The US Department of Labor’s final ERISA regulation generally follows its proposal but without the focus on environmental, social, and governance investing.
Over the summer, the US Department of Labor (DOL) proposed three ERISA regulations and one prohibited transaction class exemption, in addition to issuing an interim final regulation. The earliest of those, a regulation titled Financial Factors in Selecting Plan Investments, has now been finalized.
The proposed regulation would have more directly called into question so-called “ESG investing”—investing that takes into account environmental, social and (corporate) governance (ESG) considerations―on the basis that such factors may be “non-pecuniary” in nature, and as such, not appropriate investment considerations for ERISA fiduciaries. In part for this reason, the proposal generated more than 8,700 comments (although the DOL pointed out that 7,600 were based on six form letters). While the final rule retains the concept that a fiduciary’s evaluation of investments must, except as otherwise provided in the rule, be based only on pecuniary factors, it eliminates any specific mention of ESG factors so as to avoid any presumption of whether a factor labeled as ESG is necessarily non-pecuniary.
The rule is effective January 12, 2021―60 days after its publication in the Federal Register―subject to a later effective date of April 30, 2022, for its application to so-called “qualified default investment alternatives” (QDIAs) in participant-directed defined contribution plans.
In light of these changes and the upcoming effective date, ERISA plan fiduciaries and fund managers will want to review their current practices to determine whether any changes may be appropriate.
Final Rule Amends ERISA Prudence Regulation
The rule amends ERISA’s prudence regulation, which applies the fiduciary duty of prudence to plan investment decisions. In the nature of a safe harbor, it establishes the concept that the fiduciary duty of prudence can be met by following a process that gives appropriate consideration to the facts and circumstances relevant to the particular investment or investment course of action.
The amended regulation retains the original prudence rule with only a few changes, the primary substantive change being the following:
- New requirement to compare to reasonably available alternatives: As modified, the regulation now requires a fiduciary to evaluate an investment “compared to the opportunity for gain (or other return) associated with reasonably available alternatives with similar risks.” This appears to be generally consistent with recently adopted requirements that apply to broker-dealers when providing recommendations to retail investors under the SEC’s Regulation Best Interest. Responding to comments, the DOL explained that this is not intended to require fiduciaries to “scour the market” and incur search costs to look at an infinite number of potential portfolios, nor would it be prudent to do so. To make that concept clear, the DOL added “reasonably” before “available alternatives” in the final version. The DOL explained that this change is intended to confirm that fiduciaries are not required to consider every possible alternative, and if a given investment has “sufficiently rare” characteristics and purposes, a fiduciary could prudently determine, and document, that there were no other reasonably available alternatives to which it could be compared.
Apart from that change, the primary focus of the current rulemaking is the ERISA duty of loyalty. The final rule is intended to interpret that duty of loyalty with respect to fiduciary investment decisions, focusing on a fiduciary’s ability to consider non-pecuniary factors.
The application of the duty of loyalty to so-called “economically targeted investments” and ESG investing had been addressed in a series of sub-regulatory guidance, most recently in 2015 and further interpreted in 2018, as discussed in our prior LawFlash.
The final rule is intended to clarify and codify these prior interpretations and more general standards for how the ERISA duty of loyalty applies to plan investments, in the form of a regulation that has been subject to a notice-and-comment rulemaking process. The DOL noted that while the prudence part of the regulation is in the nature of a “safe harbor,” the duty of loyalty sections impose a “legal requirement” or “minimum requirements,” not a safe harbor.
Basic Rule: Primacy of ‘Pecuniary’ Factors
As finalized by the DOL, the new rule provides that in order to meet the ERISA duty of loyalty, a plan fiduciary’s evaluation of an investment or investment course of action must be based only on “pecuniary” factors, subject to two limited exceptions, discussed below.
- The term “pecuniary factor” is defined as follows (emphasis added): “[A] factor that a fiduciary prudently determines is expected to have a material effect on the risk and/or return of an investment based on appropriate investment horizons consistent with the plan’s investment objectives and the funding policy established pursuant to section 402(b)(1) of ERISA.”
- According to the regulation, this standard follows from the principle, also stated in the previous sub-regulatory guidance, that a “fiduciary may not subordinate the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to other objectives, and may not sacrifice investment return or take on additional investment risk to promote non-pecuniary benefits or goals.”
There are several important terms in the “pecuniary factor” definition:
- “Prudently determines” – The final rule provides a standard for plan fiduciary determinations of whether a factor is “pecuniary”―the ERISA prudence standard. As compared to the proposal, which did not provide a standard, the final rule is intended to incorporate more flexibility by adopting a “reasonableness standard of care,” recognizing that these judgments will necessarily involve forward-looking expectations.
- “Material effect” – The final rule retains the “material effect” language from the proposal. In so doing, the DOL said that it believes fiduciaries and investment managers are generally familiar with this concept from its use in connection with both ERISA and federal securities laws.
- “Appropriate investment horizons” – This requirement is intended to be sufficiently flexible to permit a plan fiduciary to determine the appropriate time horizon for the particular plan, and also appears intended to rule out making judgments based on time periods that would extend beyond when participants would be receiving their benefits.
In addition, the rule clarifies that in considering any “pecuniary factor,” the weight given to such pecuniary factor should “appropriately reflect a prudent assessment of its impact on risk-return.” This is intended to prevent fiduciaries from circumventing the rule by giving undue weight to what should be relatively minor considerations.
While the DOL deleted a requirement to evaluate whether considerations are “pecuniary” based on whether they would be treated as such by qualified investment professionals under “generally accepted investment theories,” the DOL noted that it would be consistent with ERISA and the final rule for a fiduciary to take prevailing investment professional views into account.
There were comments questioning whether the DOL’s proposed standards would restrict use of proprietary products and certain other practices. The DOL explained that the final rule “neither specifically prohibits nor permits the use of proprietary products, fee sharing, or fee aggregation, but requires the fiduciary to evaluate whether such practices are expected to have a material effect on risk and/or return as compared to the reasonably available alternatives.” Thus, the DOL said, by way of example, a fiduciary could prudently conclude that a fund manager’s brand or reputation would materially affect the expected risk or return of a fund, or that net plan expenses would be expected to have such an effect. The DOL added that it did not intend to imply that in evaluating plan investments, a fiduciary must always select the one with the lowest cost; instead, the DOL acknowledged (as it has in other guidance) that a higher risk or cost investment may, depending on the facts and circumstances, be prudent.
In issuing the final rule, the DOL also covered two other issues in response to comments on the proposal:
- Company Stock – The DOL said that commenters should not be concerned about the impact of the final rule on company stock investments because company stock investments are subject to long-established basic principles of ERISA that are not disturbed by this rule.
- Multiemployer Plan Contributions – The DOL rejected the suggestion that multiemployer plans should be able to make investments that, by increasing covered employment, would increase plan contributions. The DOL had previously taken the position that increased plan contributions and similar considerations are a “non-economic factor” that may only be considered where a fiduciary is permitted to make an investment decision based on non-pecuniary factors. With this rule, the DOL reiterated that relevant performance is to be measured based on the investment in question, not future considerations. As a result, under this rule, strengthening employers or unions would not be “pecuniary” factors, although they could be permissible “non-pecuniary” considerations under the “tie-breaker” exception described below.
Exceptions to Pecuniary Factors Rule
Although the rule provides that in order to meet the ERISA duty of loyalty, a plan fiduciary’s evaluation of an investment or investment course of action must generally be based only on “pecuniary” factors, it sets out two exceptions that would permit consideration of “non-pecuniary” factors.
Revised Formulation of “Tie-Breaker” Rule
The first exception is an updated formulation of the so-called “tie-breaker” rule first specifically stated in 1995 guidance―the concept that, all other things being equal based on risk and return considerations, a fiduciary is permitted to take into account non-financial considerations. Recognizing that all other things are rarely ever equal, the new formulation in the final rule (revised in response to comments) permits a fiduciary to apply non-pecuniary factors, and to make an investment decision based on such non-pecuniary factors, when the fiduciary is “unable to distinguish [among investment alternatives] on the basis of pecuniary factors alone.” This should provide more flexibility in determining when the exception can be available.
To rely on this exception, the fiduciary is required to document
- why pecuniary factors were not sufficient,
- how the selected investment compares to the other comparable investments with regard to the prudence factors enumerated in the regulation, and
- how the chosen non-pecuniary factors are consistent with the interests of the plan participants and beneficiaries in their retirement income or financial benefits under the plan.
According to the DOL analysis, these circumstances should be relatively uncommon and reflect an analysis that the plan fiduciaries should be conducting in any event, so that the costs of any additional required documentation should be limited.
The DOL also noted that the types of non-pecuniary factors that may be taken into consideration are subject to ERISA’s general loyalty obligation. Thus, for example, while creating jobs for current or future plan participants could be a permitted consideration, bringing “greater personal accolades” to the plan sponsor’s CEO or reflecting a fiduciary’s “personal policy preferences” would not. However, the DOL noted that, in the context of a participant-directed plan, participant preferences for certain types of investments could be a permitted non-pecuniary consideration.
Designated Investment Alternatives for Participant-Directed Plans
The second exception under which the rule permits a fiduciary to consider non-pecuniary factors is in the selection and oversight of designated investment alternatives for a participant-directed individual account plan. For such a plan, a fiduciary may consider investment funds that promote, seek, or support non-pecuniary goals, provided the fiduciary satisfies the basic prudence and loyalty standards described in the regulation and the fund is not used as, or as a component of, a QDIA.
The DOL emphasized that this is a limited exception, which applies only if the alternatives can be justified solely on the basis of pecuniary factors. Choosing investments with expected reduced returns or greater risks to secure non-pecuniary benefits would not meet this standard. Thus, fiduciaries should carefully review prospectuses and other disclosure documents to see if they include statements to that effect.
With respect to the prohibition against using funds as QDIAs if they consider non-pecuniary factors, the final rule says that the QDIA limitation only applies if the fund’s described investment objectives or goals, or its principal investment strategies, include, consider, or indicate the use of one or more non-pecuniary factors. According to the DOL, this provides a test that it believes can be applied objectively without difficulty.
Status of ESG Factors
As noted above, the proposal was generally viewed as intended to regulate ESG investing, in large part because it had applied its standards specifically to ESG-based/branded investments. As a result, many commenters viewed the rule—and criticized the rule―as creating a presumption that ESG investing by its nature is based on non-pecuniary factors, requiring additional steps and documentation to demonstrate otherwise. The critics countered that ESG factors can in fact be pecuniary factors.
In response to criticism of this position, the DOL eliminated all references in the regulation itself to ESG factors, instead reframing the rule as a more general standard based on pecuniary vs. non-pecuniary considerations. The DOL emphasized that the final rule does not single out ESG investing or any other investment approach for particularized treatment, recognizing that at least some ESG factors may, at times, also be pecuniary factors. This is seen by many as a significant shift from the proposal, and may be viewed as a welcome change to those plan sponsors that may have included funds with investment strategies that incorporate “pecuniary ESG” factors as their plans’ QDIAs.
But it is still possible that the rule could raise questions on ESG investing. The DOL cautioned fiduciaries against “too hastily concluding that ESG-themed funds [that] may be selected based on pecuniary factors or [under the “tie-breaker” rule] are not distinguishable based on pecuniary factors.”
Status of Brokerage Windows
Under the final rule, the duty of loyalty standards do not apply to investment options in a participant-directed individual account plan that are not “designated investment alternatives.” This has the effect—and the DOL acknowledged as much—of excluding investments available under a brokerage window from these regulatory standards.
But the DOL cautioned that there would not be any exception for a plan that does not designate any “designated investment alternatives,” so that a plan could not avoid these rules by just providing a brokerage window. The DOL added that it has not addressed whether, or under what circumstances, the duties of prudence and loyalty may require a fiduciary to disregard or overrule a participant’s selection of investments in a brokerage window, and that nothing in the regulation should be construed as addressing that issue, noting that it could address such issues in future rulemaking or sub-regulatory guidance. This is a signal that the DOL may still have under consideration guidance on the status of brokerage windows under ERISA’s fiduciary responsibility rules, following up on a request for information on this issue that it had published in August 2014 and issues raised by FAQ 30 on its participant fee disclosure regulation from 2012.
Status of Investment Screens
A common approach to so-called “social” investing has been to screen out investments viewed as unacceptable or controversial, such as by excluding companies producing fossil fuels or guns, or those doing business in foreign countries with unfavorable human rights records. The DOL commented in the final rule notice that “positive” or “negative” screens may not comply with the rule if they are based on non-pecuniary factors, reasoning that it would first be necessary to conduct a prudent analysis of the economic consequences to determine that the exclusion would not be economically harmful to the plan.
But, the DOL added that based on the revised rule for QDIAs, the final rule does not prevent selecting a negatively screened fund as a QDIA if no non-pecuniary factors are reflected in its stated investment objectives or principal strategies.
As noted above, the final rule will generally become effective on January 12, 2021. However, given that some plans may need to make changes to their QDIAs if those QDIAs do not comply with the rule’s standards, the QDIA subsection is not effective until April 30, 2022.
Commenters expressed concern that the DOL may take enforcement action for past investments based on the new rule. While the DOL is of the view that much of the final rule explains preexisting ERISA fiduciary duties, it said that it will not pursue enforcement, and believes private actions would not be viable, for any actions taken or decisions made prior to the rule’s effective date, to the extent that such action would rely on citation to the final rule. This reflects the current administration’s view that enforcement actions should not be based on sub-regulatory guidance.
However, the DOL added, nothing in the rule would foreclose action based on violations of the statutory and regulatory standards in effect at the time of the violation, raising the possibility of post-effective date enforcement action or litigation targeting investments originally made prior to the effective date. As has been noted in the press, the DOL initiated earlier this year a number of inquiries and investigations focused on ESG investing by ERISA plans and plan investment managers, so the impact on those pending matters remains to be seen.
Observations and Next Steps
The final rule alleviates some of the more serious concerns raised by the proposal, by eliminating the prospect of a presumption that any ESG-based investments are non-pecuniary in nature and thus require additional justification to be retained by an ERISA plan. Also, the changes provide for greater flexibility in applying the duty of loyalty standard, including as to offering what the notice refers to as “ESG-themed funds” as available investments (including QDIAs) in participant-directed plans.
But this is now a final regulation that, under the standards established by the current administration and case law, can be cited in enforcement actions and litigation. For this reason, ERISA plan fiduciaries (including managers of plan assets pooled investment vehicles) and managers of investment funds marketed to ERISA plans should review the new standards to ascertain whether their current practices are consistent with a “pecuniary factors only” standard or fit into one of the exceptions.
In particular, fiduciaries of participant-directed plans will want to review the disclosures of funds that serve as designated investment alternatives (and, in particular, as QDIAs) to determine whether the fund disclosures describe potential reduced return or increased risk based on what could be considered non-pecuniary factors, requiring further evaluation under the standards of the final rule.
These standards do not, by their terms, apply to “governmental” plans―plans sponsored by US federal, state, and local government entities―as these plans are specifically excluded from ERISA coverage, which the DOL noted in response to a comment. However, many governmental plans invoke ERISA standards by contract. Even so, many governmental plan statutes or practices explicitly impose on plan investments what the DOL rule would view as “non-pecuniary” considerations. Providers of investment services to governmental plans will want to review their agreements for any references to ERISA prudence and loyalty standards, to make sure they are clear as to the applicable rules in light of the final regulation.
Another potential issue for investment managers is the impact of recent European regulations designed to promote “sustainable” finance, which encompasses ESG investing, and other similar non-US rules. On this basis, comments to the DOL on the proposal argued that the proposal was inconsistent with the international trend in favor of ESG-based investing. The DOL responded that the final rule does not preclude consideration of factors that are financially material to investments, so there may be no inconsistency, but also added that international trends in the consideration of ESG factors “are not an appropriate gauge for evaluating ERISA’s requirements” in this area. Thus, investment managers will have to determine whether they can reconcile ERISA’s requirements with other governing standards.