On November 22, 2022, the U.S. Department of Labor (DOL) released a final rule (Final Rule) under the Employee Retirement Income Security Act (ERISA) that empowers retirement plan fiduciaries to consider climate change and other environmental, social, and governance (ESG) factors when making investment decisions and exercising shareholder rights, such as proxy voting.
The Final Rule will generally become effective 60 days after publication in the Federal Register. However, the effective date of certain proxy voting provisions is delayed for a year to give fiduciaries adequate time to prepare for their implementation.
In 2020, the DOL under the Trump administration adopted two fiduciary rules (the Prior Rules) that required plan fiduciaries to consider only “pecuniary factors” in making investment decisions and when voting proxies and exercising other shareholder rights in connection with plan investments. The former Secretary of Labor indicated that the Prior Rules would cause fiduciaries to consider only plans’ financial interests rather than nonpecuniary goals or other policy objectives. These Prior Rules became effective in January 2021.
Upon taking office, President Joe Biden signed Executive Order 13990, which ordered a review of the Prior Rules, and subsequently signed Executive Order 14030, which directed the federal government to identify and assess policies to protect the life savings and pensions of American workers and families from the threats of climate-related financial risk.
In October 2021, the DOL published a Notice of Proposed Rulemaking (Proposed Rule) (as discussed in our prior Update) to address the uncertainty for ERISA fiduciaries around considering climate change and other ESG factors in investment decisions, citing the chilling effect and other potential negative consequences caused by the current regulation with respect to such consideration. In response to the Proposed Rule, the DOL received hundreds of written comments and thousands of petitions during the 60-day comment period from a wide variety of stakeholders. The Final Rule generally tracks the Proposed Rule but makes certain clarifications and changes in response to the public comments.
Overview of the Final Rule
When making investment decisions (including selecting investment options available to plan participants), ERISA fiduciaries must satisfy both a prudence requirement (i.e., acting with the care, skill, prudence, and diligence of a prudent professional acting in a like capacity) and a loyalty requirement (i.e., acting for the exclusive purpose of providing benefits to participants and defraying the reasonable expenses of administering the plan). The Final Rule clarifies how the duties of prudence and loyalty apply to selecting investments and investment courses of action and exercising shareholder rights, such as proxy voting.
- Removal of Pecuniary/Nonpecuniary Terminology. Like the Proposed Rule, the Final Rule amends the current regulation to delete the “pecuniary/nonpecuniary” terminology based on concerns that the terminology causes confusion and a chilling effect to financially beneficial choices.
- Consideration of ESG Factors Permitted (Though Not Required) Under Proper Circumstances. The Final Rule emphasizes that a fiduciary’s determination with respect to an investment must be based on factors that the fiduciary reasonably determines are relevant to the risk-and-return analysis. The regulation specifically states that risk-and-return factors may include the economic effects of climate change and other ESG factors on a particular investment. Whether any particular consideration is a relevant factor depends on the specific facts and circumstances, and the weight given to any factor by a fiduciary should appropriately reflect the fiduciary’s reasonable assessment of the factor’s impact on risk and return. In any event, the fiduciary may not subordinate the interests of participants and beneficiaries in their plan benefits to other objectives.
Note that the Final Rule does not require consideration of ESG factors in all cases. The preamble to the Final Rule states that the new rule is intended to ensure that “plan fiduciaries do not misinterpret the final rule as a mandate to consider the economic effects of climate change and other ESG factors under all circumstances. Instead, the final rule makes clear that a fiduciary may exercise discretion in determining, in light of the surrounding facts and circumstances, the relevance of any factor to a risk-return analysis of an investment. A fiduciary therefore remains free under the final rule to determine that an ESG-focused investment is not in fact prudent.” To that end, a set of examples included in the Proposed Rule, which highlighted certain ESG factors that fiduciaries might consider when selecting an investment, were removed from the Final Rule, likely in order to allay certain commenters’ concerns that the DOL might be subtly mandating fiduciaries’ consideration of ESG factors in their investment analysis.
- Same Standard Applies to Qualified Default Investment Alternative (QDIA) Selection. As in the Proposed Rule, the Final Rule removes stricter investment requirements for QDIAs so that the same standards will apply to the selection of QDIAs as to the selection of investments generally. Thus, an ESG-focused fund may be selected as a QDIA.
- A More Permissive Tiebreaker Test. The Final Rule allows fiduciaries to consider collateral benefits (i.e., benefits other than investment returns) as “tiebreakers” when choosing between competing investments that serve the plan’s economic interests equally well. This relaxes the Prior Rule’s iteration of the “tiebreaker” test, which required investments to be “economically indistinguishable” before fiduciaries could consider other factors. The Final Rule also removes the special documentation requirement on the use of collateral factors that discouraged use of the Prior Rule’s tiebreaker provision.
- Re-emphasis on Proxy Voting. The Final Rule retains the DOL’s principles-based approach to shareholder rights issues while affirming that proxy voting is a “fiduciary act” subject to ERISA requirements. Thus, the Final Rule amends the Prior Rules to eliminate the statement that “the fiduciary duty to manage shareholder rights appurtenant to shares of stock does not require the voting of every proxy or the exercise of every shareholder right.” The DOL stated that the provision was eliminated because it could be misread to suggest that plan fiduciaries should be indifferent to the exercise of their rights as shareholders even if the cost is minimal. The Final Rule also removes two “safe harbors” applicable to proxy voting policies because the DOL believes the safe harbors encouraged abstention as the normal course, and the DOL does not support that position because it fails to recognize the importance that prudent management of shareholder rights can have in enhancing the value of plan assets or protecting plan assets from risk. Finally, the Final Rule eliminates certain specific record maintenance and proxy monitoring requirements because the DOL believes that these requirements are adequately addressed by the statutory obligations of prudence and loyalty that generally apply to other fiduciary activities.
- Participant Preferences May Be Considered When Selecting Investment Options. The Final Rule includes a new provision that clarifies that fiduciaries will not violate their duty of loyalty solely because they take participants’ preferences into account when constructing a menu of prudent investment options for participant-directed individual account plans. Specifically, if accommodating the preferences of participants will lead to greater participation levels and deferral rates, it should also increase retirement security of such participants.
As the shift from the Prior Rule to the Final Rule based on changing presidential administrations would indicate, ESG has become part of the broader political and cultural discourse in the United States. In the event of future presidential transitions, the DOL’s view on the consideration of ESG factors may change yet again. Therefore, while the hope is that the Final Rule will provide some clarity on this topic, it remains to be seen whether such guidance proves lasting and definitive.