Background. On June 23, 2020, the Department of Labor (DOL) issued proposed regulations clarifying its position on the fiduciary rules that apply to environmental, social and governance (ESG) investments. The DOL issued the proposed regulations in response to (i) an accelerating trend of plan investments in ESG funds, and (ii) a proliferation of ESG metrics and ratings that are offered by third-party providers but that may not be consistent with ERISA considerations. The DOL believes that the increased use and offering of these funds results from overly liberal interpretations of the DOL’s previously published guidance dealing with this topic.
Setting the tone for the proposed regulations, the Secretary of Labor, Eugene Scalia stated, “Private employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan. Rather, ERISA plans should be managed with the unwavering focus on a single, very important social goal: providing for the retirement security of American workers.”
The DOL stated that ERISA’s duty of loyalty prohibits a plan fiduciary from investing in ESG vehicles if that investment subordinates return or increases risk for the purpose of non-pecuniary objectives. However, the significant growth of plan investments in these vehicles raises concerns that fiduciaries may be violating the duty of loyalty. The DOL is expanding its audit guidelines to focus on ESG investments.
General Rules for Defined Contribution Plans. The proposed regulations provide for the following for defined contributions plans:
- General Fiduciary Considerations. In selecting any investment fund, a fiduciary must:
- Comply with the duty of loyalty, acting solely in the interests of participants and beneficiaries, for the exclusive purpose of providing benefits to them and providing funds to pay reasonable expenses of administering the plan; and
- Comply with ERISA’s duty of prudence.
- Compliance with the Duty of Loyalty and Prudence. To comply with the duty of loyalty and prudence in regard to making investment decisions, the fiduciary must:
- Examine all facts and circumstances related to the investment, including the role that fund will play in the overall portfolio;
- Evaluate investment fund alternatives based solely on the pecuniary factors that have a material effect on risk and return relative to investment horizons under the investment policy statement; and
- Not (i) subordinate the pecuniary, financial interests of the participants or (ii) sacrifice return or take on additional risk, to promote goals unrelated to participants’ financial interests.
- Sole Focus on Pecuniary Factors. A fiduciary’s evaluation of investment funds must be based solely on pecuniary factors:
- ESG or similar 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 DOL stated that ESG factors will be pecuniary in nature only in rare situations, and the DOL anticipates that these factors will be considered very infrequently.
- ESG Factors as a Tie-Breaker. If the return and risk profiles of two funds are identical, then and only then can the non-pecuniary ESG factors be considered as a tie-breaker.
- In this instance, the fiduciary must document specifically why the funds were considered indistinguishable in regard to maximizing participants’ benefits.
Special Rules Plans with Participant-Directed Investments. The proposed regulations provide the following for defined contributions plans under which participants select investments from a group of funds chosen by the plan fiduciary:
- The duty of loyalty and prudence as described above apply to the selection of a broad range of investment alternatives from which participants may select to invest their accounts.
- The inclusion of one or more ESG funds among the investment alternatives will not violate the duty of loyalty and prudence under the following circumstances:
- The fiduciary selects the ESG funds using only objective risk-return factors (g., benchmarks, expense ratios, fund size, long-term investment returns, volatility measures, investment manager philosophy and experience, mix of assets, value and growth styles, etc.);
- The fiduciary documents its selection and monitoring of the ESG funds; and
- The ESG fund is not used as the qualified default investment fund (QDIA).
Process for Finalizing Regulations. The DOL has established a 30-day comment period in which comments and suggested changes can be made. The DOL then will consider those comments. The final regulation will be effective 60 days after it is first published.