ESG Investing Under ERISA
Art by Tim Bower
On November 13, 2020, the Department of Labor (DOL) issued its final rule Financial Factors in Selecting Plan Investments. The regulation became effective on January 12 and targets advisers and other fiduciaries under the Employee Retirement Income Security Act (ERISA) who wish to consider economic, social and governance (ESG) factors when making investment decisions or recommendations. Advisers and other fiduciaries should consider how they will comply with it.
Looking Back
From 1994 through 2018, the DOL issued a series of interpretive bulletins (IBs) and a field assistance bulletin (FAB) that explained how to comply with ERISA’s fiduciary duties of prudence and loyalty. The issuance of the guidance tended to follow changes in presidential administrations, particularly changes in what party controlled the White House. Generally, Democratic administrations have been more open to the consideration of ESG factors than have Republican. Regardless of the party in charge, the DOL has recognized that ESG factors may be considered so long as fiduciaries prioritize a plan’s economic interests when making investment decisions. The final regulation is the first codification by the DOL of its views of how fiduciaries should consider ESG factors.
The final rule’s text makes no reference to ESG or other terms commonly associated with ESG investing such as “socially responsible investing” (“SRI”) or “economically targeted investing.” Rather, the regulation requires that fiduciaries consider only “pecuniary factors” when making an investment decision.
A pecuniary factor is a factor that a fiduciary prudently determines is expected to have a material effect on the risk and/or return of an investment. Then, if the fiduciaries cannot distinguish between two or more investment options or courses of action based upon pecuniary factors, the fiduciary may consider non-pecuniary factors as the basis for an investment decision. Notably, the DOL states in the preamble that it expects the latter situation to be “… discrete (and likely rare) …”
The Tiebreaker Concept
The final regulation allows for the possibility that an ESG factor is a pecuniary factor. The DOL points to “disposal of hazardous waste” and “dysfunctional corporate governance” as possible examples. However, to be sure, the agency expects fiduciaries to be able to make such connections and to give appropriate weight to such factors when considered against other pecuniary factors, e.g., risks and costs.
The provisions of the regulation apply the same way to retirement plans whose assets are managed by a fiduciary on a discretionary basis and participant-directed defined contribution (DC) plans, with one key exception. The above-discussed tiebreaker concept may never be applied with regard to a qualified default investment alternative (QDIA).
The rule became effective before the Biden administration was in office. Given the stance taken by prior Democratic administrations with respect to ESG investing, we can expect the DOL to revisit the regulation. However, advisers and other fiduciaries should not assume the DOL will be able to take immediate action, because of other regulatory priorities. Additionally, participants and other parties with standing may sue for losses resulting from a breach of fiduciary duty.
Therefore, advisers and other fiduciaries should review their practices and procedures to determine whether their current ESG investing activities appropriately consider pecuniary factors and, to the extent ESG factors are not pecuniary, whether the fiduciary properly applies the tiebreaker concept in the regulation. For example, increasingly, advisers offer plans and plan participants “ESG screens.” Such screens are subject to the final regulation. Further, an adviser should consider the impact the rule would have on any QDIA offered in a participant-directed defined contribution plan.
David Kaleda is a principal in the fiduciary responsibility practice group at Groom Law Group, Chartered, in Washington, D.C. He has an extensive background in the financial services sector. His range of experience includes handling fiduciary matters affecting investment managers, advisers, broker/dealers, insurers, banks and service providers.