A little more than a week ago, the U.S. Department of Labor unveiled
its much-anticipated final ESG rule. There’s a lot to unpack in that
regulation (and the rest of the 236-pages that help explain its process
and rationale), but here’s a few things that seem particularly important
to note at the outset.
There are some (important) things that did NOT change.
First, and to my mind, foremost, the Labor Department noted that “The
duties of prudence and loyalty require ERISA plan fiduciaries to focus
on relevant risk-return factors and not subordinate the interests of
participants and beneficiaries (such as by sacrificing investment
returns or taking on additional investment risk) to objectives unrelated
to the provision of benefits under the plan.
But it also included an important clarification:
“…the final rule amends the current regulation to make it clear that a
fiduciary’s determination with respect to an investment or investment
course of action must be based on factors that the fiduciary reasonably
determines are relevant to a risk and return analysis and that such
factors may (emphasis mine) include the economic
effects of climate change and other environmental, social, or governance
factors on the particular investment or investment course of action.”
It does away with “pecuniary” as a standard (or at least as a word claiming to be the standard).
The Trump Administration’s version defined pecuniary (a term “introduced” to the ERISA lexicon by the United States Supreme Court in the Fifth Third v. Dudenhoefer decision[i]) 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.”
However, that word choice was determined by the Labor Department to
be causing “confusion” and to have a “chilling effect” — “deterring
fiduciaries from taking steps that other marketplace investors would
take in enhancing investment value and performance, or improving
investment portfolio resilience against the potential financial risks
and impacts associated with climate change and other ESG factors.”
However, and despite what some saw as an implication in the
proposed regulation, the final regulation does NOT mandate consideration
of ESG factors.
Quite the contrary—quoting from the Labor Department:
“The final rule makes unambiguous that it is not establishing a
mandate that ESG factors are relevant under every circumstance, nor is
it creating an incentive for a fiduciary to put a thumb on the scale in
favor of ESG factors.”
“Outside the ERISA context, investors may choose to invest in funds
that promote collateral objectives, and even choose to sacrifice return
or increase risk to achieve those objectives. Such conduct, however,
would be impermissible for ERISA plan fiduciaries, who cannot sacrifice
return or increase risk for the purpose of promoting collateral goals
unrelated to the economic interests of plan participants in their
benefits.”
It treats QDIAs just like any other investment option in the plan.
The Trump Administration in its preliminary regulation had barred
funds with an ESG focus from qualifying as a qualified default
investment alternative (QDIA), and then—following criticism on that
front—in its final regulation modified the provision in the proposal on
QDIAs to prohibit plans from adding or retaining any investment fund,
product, or model portfolio as a QDIA or as a component of such a
default investment alternative, if its objectives, goals or principal
investment strategies include the use of non-pecuniary factors.
The new regulation removes that distinction, noting that “QDIAs would
continue to be subject to the same legal standards under the final rule
as all other investments, including the prohibition against
subordinating the interests of participants and beneficiaries in their
retirement income to other objectives. QDIAs also would continue to be
subject to the separate protections of the QDIA regulation.”
That said, the Labor Department says it expects to see an increase in
the number of QDIAs that are ESG funds—though, considering the number
currently in the market (and there are some), that hardly seems a
controversial call.
Eliminated additional disclosure/labeling requirements associated with alternative investments with collateral benefits.
The Trump era regulation imposed a requirement that competing
investments be indistinguishable based solely on pecuniary factors
before you could turn to collateral factors to break a tie—oh, and even
then, you would have had to comply with a special documentation
requirement on the use of such factors.
The final rule, on the other hand, replaces that with a standard that instead requires the fiduciary to conclude prudently
that competing investments, or competing investment courses of action,
equally serve the financial interests of the plan over the appropriate
time horizon—and, having determined that they equally serve those goals,
is not prohibited from selecting the investment, or investment course
of action (like an ESG focus), based on collateral benefits other than
investment returns.
And they no longer have to document that evaluation (which, interestingly enough, turns out to be one of the cost benefits[ii] associated with the new rule).
Participant preferences can (still) play a role in menu design.
Now, in my experience, plan sponsors (and advisors) have long
considered participant preferences in menu design. Not to the
subordination of prudent fiduciary standards, of course—though there
have been concerns that some might not see it that way.
Well, the new regulation contains a new and interesting provision
that “clarifies” that fiduciaries “do 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. If accommodating
participants’ preferences will lead to greater participation and higher
deferral rates, as suggested by commenters, then it could lead to
greater retirement security."
Now, notice that while such considerations don’t necessarily violate
the duty of loyalty—but there is no setting aside of the standards of
prudence in evaluating and monitoring those investments noted above.
More specifically, those decisions need to be evaluated “taking into
consideration the risk of loss and the opportunity for gain” compared to
the opportunity for gain “with reasonably available alternatives with
similar risks.”
As noted above, there’s a lot to unpack here—and we’ll continue to do so right up to the Jan. 30, 2023 effective date—and beyond.
- Nevin E. Adams, JD
[i]
In that case, the nation’s highest court concluded that the
responsibilities of an ESOP fiduciary must be directed toward the duty
to provide benefits and defray expenses—and that any non-pecuniary
interests, such as Congress' strong encouragement of employee stock
ownership, did not warrant an alteration of the fiduciary standard.
[ii]
Noting that in view of the “large scale of investments held by covered
plans, approximately $12.0 trillion, changes in investment decisions
and/or plan performance may result in changes in returns in excess of
$100 million in a given year,” the Labor Department estimates that 20%
of defined contribution and defined benefit plans (149,300 plans with
some 28.5 million participants) will be affected by the regulation
“because their fiduciaries consider or will begin considering climate
change or other ESG factors when selecting investments.” In the Labor
Department’s estimation, for each plan, a “legal professional will need
to review paragraphs (b)-(c) of the final rule, evaluate how these
provisions might affect their investment practices and assess whether
the plan will need to make changes to investment practices. The
Department estimates that this review will take a legal professional
approximately four hours to complete, resulting in an aggregate cost
burden of approximately $91.5 million or a per-plan cost burden of
approximately $613.[ii]”
That said, the Labor Department noted that plan fiduciaries
“generally already undertake deliberative evaluations as part of their
investment selection decision-making process and this final rule does
not add burden to those deliberations; but rather, the final rule
clarifies that the scope of those deliberations may include climate
change and other ESG factors within the confines of paragraphs (b)(4)
and (c)(1) of the final rule. The Department does not intend to increase
fiduciaries’ burden of care attendant to such consideration; therefore,
no incremental costs are estimated for these requirements.”
