC plan investment platforms allowing participants to choose from a “broad range of investment alternatives,” a more limited/less strict set of rules apply. ESG funds may be included in the platform provided:
“The fiduciary uses 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.”
The fiduciary documents its selection and monitoring decision(s) in accordance with the general rules (discussed above). The special documentation rule applicable to “tie-breakers,” however, would not apply.
No ESG fund is part of a qualified default investment alternative (QDIA) (typically the plans default investment). Given the significance of QDIA investments (typically, target date funds) in current 401(k) plan investment, this requirement is likely to generate some push back from the ESG fund community.
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This is only a proposal, and there is likely to be a significant number of comments from all concerned.
We will continue to follow this issue.