Good to Know: Environment, Social, and Governance (ESG) Investing in Employer-Sponsored Retirement Plans
Good to Know
We look to a highly respected source - The National Law Review1 - to help clarify confusion over ESG (Environmental, Social, Governance) investing issues in employer-sponsored retirement plans. Specially, we focus upon The National Law Review’s commentary on these issues:
- An overview of the final rule,
- Key requirements of the final rule,
- Effective and compliance dates, and
- Key takeaways.
Overview of the Final Rule
“On October 30, 2020, the U.S. Department of Labor (the “DOL”) issued a final rule on factors for selecting plan investments, which restricts…“do-good” or “ESG” [Environmental, Social, Governance] investing. In response to public comments, the final rule rolls back some of the restrictions and burdens from its proposed rule issued in June…, but it reaffirms the DOL’s longstanding position that ERISA requires plan fiduciaries to treat the financial interests of plan participants and beneficiaries as paramount when making investment decisions. The final rule states that “ESG” funds may be offered in a 401(k)- or 403(b)-type plan where participants direct investments [emphasis added], but the selection is subject to conditions that could pose a challenge.
Consistent with the proposed rule, the final rule generally requires ERISA plan fiduciaries to base investment decisions on financial factors alone and prohibits fiduciaries from selecting investments based on non-pecuniary [non-financial] considerations. Given the lack of a precise or generally accepted definition of “ESG,” the final rule instead refers to “pecuniary” and “non-pecuniary” factors in delineating the relevant fiduciary investment duties to be followed by plan fiduciaries.”
Key Requirements of the Final Rule
- “Investment decisions must be based only on pecuniary factors (i.e., factors that a fiduciary prudently determines are expected to have a material effect on risk/return in light of the plan’s investment objectives and funding policy), except in the event of a “tie-breaker” (as discussed below).
- Consistent with the text of the proposed rule, the preamble once again acknowledges that an “ESG”-type factor could be considered a “pecuniary” factor under certain circumstances. For example, a fiduciary may conclude that board/management diversity or a company’s environmental record would have a material financial effect on the investment.
- However, the preamble also cautions against concluding too hastily that “ESG”-type factors are actually “pecuniary.”
- A plan fiduciary may not subordinate the financial interests of plan participants and beneficiaries to other objectives and may not sacrifice investment return or take on additional risk to promote non-pecuniary goals.
- When making an investment decision, a plan fiduciary is required to consider reasonably available alternatives with similar risks in order to satisfy its duty of prudence.
- The preamble states that this rule does not require scouring the market or considering every possible alternative.
- A plan fiduciary may consider non-pecuniary factors as a “tie-breaker” between two or more investment alternatives if the fiduciary is unable to distinguish them on pecuniary factors alone, provided that the fiduciary documents (i) why considering only pecuniary factors was not sufficient to make the decision; (ii) how the selected investment compares to the considered alternative(s) in light of the plan’s diversification, liquidity, cash flow requirements and funding objectives; and (iii) how the applicable non-pecuniary factor(s) is consistent with the financial interests of the plan participants and beneficiaries…
- The general requirement to evaluate investments based solely on pecuniary factors applies to a 401(k)- or 403(b)-type plan fiduciary’s selection and retention of available plan investment alternatives (other than brokerage window or self-directed brokerage account investment options). However, the final rule does not categorically prohibit including an investment option that supports non-pecuniary goals (for example, in response to participant demand) if [specified]… conditions are satisfied.
- The DOL has helpfully clarified that the final rule applies only to “designated” investment alternatives (i.e., alternatives that are selected and monitored by plan fiduciaries). The final rule does not apply to self-directed brokerage windows and similar arrangements that enable participants to select investments beyond those specifically designated by the plan.”
Effective and Compliance Dates
“Although the final rule is set to become effective 60 days after publication in the Federal Register, 401(k)- and 403(b)-type plans will have until April 30, 2022, to make any changes that are necessary to comply with the requirements related to the selection or retention of QDIAs.”
Key Takeaways
“Although the DOL has cleared a path for ERISA fiduciaries to consider “ESG” factors when making investment decisions and to offer “ESG” funds in a 401(k)- or 403(b)-type plan, the path remains relatively narrow as the final rule still requires that selection of the investment option be based solely on pecuniary factors (outside of the “tie-breaker” context). Accordingly, decisions with respect to “ESG” require careful deliberation, balancing of risks, and documentation.”
Disclaimer
The information presented herein is provided purely for educational purposes and to raise awareness of these issues; it is not meant to provide and should not be used to provide legal, compliance or financial advice. There are variations, alternatives, and exceptions to this material that could not be covered within the scope of this blog.
1Bogner, I. (2020, November 10). DOL Issues Final “ESG” Rule Restricting ERISA Fiduciary Consideration of Non-Pecuniary Investment Factors. The National Law Review. https://www.natlawreview.com/article/dol-issues-final-esg-rule-restricting-erisa-fiduciary-consideration-non-pecuniary
