DOL Issues Proposed Rule on Environmental, Social, and Governance (ESG) Investing for Retirement Plans | Practical Law

DOL Issues Proposed Rule on Environmental, Social, and Governance (ESG) Investing for Retirement Plans | Practical Law

The Department of Labor (DOL) has issued a proposed rule that would amend DOL Regulation Section 2550.404a-1 to clarify the legal standards under Sections 403 and 404 of the Employee Retirement Income Security Act of 1974 (ERISA) that apply to a retirement plan fiduciary's decision to invest plan assets because of non-financial objectives, including environmental, social, and governance (ESG) factors (also referred to as economically targeted investments (ETIs)).

DOL Issues Proposed Rule on Environmental, Social, and Governance (ESG) Investing for Retirement Plans

by Practical Law Employee Benefits & Executive Compensation
Published on 29 Jun 2020 • USA (National/Federal)
The Department of Labor (DOL) has issued a proposed rule that would amend DOL Regulation Section 2550.404a-1 to clarify the legal standards under Sections 403 and 404 of the Employee Retirement Income Security Act of 1974 (ERISA) that apply to a retirement plan fiduciary's decision to invest plan assets because of non-financial objectives, including environmental, social, and governance (ESG) factors (also referred to as economically targeted investments (ETIs)).
On June 23, 2020, the DOL announced the release of a proposed rule that would amend DOL Regulation Section 2550.404a-1 (29 C.F.R. § 2550.404a-1) to clarify when selecting environmental, social, and governance (ESG) investments can be achieved in accordance with the fiduciary duties of Sections 403 and 404 of the Employee Retirement Income Security Act of 1974 (ERISA) (29 U.S.C. §§ 1103 and 1104) (85 Fed. Reg. 39113 (June 30, 2020)).
The DOL also issued a press release and fact sheet that explain the proposed rule.

ESG Investments

ESG investments are investments that are selected, in part, for their collateral economic or social benefits. While retirement plans have begun to utilize ESG factors in making their investment offering decisions, questions have been raised for many years on whether plan investments in ESGs are compatible with ERISA's fiduciary standards under ERISA Sections 403 and 404 (29 U.S.C. §§ 1103 and 1104) which require 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, ERISA Fiduciary Duties: Overview.
In light of these stringent standards, retirement plan fiduciaries have been wary of considering ESG factors when selecting and reviewing plan investments. Alternatively, some plan fiduciaries have 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 Guidance

The DOL has been asked to consider the application of the rules under ERISA to investments in ESGs because of the non-pecuniary benefits ESG investments further.
The DOL's first guidance addressing ESG investment issues was Interpretive Bulletin 94-1 (IB 94-1) (59 Fed. Reg. 32606 (June 23, 1994)). In IB 94-1, the DOL explained that the requirements of ERISA Sections 403 and 404 do not prevent fiduciaries from investing in ESGs if:
  • The investment has an expected rate of return commensurate to rates of return available with alternative investments with similar risk characteristics.
  • The investment vehicle is otherwise an appropriate investment for the plan in terms of such factors as diversification and the investment policy of the plan.
This has been referred to as the "all things being equal" test or the "tie-breaker test." When competing investments serve the plan's economic interests equally well, plan fiduciaries can use such non-pecuniary considerations as the deciding factor for an investment decision.
IB 94-1 was replaced with Interpretive Bulletin 2008-1 (IB 2008-1) (73 Fed. Reg. 61734 (Oct. 17, 2008)). In 2015, the DOL replaced IB 2008-1 with Interpretive Bulletin 2015-01 (IB 2015-01) (see Legal Update, For Plan Investments in ETIs, the All Things Being Equal Test Prevails (Again)). All of the IBs emphasized that:
  • The plan fiduciary's focus must be on the plan's financial returns.
  • Furthering the interest of plan participants and beneficiaries under the plan is of the utmost importance.
Each IB restates the "all things being equal" test, but the DOL has cautioned that fiduciaries still can violate ERISA if they accept reduced returns or greater risk to secure social, environmental, or other public policy goals.
In IB 2015-01, the DOL explained that if a fiduciary prudently determines that an investment is appropriate based on economic considerations, including those that may derive from ESG factors, the fiduciary may make the investment without regard to any collateral benefits the investment may promote. The DOL notes that in these situations:
  • The issues are appropriate economic considerations, and thus may be considered by a prudent fiduciary along with other relevant factors to evaluate the risk and return profiles of different investments.
  • The factors are not "tie-breakers" but pecuniary factors affecting the economic merits of the investment.
Most recently in FAB 2018-01, the DOL made clarifications to IB 2015-01 (see Legal Update, In FAB 2018-01, DOL Clarifies Its Views on Proxy Voting, Shareholder Engagement, and Plan Investments in ETIs).

Proposed Rule

The DOL indicates that the purpose of the proposed rule is to:
  • Invite public comments on the proposal codifying the regulatory structure for ESG investing in the investment duties regulation at 29 C.F.R. Section 2550.404a-1.
  • Assist ERISA fiduciaries by establishing clear regulatory guideposts for plan fiduciaries in light of recent trends involving ESG investing. It is these trends that the DOL is concerned may lead ERISA plan fiduciaries to choose investments or investment courses of action to promote ESG goals unrelated to the interests of plan participants and beneficiaries in financial benefits from the plan and expose plan participants and beneficiaries to inappropriate investment risks.
The proposed rule makes five core proposed additions to the regulation by:
  • Codifying the longstanding position that has been articulated in previously published guidance and that requires ERISA plan fiduciaries to select investments and investment courses of action based on financial considerations relevant to the risk-adjusted economic value of a particular investment or investment course.
  • Stating that compliance with the exclusive purpose rule in ERISA prohibits fiduciaries from subordinating the interests of plan participants and beneficiaries in retirement income and financial benefits under the plan to non-pecuniary goals.
  • Requiring fiduciaries to consider other available investments to meet their prudence and loyalty duties under ERISA in furthering the purposes of the plan.
  • Acknowledging that ESG factors can be pecuniary, but only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories. The proposed regulations add a required investment analysis and documentation requirement if fiduciaries choose among economically indistinguishable investments (related to the "tie-breaker rule").
  • Providing guidance on selecting designated investment alternatives for 401(k) plans. This provision describes the requirements for the selection of investment alternatives for such plans that purport to use one or more ESG objectives in their investment mandates or that include such parameters in the fund name.
The DOL also indicates that:
  • Some plans may have to modify their process for selecting and monitoring investments.
  • The rule may impose costs on plans whose current documentation and recordkeeping is insufficient to meet the new requirement.
  • Plans would need to document selections in some circumstances where a fiduciary concludes the alternative investment options are economically indistinguishable.
The revised Section 2550.404a-1 would be effective 60 days after the date of publication of the final rule.
The DOL is requesting comments on the proposed rule, particularly on whether the "all things being equal" test should be retained.

Practical Implications

The DOL is concerned that ERISA plan fiduciaries could choose investments or investment courses of action that promote ESG factors that:
  • Are unrelated to the interests of plan participants and beneficiaries in financial benefits from the plan.
  • Could expose plan participants and beneficiaries to inappropriate investment risks.
Plan fiduciaries should review the DOL's proposed rule and be mindful of the requirements it would add for choosing plan investments that promote ESG factors or other collateral benefits. In particular, plan fiduciaries should also note the new proposed documentation requirements.