DOL Proposes New Fiduciary Guidance for Selection of Socially Responsible Plan Investments

Summary

Proposed Rule on Selecting Environmental, Social and Governance (ESG) Investment Options: On June 22, 2020, the Department of Law (“DOL”) proposed a new rule that describes the permissible factors for plan fiduciaries to consider when selecting Environmental, Social and Governance (“ESG”) themed investments in individual account plans (such as a 401(k) plan). The proposed rule makes it clear that fiduciaries must select those investments based solely on financial considerations that impact the economic value of the investments. In other words, plan fiduciaries must not sacrifice performance or expose the plan participants and beneficiaries to additional risk by including investment options that primarily serve the non-financial (e.g., ESG) interests of the plan fiduciaries.

Guidance Overview

Background

The Employee Retirement Income Security Act of 1974, as amended (ERISA), generally requires that plan fiduciaries must act prudently and diversify plan investments to minimize the risk of large losses. The preamble to the proposed rule acknowledges a significant increase over the last several years of ESG funds as investment options within retirement plans. These funds often have higher fees, which raises questions about proper selection by fiduciaries and whether these funds are a financial impediment to maximizing participant assets for their retirement. Since the selection of ESG-themed investment options may serve non-pecuniary interests, at least in part, it is understandable that the DOL would raise these fiduciary concerns.

The Proposed Rule

The DOL’s proposed rule emphasizes that plan fiduciaries must carefully avoid placing their own social and policy goals ahead of the financial interests of plan participants and beneficiaries when making investment choices based on ESG factors. The proposed guidance identifies the “objective risk-return criteria” a fiduciary must consider when reviewing ESG investment options to satisfy its duties of loyalty and prudence (e.g., expense ratios, fund size, volatility measures and the investment philosophy and experience of the investment manager). The fiduciary must consider how the investments in the plan compare to available alternate investments, and in doing so, must also consider the level of diversification, degree of liquidity and potential risk and return in comparison to alternative investments. Additionally, a plan fiduciary must carefully document its selection and monitoring of the ESG investments with these economic criteria.

The proposed rule would only allow the factors that promote public policy or social good to serve as a “tie-breaker” when deciding between several investment options that are economically indistinguishable. Further, the DOL believes that such “ties” between two investment options would “rarely, if ever, occur,” although the proposed rule requests comment on the frequency of such “ties.” In these rare cases, the fiduciary must also document the reasons for determining the investment options are so “indistinguishable” that ESG factors are required to break the “tie.”

Plan fiduciaries may certainly include an ESG fund as part of the menu of plan investment options as long as all of the economic factors listed in the proposed rule were properly considered. However, the proposed rule would not permit an ESG-themed investment option to serve as a plan’s qualified default investment alternative (“QDIA”) under any circumstances, including if the investment option was selected entirely based on objective pecuniary criteria.

Takeaways

In its current version, this guidance could easily steer plan fiduciaries away from ESG-themed investments or at least make them be certain these investments are selected only for economic reasons. The proposed rule leaves several unanswered questions that will hopefully be addressed in final guidance. For instance, the proposed rule does not address the financial criteria that must be used to determine when investments are considered “indistinguishable” for purposes of selecting an ESG as a “tie-breaker.” As the DOL noted in the preamble, it is difficult to imagine that any two funds could ever be considered indistinguishable based on all performance and risk metrics. Additionally, the proposed rule does not address a specific time period that should be considered when comparing the financial metrics of ESG and non-ESG options. Until there is further IRS guidance, plan fiduciaries should thoroughly document the decision-making process by which they select and monitor all plan investments and especially, when selecting ESG-themed investment options.

For more information, please contact Gary Blachman, Ian Minkin, Erik Hansen or any attorney in the Employee Benefits or Investment Management Group with whom you work.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.