Final DOL Rule Addresses Use of Non-Financial Factors in Selecting Retirement Plan Investments | Practical Law

Final DOL Rule Addresses Use of Non-Financial Factors in Selecting Retirement Plan Investments | Practical Law

The Department of Labor (DOL) has issued a final rule amending 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-pecuniary objectives. The final rule is substantially similar to the proposed rule, but omits the environmental, social, and governance (ESG) terminology used in the proposed rule.

Final DOL Rule Addresses Use of Non-Financial Factors in Selecting Retirement Plan Investments

by Practical Law Employee Benefits & Executive Compensation
Published on 03 Nov 2020 • USA (National/Federal)
The Department of Labor (DOL) has issued a final rule amending 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-pecuniary objectives. The final rule is substantially similar to the proposed rule, but omits the environmental, social, and governance (ESG) terminology used in the proposed rule.
On October 30, 2020, the DOL issued a final rule that amends DOL Regulation Section 2550.404a-1 (29 C.F.R. § 2550.404a-1) to address when retirement plan fiduciaries may consider non-pecuniary factors in selecting plan investments without violating their fiduciary duties under Sections 403 and 404 of the Employee Retirement Income Security Act of 1974 (ERISA) (29 U.S.C. §§ 1103 and 1104). The final rule is substantially similar to the proposed rule, but omits the environmental, social, and governance (ESG) terminology used in 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).
In June 2020, the DOL issued a proposed rule intended to clarify when selecting ESG investments can be achieved in accordance with ERISA's fiduciary duties (85 Fed. Reg. 39113 (June 30, 2020); see Legal Update, DOL Issues Proposed Rule on Environmental, Social, and Governance (ESG) Investing for Retirement Plans). According to the DOL, the purpose of the proposed rule was to 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.

Final Rule

The final rule adopts the five core proposed additions to the regulation with certain modifications. These additions include:
  • Codifying the DOL's position that ERISA plan fiduciaries must select investments and investment courses of action based on pecuniary factors (see Selection of Plan Investments Must Be Based on Pecuniary Factors).
  • 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 (see Duty of Loyalty).
  • Requiring fiduciaries to consider other available investments to meet their prudence and loyalty duties under ERISA in furthering the purposes of the plan (see Consideration of Other Available Investments).
  • A required investment analysis and documentation requirement if fiduciaries use non-pecuniary factors when choosing among economically indistinguishable investments (related to the "tie-breaker rule") (see All Things Being Equal Test).
  • Providing guidance on selecting designated investment alternatives for 401(k) plans (see Selecting Designated Investment Alternatives).

Selection of Plan Investments Must Be Based on Pecuniary Factors

The final rule requires plan fiduciaries to select plan investments and investment courses of action based on pecuniary factors. In response to public comments arguing, among other things, that there is no clear definition of ESG, the DOL removed ESG terminology from the final rule. Accordingly, the final rule instructs fiduciaries to focus on whether the factor being considered is pecuniary rather than whether it is an ESG consideration.
The final rule also modifies the definition of "pecuniary factor" to include a factor that a plan fiduciary determines is "expected to have a material effect on the risk and/or return of an investment."

Duty of Loyalty

The final rule modifies the provisions regarding ERISA's exclusive purpose rule, which prohibits fiduciaries from subordinating the interests of plan participants and beneficiaries in retirement income and financial benefits under the plan to non-pecuniary goals (see Practice Note, ERISA Fiduciary Duties: Overview: Duty of Loyalty). The final rule:
  • Separates the language concerning the duty of prudence and the duty of loyalty.
  • Retains the safe harbor for the duty of prudence.

Consideration of Other Available Investments

The proposed rule included language requiring fiduciaries to consider other available investments to meet their prudence and loyalty duties under ERISA in furthering the purposes of the plan. In response to comments, the final rule clarifies that, in comparing investment alternatives, plan fiduciaries need not "scour the market." Instead, they need only compare "reasonably available" alternatives.

All Things Being Equal Test

The proposed rule included the "all things being equal" test, but requested comments on whether it was needed. Many commenters argued that the proposed rule's language, which provided that fiduciaries could look to non-pecuniary factors if the investments were "economically indistinguishable," meant that that the investments had to be identical before the tie-breaker provisions could apply. In response, the final rule omits the "economically indistinguishable" language and instead provides that fiduciaries may use non-pecuniary factors if they are unable to distinguish between investments based solely on pecuniary factors. The final rule retains the related documentation requirement to ensure that fiduciaries do not "improperly find economic equivalence and make decisions based on non-pecuniary factors without a proper analysis and evaluation."
In a change from the proposed rule, the final rule makes the tie-breaker provision available to fiduciaries selecting investment options for individual account plans, though the DOL expressed doubt that ties would arise in that context.

Selecting Designated Investment Alternatives

Like the proposal, the final rule addresses fiduciaries' selection of investment alternatives for participant-directed individual account plans. In response to comments, the DOL clarified that fiduciaries are not prohibited from considering or selecting an investment fund, product, or model portfolio as a designated investment alternative that promotes or supports a non-pecuniary goal, provided that:
  • In making the selection, the fiduciary:
    • satisfies its duties of prudence and loyalty in making the selection; and
    • relies on the relevant pecuniary factors.
  • The investment fund, product, or model portfolio is not added as a qualified default investment alternative (QDIA) if its objectives, goals, or principal investment strategies indicate that it uses non-pecuniary factors (see Practice Note, Qualified Default Investment Alternatives (QDIAs)).
In addition, the final rule:
  • Adds a definition for "designated investment alternative."
  • Removes the provision requiring fiduciaries to use only "objective risk-return criteria" in selecting investment alternatives and the related documentation requirement.

Effective and Compliance Dates

The final rule is effective 60 days after publication in the Federal Register and applies prospectively to investment decisions made after the effective date. Regarding plans with QDIAs that do not comply with the rule, the deadline for making changes to their QDIAs is April 30, 2022.

Practical Implications

In response to numerous comments to the proposed regulations, which included backlash to the proposed rules regarding ESG investments in ERISA plans, the DOL chose to omit this language. While the final rule does not stop investment in ESGs, it remains to be seen whether not addressing ESGs will have the effect of curbing their future use in ERISA plans.