The United States Department of Labor (the “DOL”) recently issued a proposed rule on the fiduciary requirements under the federal pension law, ERISA, that apply to the selection and monitoring of environmental, social, and corporate governance (“ESG”) investments in retirement plans. Under the proposed rule, which would be effective 60 days after it becomes finalized, retirement plan investment fiduciaries (e.g., investment committees for 401(k) and defined benefit pension plans), must apply a substantially heightened level of scrutiny when selecting or retaining ESG-based funds as investment options under their plans.
At its core, the proposed rule requires retirement plan investment fiduciaries, when making ESG-related investment decisions, to abide by the DOL’s “longstanding and consistent position” that such decisions must be “focused solely on the plan’s financial risks and returns, and the interests of plan participants and beneficiaries in their plan benefits must be paramount.” Stated differently, retirement plan investment fiduciaries “must never sacrifice investment returns, take on additional investment risk, or pay higher fees to promote non-pecuniary benefits or goals.”
It is a concern with the perceived non-pecuniary focus of ESG investing that has triggered the DOL to issue its proposed rule. The DOL writes that it “is concerned . . . that the growing emphasis on ESG investing may be prompting ERISA plan fiduciaries to make investment decisions for purposes distinct from providing benefits to participants and beneficiaries and defraying reasonable expenses of administering the plan. The Department is also concerned that some investment products may be marketed to ERISA fiduciaries [based on] purported benefits and goals unrelated to performance.”
The proposed rule includes several enhanced/new requirements for retirement plan investment fiduciaries to satisfy, including, principally, the following:
- Requiring a comparison of ESG investments or investment courses of action to other investment courses of action regarding factors such as diversification, liquidity, and potential risk and return. The DOL’s views this requirement “as an important reminder that fiduciaries must not let non-pecuniary considerations draw them away from an alternative option that would provide better financial results.”
- Making it “unlawful” for a fiduciary to “sacrifice return or accept additional risk to promote a public policy, political, or any other non-pecuniary goal,” and conditioning the qualification of ESG factors as economic factors considered pecuniary on such factors being considered alongside other relevant economic factors to evaluate the risk and return profiles of alternative investments. (This element of the rule tracks the DOL’s “longstanding and consistent position” on ESG investing, as well as the tenets of DOL Field Assistance Bulletin 2018-01, which addresses this comparative analysis.)
- Requiring adequate documentation of occurrences of ESG investments being chosen because they satisfy the “all things being equal test.” Under this test, which reflects the DOL’s “current guidance,” but on which the DOL requests comments, if, after the comparative evaluation of ESG and non-ESG investments described above, the investments “appear economically indistinguishable,” a fiduciary may then, in effect, “beak a tie” by relying on non-pecuniary factors. To be clear, however, the DOL views the “all things being equal test” as mostly theoretical.
- Adding requirements for a prudent retirement plan investment fiduciary to consider in selecting investment funds for a defined contribution plan (e.g., a 401(k) plan), where such funds include one or more ESG assessments or judgments in their investment mandates or their fund names. Adding such an ESG fund is permissible only if:
- The fiduciary uses only objective risk-return criteria, such as benchmarks, expense ratios, fund size, long-term investment returns, volatility measures, investment manager tenure, and mix of asset types in selecting and monitoring all investment alternatives for the plan, including any ESG investment alternatives;
- The fiduciary documents compliance with such use on objective risk-return criteria; and
- The plan does not use the ESG fund as a qualified default investment alternative (“QDIA”) under the plan. A QDIA is a fund into which participant accounts are invested absent participant investment elections.
The DOL has given interested persons 30 days to submit comments on the proposed rule. Despite such comments, however, the DOL views much of the proposed rule as a restatement of its “longstanding and consistent position” on ESG investing.
It is troubling that, although the rule is proposed to be effective only after it is finalized, the DOL has issued ESG investigatory letters to plan investment fiduciaries over the past few months. These letters not only focus significantly on the ESG issues addressed in the proposed rule, but also require the fiduciary to produce an extensive array of plan- and investment-related documents for the DOL to review.
In short, retirement plan investment fiduciaries would be well-advised to note the increasing level of scrutiny the DOL is applying to ESG funds in retirement plans. Selecting or retaining ESG funds can be fraught with increased audit risk, including, potentially, imposing penalties for breach of fiduciary duty under ERISA. 401(k) and other defined contribution plans are at enhanced risk. Any fiduciary receiving an ESG investigatory letter should consult immediately with qualified ERISA counsel on how to respond. The stakes are too high to go into the lion’s den of a DOL audit alone.