DOL’s Final Rule on Investment Duties of ERISA Fiduciaries and its Impact on Retirement Plan ESG Investing
On October 30, 2020, the Department of Labor (DOL) adopted the Final Rule amending the Investment Duties DOL Regulation, §2550.404a-1, which governs the obligations of ERISA fiduciaries when selecting investments for ERISA plans. The Final Rule made several changes to the June 2020 Proposed Rule, which proposed to define the duties of fiduciaries when considering investments that promote environmental, social, and corporate governance goals (ESG investments). As reported here, DOL received extensive and largely negative comments to the Proposed Rule and most of the objections concerned the treatment of ESG investments.
DOL responded by eliminating references to ESG and ESG investing from the text of the Final Rule. However, DOL’s News Release stated that it issued the Final Rule “to provide clear regulatory guideposts” for ERISA fiduciaries to address recent trends in involving ESG investing. Further, DOL’s explanatory comments, which accompanied the Final Rule, remind fiduciaries that “plan assets may never be enlisted in pursuit of other social or environmental objectives at the expense of ERISA’s fundamental purpose of providing secure and valuable retirement benefits.” 85 Fed. Reg. at 72848. Thus, although the Final Rule does not mention ESG investing, it is clearly intended to govern the use of ESG investments in ERISA plans.
A. The Final Rule Expressly Reflects ERISA’s Duty of Loyalty
The Final Rule clarifies that ERISA’s duty of loyalty, which requires a fiduciary to act solely in the interest of plan participants and beneficiaries for the exclusive purpose of providing benefits and defraying expenses, applies to the evaluation of investments and investment courses of action. The Final Rule therefore states that the duty of loyalty forbids ERISA fiduciaries from sacrificing investment returns or taking additional risks to promote non-pecuniary goals. Thus, ERISA fiduciaries may not select ESG investments to promote any goal other than ensuring financial benefits for plan participants.
B. Fiduciaries Must Rely on Pecuniary Factors to Evaluate Investment and Investment Courses of Action
The Final Rule requires fiduciaries to evaluate investments and investment courses of action based only on “pecuniary factors,” except when two investment alternatives are indistinguishable based on pecuniary factors. The Final Rule defines a pecuniary factor as a factor that a fiduciary prudently determines is expected to have a “material effect on the risk and/or return of an investment.”
In the unlikely event that fiduciaries cannot distinguish between investments based upon their pecuniary characteristics, the Final Rule permits fiduciaries to consider ESG factors as “tie-breakers,” provided they perform and document an analysis, which is similar to the “tie-breaker” analysis required by DOL’s prior guidance. Fiduciaries who rely on “non-pecuniary” factors as tie-breakers between indistinguishable investments must document: (i) why they were unable to choose an investment based on pecuniary factors alone; (ii) how the selected investment compares to alternative investments with respect to: (a) considerations of portfolio diversification, (b) the liquidity and rate of return relative to cash flow requirements, and (c) the rate of return relative to funding objectives; and (iii) how the non-pecuniary factor is consistent with plan participants’ interest in retirement income or other financial benefits. Thus, fiduciaries must explain how the ESG factor serves the financial interest of the plan, and should avoid any justification based on the societal benefits of ESG.
However, DOL’s Comments also acknowledge that ESG factors may be pecuniary factors and the Final Rule does not require documentation of the decision to rely on pecuniary ESG factors when selecting investments. New York’s comptroller recently provided an example of treating ESG factors as pecuniary when he explained that New York intended to drop fossil fuel stocks from its pension fund to ensure long-term investment returns. Although DOL’s Comments caution fiduciaries against hastily treating ESG factors as pecuniary factors, they also emphasize that the Final Rule does not single out ESG investing. According to DOL, the Final Rule should not “inappropriately chill” fiduciaries from considering ESG investments when the ESG factors “can be shown to be pecuniary.”
In sum, ERISA fiduciaries should proceed with caution when selecting ESG investments and document how such investments serve the financial interests of participants and beneficiaries. Regardless of whether fiduciaries view ESG characteristics as pecuniary factors or “tie-breakers,” they should document their analysis and their reasons for choosing ESG investments. Given the prevalence of ERISA litigation, fiduciaries should consider consulting both their counsel and investment advisor because poor documentation may bolster breach of fiduciary duty claims.
C. Special Considerations for Participant-Directed Individual Account Plans
The Final Rule also requires fiduciaries to act solely in the interest of plan participants and to rely on pecuniary factors when selecting or retaining investment options for participant-directed individual account plans. Thus, the Final Rule permits plan fiduciaries to include investment options that produce “socially desirable” goals, but only if the investment can be justified solely based on pecuniary factors. Although participant preference for ESG investments is not a pecuniary factor, fiduciaries may consider preferences as part of a tie-breaker analysis.
DOL’s Comments advise fiduciaries to “carefully review” any prospectus or investment disclosure for ESG statements and to “be particularly cautious in exercising their due diligence obligation” when such disclosures refer to non-pecuniary factors in the statement of fund objectives or investment strategies. However, these obligations do not apply to investment options available through to “brokerage windows,” “self-directed brokerage accounts,” or other arrangements that allow participants to select investments beyond those designated by the plan.
D. Special Considerations for Qualified Default Investment Alternatives (QDIAs)
Finally, the Final Rule prohibits fiduciaries from designating as a QDIA any investment that has a “non-pecuniary” objective or investment strategy. Specifically, fiduciaries may not identify an investment as a QDIA if its objective or principal investment strategy includes a non-financial goal. The Final Rule also prohibits identifying as QDIAs, any fund that uses “screening strategies,” which prohibit investing in sectors such as fossil fuels, weapons or gaming. DOL provided special treatment for QDIAs because they help ensure the retirement savings of plan participants who do not make affirmative investment election and fiduciaries are shielded from liability for investment outcomes when the fiduciary invests a participant’s assets in a QDIA.
E. Effective Dates and Conclusion
The Final Rule becomes effective January 13, 2021, and governs only investments made and investment courses of action taken after that date. Further, it gives plans until April 30, 2022 to make any changes to QDIAs. Given the popularity of ESG investing, the resources of the relevant stakeholders, and the upcoming change in administration, the future of the Final Rule is unclear. Indeed, as reported here, and here, Congressman Andy Levin (D-Michigan) has announced his intention to draft legislation that requires plan fiduciaries to consider ESG criteria in their plan investment policies. Further, if large pension funds follow New York’s example, it will be easier to justify ESG factors as pecuniary factors. Thus, fiduciaries should monitor legislative developments, court proceedings, and investing trends that may affect the permissibility of ESG investing.