Proposed DOL Regulation Responds to Growth of ESG Investments by Prohibiting Subordination of Financial Interests

The DOL has proposed amending its investment duties regulation to clarify that plan fiduciaries must evaluate investments solely on the basis of financial considerations, and may not subordinate the financial interests of participants and beneficiaries to environmental, social, corporate governance (ESG) or similarly oriented nonfinancial considerations. The proposal’s preamble expresses concern that a growing emphasis on ESG investing may be leading ERISA plan fiduciaries to make investment decisions on grounds other than financial considerations. It stresses that financial considerations are paramount in selecting a plan investment or “investment course of action” (a term that specifically includes selecting investment funds or designated investment alternatives). Past DOL guidance has consistently required fiduciaries to focus on financial returns and risk, while acknowledging that those considerations may be affected by ESG factors, and that ESG considerations may be used as a tiebreaker when choosing between otherwise equal investment choices (see our Checkpoint article). These varied statements may have led to confusion about when and how ESG factors may be taken into account (see our Checkpoint article). The proposal seeks to eliminate that confusion by amending the investment duties regulation to prevent fiduciaries from selecting “inappropriate investments that sacrifice investment return, increase costs, or assume additional investment risk to promote non-pecuniary benefits or objectives.” Here are highlights:

• Investment Duties. The proposal would revise the regulation’s description of a fiduciary’s duties of loyalty and prudence. A new provision would require that investments and investment courses of action be evaluated based solely on pecuniary factors having a material effect on the investment’s risk and return in light of its expected duration and the plan’s funding and investment objectives. And fiduciaries would be expressly prohibited from subordinating the interests of participants and beneficiaries in their retirement income or financial benefits to other unrelated objectives or goals.
• Alternatives Must Be Considered. The proposal would clarify that “appropriate consideration” of an investment requires considering how it compares to available alternatives in light of the plan’s diversification, liquidity, and current return relative to the plan’s cash flow requirements, and projected return relative to the plan’s funding objectives.
• Pecuniary Factors. The proposal requires that a fiduciary’s investment evaluation focus solely on pecuniary factors (defined as factors having a “material effect on the risk and/or return of an investment” based on appropriate time horizons, and consistent with the plan’s investment objectives and funding policy). The proposal explains when an ESG factor may constitute a pecuniary factor, cautions that the weight given to such factors must reflect a prudent assessment of their impact, and lists other considerations that must be examined when comparing an ESG investment to other available investments.
• Tiebreaker Rule. The proposal repeatedly suggests that it will be “rare” for ESG and alternative investments to be “economically indistinguishable.” But if that occurs and ESG considerations are used as a tiebreaker, fiduciaries would have to document why the investments were considered indistinguishable and why the selected investment was chosen.
• Designated Investment Alternatives. Fiduciaries could select designated investment alternatives that include ESG assessments or judgments in their investment mandates, or ESG parameters in their fund names, but only when (a) the selection is based solely on objective risk-return criteria used to select all of the plan’s investment options (including ESG alternatives), (b) the investment’s selection and monitoring is documented, and (c) the ESG investment is not added as, or as a component of, a qualified default investment alternative (QDIA).

EBIA Comment: The proposal characterizes ESG investing as a “growing threat” to ERISA’s fiduciary standards and, ultimately, to the investment returns of participants and beneficiaries. It would apply to both the selection of plan investments (where one investment’s selection necessarily results in forgoing another), and the selection of investment alternatives offered to participants. While ESG alternatives may be popular with some plan participants, the proposed regulation would make it clear that sacrificing returns or increasing risk to provide such options would violate the fiduciary’s duties under ERISA. Public comments are requested and are due no later than July 30, 2020. For more information, see EBIA’s 401(k) Plans manual at Sections XXV.D (“Selecting the Plan’s Investment Funds”) and XXVI.J (“Fiduciary Protection for Qualified Default Investment Alternative (QDIA)”).

Contributing Editors: EBIA Staff.