During the last 30 years, the DOL has issued piecemeal guidance on plan investments that involve non-financial objectives and the application of fiduciary duties of prudence and loyalty to those investments (see, e.g., Interpretative Bulletin 2015-1 and Field Assistance Bulletin 2018-1). As the trend in environmental, social and corporate governance (ESG) investing has continually increased, the DOL has grown concerned with the risk that plan fiduciaries may make investment decisions for purposes distinct from providing benefits to participants.
In the Financial Factors Rule, the DOL provides clarity on ESG investment standards. Unlike its proposed version, however, the Financial Factors Rule does not specifically scrutinize ESG investments. Due to complaints from commentators about a lack of industry consensus about what constitutes an “ESG” investment, the DOL dropped the “ESG” terminology from the Financial Factors Rule. Instead, the Financial Factors Rule concentrates on whether a factor involved in selecting plan investments is “pecuniary.”
Seemingly conceding that an “ESG” factor is not necessarily synonymous with “non-pecuniary factor,” the Financial Factors Rule provides the following revised definition of “pecuniary factor”:
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.
This revised definition gives plan fiduciaries the explicit discretion to determine whether a particular aspect of an investment will impact its risk/return calculus, and therefore, constitute a pecuniary factor. Under the Financial Factors Rule, the following could all potentially be considered pecuniary factors: brand, reputation, use of proprietary products, fee aggregation and fee-sharing.
In other words, the Financial Factors Rule makes clear that an Employee Retirement Income Security Act (ERISA) fiduciary must never sacrifice investment returns, take on additional investment risk or pay higher fees to promote non-pecuniary benefits or goals.
However, in limited circumstances, non-pecuniary factors may still be material and can be considered in investing. The Financial Factors Rule includes a “tie-breaking” test that allows the fiduciary to consider non-pecuniary factors, “unable to distinguish investment alternatives on the basis of pecuniary factors alone.” The Financial Factors Rule does, however, note that the DOL believes that it is rare that a plan fiduciary will be unable to distinguish two investment options based on pecuniary factors and that any tie-breaking decisions must comport with the duty of loyalty.
Whenever non-pecuniary factors are considered, the Financial Factors Rule requires that the fiduciary document the following to “safeguard against the risk that fiduciaries will improperly find economic equivalence and make decisions based on non-pecuniary factors without a proper analysis and evaluation”:
- Why pecuniary factors were not sufficient to select the investment or investment course of action;
- How the investment compares to the alternative investments with regard to the factors listed in the Financial Factors Rule; and
- How the chosen non-pecuniary factor or factors are consistent with the interests of the plan’s participants and beneficiaries in their retirement income or financial benefits under the plan.
The Financial Factors Rule also adopted a general restatement of the duty of loyalty under ERISA section 404(a)(1)(A) and restored the original 1979 “safe harbor” provisions for the duty of prudence. It further provides that when making an investment decision, fiduciaries only need to consider reasonably available alternatives with similar risks to satisfy the duty of prudence. The Financial Factors Rule does not require “scouring the market” for every possible alternative.
The Financial Factors Rule applies to a fiduciary’s selection of designated investment alternatives to be offered to plan participants and beneficiaries in a participant-directed individual account plan, but not brokerage accounts. The Financial Factors Rule is will become effective in January 2021, but plans will have until April 30, 2022, to make changes to comply with the requirements.