On October 13, 2021, the Department of Labor (DOL) released a new proposed regulation under ERISA that would replace the previous administration’s “pecuniary factors” rule – which is widely viewed as discouraging the use of environmental, social, and governance (ESG) factors when selecting plan investments – with one that would encourage their consideration and provide a clearer pathway for plan fiduciaries to do so.
Over the years, the DOL’s stated position on the consideration of ESG and other “social” factors when selecting plan investments has toggled back and forth, largely along party lines.
On one hand, Democratic and Republican administrations alike have consistently been in agreement on two fundamental principles:
- First, that fiduciaries cannot subordinate the economic interests of plan participants – that is, they cannot accept lower returns or higher risks – in order to serve unrelated social policy goals.
- Second, that fiduciaries can nonetheless permissibly “break ties” between otherwise equivalent investment options by considering social factors as secondary considerations.
However, guidance from Republican administrations has generally taken on a cautionary tone, emphasizing that the tie-breaking scenario would be expected to occur only rarely, and expressing concern that fiduciaries might therefore be violating their statutory duty of loyalty to plan participants by too eagerly selecting ESG-focused investments. Democratic guidance has read more permissively on this point, and a 2015 bulletin issued under the Obama administration took it a step further – not only endorsing the use of social factors to break ties, but also their consideration as “primary” economic considerations when they would be expected to influence investment risks and returns.
Historically, these positions have been set forth in competing interpretive bulletins and similar guidance, which does not have the legal force of formal regulations, with subsequent administrations continually “re-interpreting” those of their predecessors on the other side of the aisle. The previous administration was the first to engage in a formal rulemaking process on the subject, which culminated in the final “pecuniary factors” regulation becoming finalized in November 2020, with a general effective date of January 12, 2021. In order to make changes to the finalized regulation, the current administration likewise had to engage in a formal regulatory process.
Status of the Pecuniary Factors Rule
The currently applicable “pecuniary factors” rule – while not written as an ESG-specific pronouncement – nonetheless has been generally regarded as not ESG-friendly. To be clear, it does not prohibit the consideration of ESG factors or the selection of ESG investments. The overall thrust of this current rule, rather, is simply that investments must generally be selected solely on the basis of factors deemed by fiduciaries to be pecuniary (economic) in nature. Thus, it does not prohibit (or, on its face, even necessarily discourage) the consideration of ESG factors insofar as they are employed as part of the risk/return analysis, rather than for unrelated social attributes.
However, certain substantive aspects of the “pecuniary factors” rule and its preamble commentary can be read to indicate that ESG investments may be subjected to particular scrutiny. It has likewise been criticized for establishing standards that are unclear and difficult to reliably apply in practice. As summarized by the DOL in the release of its new proposed rule:
[the current rules] have created uncertainty and are having the undesirable effect of discouraging ERISA fiduciaries’ consideration of climate change and other ESG factors in investment decisions, even in cases when it is in the financial interest of plans to take such considerations into account. This uncertainty may deter fiduciaries from taking steps that other marketplace investors 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. (Emphasis added)
Even prior to the issuance of its new proposed rule, the pecuniary factors rule has been met with resistance from the current administration, with the DOL even taking the unusual step of stating that it would not enforce it (this occurred in March 2021, and is discussed in our prior Spotlight on Benefits post). The proposal would change the currently-applicable pecuniary factors rule in several respects, with the following being the most significant:
Consideration of ESG Factors – Prudence Duty
First, and probably most fundamentally, the proposal would provide that a fiduciary’s duties of prudence when evaluating the projected returns of investments “may often” require consideration of the economic effects of climate change and other ESG factors. It goes on to state that a prudent fiduciary may consider any factor that is material to a risk-return analysis, and offers three categories of considerations which might be relevant to such an analysis – to summarize:
- Climate change-related factors, including both direct exposure to climate change risks as well as the effects of government policies to mitigate climate change;
- Governance factors, including “board composition, executive compensation and transparency and accountability in corporate decision making,” as well as compliance with applicable laws and regulations; and
- Workforce practices, including diversity and inclusion, investments in training, equal employment opportunity and labor relations.
These categories are presented as a non-exhaustive list of examples. This portion of the proposal makes clear the current DOL viewpoint that ESG and similar considerations should often be regarded as bona fide economic considerations, and not merely collateral factors. And while the proposal’s language is generally flexible, it goes beyond merely “permitting” the consideration of these types of factors, and rather indicates that they likely should be considered, at least in many cases.
“Breaking Ties” – Duty of Loyalty
Second, the proposal retains the concept that, while fiduciaries cannot subordinate the interests of plan participants to serve social goals or other objectives, “collateral benefits” may still be used to break ties.
Specifically, the proposal states that fiduciaries must first engage in a prudent risk-return analysis that may consider the types of ESG and related factors noted above. In doing so, the weight given to any particular factor must reflect a prudent assessment of its impact on risk/return. Following this analysis, if the fiduciary concludes that multiple available options would “equally serve the financial interests of the plan over the appropriate time horizon,” collateral benefits may then be used to select between them. For designated investment alternatives made available to participants under 401(k), 403(b) or other participant-directed plans, it is required that the collateral considerations used to break the tie be “prominently displayed” in disclosure materials furnished to participants. It should be noted that, where fiduciaries conclude that ESG factors would be expected to enhance returns, reduce risk or both, they are not merely being used as collateral tie-breaking factors and this special disclosure would not appear to be required.
These provisions differ from the current rule in several respects. Probably most importantly:
Under the current rule, fiduciaries are only permitted to use non-pecuniary factors to break ties between potential investments when they are “unable to distinguish on the basis of pecuniary factors alone.” As no two investments are identical (regardless of ESG considerations), the “unable to distinguish” test has been criticized as being unrealistic and unclear in its real-world application.
Likewise, the proposal would abolish the special documentation requirement imposed under the current rule when non-pecuniary factors are used to break ties, which the current DOL has criticized as creating unnecessary burdens and
erroneously suggest(ing) to some fiduciaries that they should be wary of considering ESG factors, even when those factors are financially material to the investment decision.
ESG Considerations for QDIAs
Again, the “pecuniary factors” rule does not prohibit the use of ESG considerations when selecting investment options for 401(k), 403(b) and other participant-directed plans (or any plan). However, it states that qualified default investment alternatives (QDIAs) cannot include any investment vehicle if
its investment objectives or goals or its principal investment strategies include, consider, or indicate the use of one or more non-pecuniary factors.
To briefly paraphrase, the previous administration’s stated rationale for this provision was that default investments justify special treatment, as they are not merely being offered to participants as an additional investment alternative within a broader lineup from which they will make a selection. However, this restriction has been criticized as creating an un-level playing field even for well-performing investment options, based just on whether or not they have (or even appear to have) any ESG characteristics.
The proposal, if finalized in its current form, would abolish the special QDIA rule and instead apply the same standards – including those summarized above – that are to be used the selection and monitoring of all investments.
Comments on the proposed regulation must be submitted no later than December 13, 2021, which is 60 days after its publication (which occurred on October 14, 2021) in the Federal Register. Of course, it cannot be finalized until the public comment and other rulemaking processes are concluded. However, if the proposal is finalized in its current form (or anything close to it), it will represent a very significant policy shift. In our experience, and particularly in light of the DOL’s non-enforcement policy of the previous administration’s pecuniary factors rule, there has been no mass exodus from ESG investments by retirement plans. However, if finalized, the proposed rule would provide additional comfort and guidance for fiduciaries, and would confirm that ESG and similar considerations should be regarded as fundamental economic considerations.
The proposed rule would also make certain changes to the existing standards for proxy voting by plan fiduciaries, which we will address in a separate Spotlight on Benefits post.
If you have any questions about these issues, please contact your Faegre Drinker benefits attorney.