For Plan Investments in ETIs, the All Things Being Equal Test Prevails (Again)

Practical Law Legal Update w-000-7096 (Approx. 6 pages)

For Plan Investments in ETIs, the All Things Being Equal Test Prevails (Again)

by Practical Law Employee Benefits & Executive Compensation

Economically Targeted Investments (ETIs)

ETIs refer to any investment that is selected, in part, for its collateral economic or social benefits, apart from the investment return to the investor (in this case, an employee benefit plan). Various terms are used to describe ETIs and related investment behaviors and methodologies, including:

Socially responsible investing (SRI).
Sustainable and responsible investing.
Environmental, social and governance (ESG) investing.

The collateral benefits of an ETI are usually based on ESG criteria. For example, an investment in a particular company may be avoided because the company does not meet certain minimum criteria for environmental or labor relations standards. Alternatively, some plan fiduciaries use ESG criteria to choose among investment opportunities in an industry or region. For example, they might choose to invest in:

A large retailer that has better employee benefits than its peers.
An oil company that is known for working to develop renewable energy sources.
A bank with comparatively modest executive pay.

ETIs and ERISA’s Fiduciary Standards

Questions have been raised for many years on whether plan investments in ETIs are compatible with ERISA’s fiduciary standards under ERISA Sections 403 and 404 (29 U.S.C. §§ 1103 and 1104). ERISA Sections 403 and 404 require, in part, that a fiduciary:

Act prudently.
Act solely in the interest of plan participants and beneficiaries.
Act for the exclusive purpose of providing benefits to participants and beneficiaries.
Diversify plan investments so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent to not do so.

For more information on ERISA’s fiduciary standards, see Practice Note: Overview: ERISA Fiduciary Duties.

In light of these stringent standards, particularly the duty to act solely in the interest of participants and beneficiaries, employee benefit plan fiduciaries were wary of considering external objectives (such as ESG factors) when selecting and reviewing plan investments. Alternatively, some plan fiduciaries argued that they would be remiss in not considering ESG factors when selecting between two plan investments that both satisfied ERISA’s fiduciary standards and, for all other intents and purposes, were equal.

Past DOL Guidance on ETIs

The DOL originally issued IB 94-01 in response to a popular misconception at the time that investments in ETIs are incompatible with ERISA’s fiduciary obligations. The preamble to IB 94-01 explains that the requirements of ERISA Sections 403 and 404 (29 U.S.C. §§ 1103 and 1104) do not prohibit a plan fiduciary from investing plan assets in an ETI if the ETI:

Has an expected rate of return that is comparable to rates of return for other available plan investments with similar risk characteristics.
Is otherwise an appropriate investment for the plan in terms of factors including:
- diversification; and
- the plan’s investment policy.

This standard is generally referred to as the “all things being equal” test. The DOL emphasized that plan fiduciaries’ primary focus should be the plan’s financial returns and risk to beneficiaries. Fiduciaries may not:

Use plan assets to promote ESG causes at the expense of the financial interests of the plan’s participants and beneficiaries.
Accept lower expected returns or take on greater risks to secure collateral benefits.

Essentially, the DOL recognized that fiduciaries may consider these types of collateral goals as “tie-breakers” when choosing between investment alternatives that are otherwise equal regarding return and risk over an appropriate time frame.

In 2008, the DOL replaced IB 94-01 with IB 2008-01 (29 C.F.R. § 2509.08-01). IB 2008-01 stated that it did not alter the basic legal principles set out in IB 94-1 but instead clarified that a fiduciary’s consideration of collateral, non-economic factors in selecting plan investments:

Should be rare.
If considered, should be documented in a manner that demonstrates compliance with ERISA’s fiduciary standards.

To date, many practitioners (and the DOL itself) believe that IB 2008-01 discouraged fiduciaries from considering ETIs and ESG factors at all, including in situations where those factors have a direct relationship to the economic value of a plan’s investment.

IB 2015-01: All Things Are Equal, Again

IB 2015-01 replaces IB 2008-01 and clarifies that the standards set out in IB 94-01 continue to apply. Specifically, IB 2015-01 establishes the following two standards regarding a plan investment in ETIs:

Where the Investment is Chosen Based Solely on Economic Considerations. If plan fiduciaries prudently determine that an investment in an ETI is appropriate based solely on economic considerations, the fiduciary may make that investment without regard to any collateral benefits the investment may also promote. In other words, fiduciaries need not treat commercially reasonable investments as “inherently suspect” or “in need of special scrutiny” merely because they take ESG factors into consideration.
Where an Investment is Chosen Based on Economic and Collateral Considerations. Plan fiduciaries may invest in ETIs based, in part, on their collateral benefits so long as the investment is economically equivalent to available investment options without those collateral benefits regarding return and risk to beneficiaries in the appropriate time horizon.

IB 2015-01 also provides that plan fiduciaries:

May address ETIs or incorporate ESG factors in the plan’s investment policy statement (IPS) (see Standard Document, Investment Policy Statement for Defined Contribution Plan).
May integrate ESG-related tools, metrics or analyses to:
- evaluate an investment’s risk or return; or
- choose among otherwise equivalent investments.
That use ERISA Section 3(38) (29 U.S.C. § 1002(38)) investment managers must reasonably conclude that the manager’s practices in selecting investments are consistent with this guidance (see Practice Note, Selecting and Hiring an Investment Manager).
Selecting designated investment alternatives for an ERISA Section 404 (c) (29 U.S.C. § 1104(c)) plan or a “socially responsible” mutual fund are subject to the same standards set out in ERISA Sections 403 and 404 (29 U.S.C. §§ 1103 and 1104) regarding ETIs (see ERISA Section 404(c) Checklist and Investment Review Checklist for 401(k) Plan Committees).

Practical Implications

Plan fiduciaries that chose not to consider investing plan assets in ETIs due to the perceived fiduciary risk suggested in IB 2008-01 may wish to reconsider this position.

Any plan fiduciary that affirmatively rejected investing in an ETI where the ETI was a more prudent economic investment as compared to other similar investments should reevaluate that decision based on IB 2015-01.

If plan fiduciaries wish to consider investing plan assets in ETIs because they promote ESG factors or other collateral benefits in addition to passing the “all things being equal” test, they are now clearly permitted to do so under IB 2015-01.

Plan fiduciaries considering investing plan assets in ETIs should discuss their options with the plans’ investment consultant and also consider addressing ETIs in the plan’s IPS.

For Plan Investments in ETIs, the All Things Being Equal Test Prevails (Again) | Practical Law