There was an important development recently in the US Department of Labor’s (DOL’s) efforts to regulate ERISA plan fiduciaries’ use of environmental, social, and governance (ESG) factors in investment decisionmaking. On October 30, the DOL announced publication of the final version of its proposed Financial Factors in Selecting Plan Investments rule (the Rule). A fact sheet is also available.
The DOL has been issuing various forms of guidance on the topic of using ESG factors in making fiduciary decisions over the last two and a half decades, with successive administrations altering interpretations. That back-and-forth guidance has consistently mandated that plan fiduciaries make investment decisions solely in the interest of plan participants, but how ESG factors fit into that decisionmaking, as well as the tone and nuances, have varied with the issuing administration.
The current DOL has now staked out its position with the finalization of the Rule, which is largely seen as cautious (if not negative) on the use of ESG factors by ERISA plan fiduciaries.
As with the DOL’s proposal in June, the final Rule interprets ERISA’s fiduciary duties under Section 404(a)(1) with respect to investment decisions, with a focus on the duty of loyalty. It primarily does so by adding a requirement that investment decisions be based only on “pecuniary factors” except in very limited circumstances.
For this purpose, the Rule defines “pecuniary factor” as 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.” In other words, the Rule seeks to frame the fiduciaries’ duties as permitting only economic evaluations except in limited circumstances, and to impose gatekeeping (in the form of procedural and documentation requirements) around those limited circumstances.
While we will provide a more in-depth analysis of the Rule soon, a few points are immediately notable about the Rule:
- Most significantly, although the DOL is viewed as seeking to regulate ESG investing (and describes the Rule accordingly in the preamble), in contrast to the proposed rule, the final Rule itself does not include the words “environmental,” “social,” or “governance.” In removing the specific reference to ESG from the final regulatory text, the DOL clarified that the Rule was intended to regulate reliance on nonpecuniary factors, which are not limited to ESG. The DOL also clarified in announcing the Rule that “ESG factors could be pecuniary in nature and that, in such cases, fiduciaries properly could consider the factors as part of their investment analysis.” This change is a helpful clarification because it removes an interpretation (that some feared the DOL was making) that ESG factors are presumptively not pecuniary. Under the Rule, then, certain ESG factors can be viewed as performance oriented, so long as the fiduciaries determine the factors can have “a material effect on the risk and/or return of an investment based on appropriate investment horizons.” The preamble emphasizes this point, observing that “the selection of ESG funds is not per se prudent or imprudent.”
- Another point of note is that in its final form, the Rule retains a modified version of a “tie-breaker” test as one of the exceptions for determining when nonpecuniary factors may be considered. This framing harkens back to earlier DOL guidance whereby “economically targeted investments (ETIs)” were permitted only as a tie-breaker.
- The Rule retains the interpretation in the proposed Rule that, subject to general compliance with the ERISA fiduciary duties of loyalty and prudence, participant-directed defined contribution plans are not precluded from offering an investment vehicle that “promotes, seeks, or supports one or more non-pecuniary goals,” i.e., ESG-themed funds. However, the Rule continues to prohibit investment alternatives (or components of an alternative) that have nonpecuniary investment objectives or principal strategies from being a qualified default investment alternative (QDIA) (or added to a QDIA).
The Rule becomes effective 60 days after its publication in the Federal Register. However, this post being published on Election Day 2020 is fitting because the ultimate impact of the Rule, and whether it remains in place as finalized, may depend on the outcome of the election, given the ongoing political nature of this regulatory interpretation.