On October 14, 2021, the US Department of Labor (DOL) proposed changes to ERISA regulations that would again shift the analysis of consideration of environmental, social, and governance (ESG) factors in retirement plans governed by ERISA. The proposal (2021 Proposal) reacts to the Trump Administration’s 2020 final regulations on ESG (2020 Regulations) by reversing course on key aspects of those regulations and implementing several changes that may have the effect of facilitating ESG considerations by plan fiduciaries. It is important to note, however, that the core analysis under ERISA has not changed, and the 2021 Proposal still requires that fiduciaries focus solely on the interests of participants in making investment decisions.
A brief review of ESG under ERISA
ERISA requires that fiduciaries must act “solely in the interest of participants and beneficiaries,” and in accordance with a specified standard of prudence and loyalty. All of the past DOL guidance on ESG has reiterated these principles, which remain at the center of fiduciary behavior. The question has been to what extent consideration of ESG factors could be consistent with these standards under ERISA.
Successive presidential administrations have attempted to clarify whether and to what extent fiduciaries can or should consider ESG factors in investment decisions. In general, Republican administrations have issued guidance that tended to raise the bar for consideration of ESG factors, while Democratic administrations have issued guidance that allowed somewhat more flexibility in considering ESG. This back-and-forth, which we summarized in a prior legal alert, led to the Trump Administration’s 2020 Regulations, which include a number of provisions perceived as limiting the ability of fiduciaries to consider ESG.
2021 Proposal
The 2021 Proposal would change key aspects of the 2020 Regulations, in each case removing perceived barriers to consideration of ESG factors. The chart below summarizes the most significant changes.
| Topic |
2020 Regulations |
2021 Proposal |
| Standard for consideration of ESG factors |
Generally requires plan fiduciaries to select plan investments based solely on “pecuniary factors.” |
Includes new language specifying that, to meet the duty of prudence, a fiduciary’s consideration of a projected return in connection with an investment “may often require” an evaluation of the effects of climate change and other ESG factors on the investment. |
| Examples of potentially permissible ESG factors |
No previous provision in the 2020 Regulations. |
Adds a new paragraph clarifying that a fiduciary may, depending on the circumstances, consider climate change and other ESG factors as material factors in its risk-return analysis and providing the following examples:
- Climate change-related factors, such as a corporation’s exposure to the real and potential economic effects of climate change, and the effect of government regulations and policies;
- Governance factors, such as board composition, executive compensation, and compliance with laws and regulations; and
- Workforce practices, including diversity, equity, and inclusion and labor relations.
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| QDIA and ESG |
Prohibits a plan from using a fund, product or model portfolio as a qualified default investment alternative (QDIA) if its objectives, goals or principal investment strategies include, consider or indicate the use of one or more non-pecuniary factors. |
Eliminates the 2020 Regulations’ special rule prohibiting these funds from serving as a QDIA and applies the same fiduciary standards with regard to selection and monitoring of a QDIA as those applicable to other designated investment alternatives, including consideration of climate change and other ESG factors. |
| Tie-breaker for comparable investments |
Imposes a requirement that competing investments be economically indistinguishable before fiduciaries can turn to collateral factors as tie-breakers, and imposes a special documentation requirement on the use of such factors. |
Reverts to the DOL’s historical tie-breaker standard, making clear that a fiduciary is not prohibited from selecting an investment based on collateral benefits other than investment returns, so long as the fiduciary prudently concludes that the proposed investment and competing investment alternatives “equally serve the financial interests of the plan.”
- Does not require the competing investments to be “indistinguishable.”
- Removes the 2020 Regulations’ specific documentation requirements for tie-breakers.
- Requires prominent disclosure of the collateral considerations used as tie-breakers.
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| Proxy voting rules |
Including language specifically stating that fiduciaries may not be required to vote proxies, imposed recordkeeping requirements when voting proxies, and provided safe harbor examples that involved less proxy voting activity. |
Removes the examples and the statement suggesting that it may be prudent not to vote proxies, as well as the special recordkeeping requirement, reverting to the former more general fiduciary standard. |
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ESsentials: The specific examples and affirmative statement in the proposed rule that prudence “may often require” consideration of ESG factors in evaluating investment alternatives should go a long way toward alleviating concerns created by the 2020 Regulations among plan sponsors and investment providers that integration of climate change and other ESG factors in investment decision-making somehow might be inconsistent with fiduciary obligations. The new language appears to be a recognition that ESG investments may provide a source of enhanced value and returns to plan investment portfolios and may improve portfolio resilience against the potential financial risks and impacts associated with climate change and other ESG factors.
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ESsentials: QDIAs often are the plan investment options with the largest asset levels, due to a combination of default contributions and participant-directed allocations. Eliminating the prohibition on ESG considerations in QDIAs could have a material effect on assets invested in this category. The lifting of this prohibition also provides plan fiduciaries with greater choice in designing their plan investment line-ups, allowing them to apply the same factors in considering a QDIA as they would in evaluating other plan investments.
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ESsentials: The proposed change to the tie-breaker standard realigns the rule more closely with the standard first articulated by DOL in Interpretive Bulletin 94-1, during the Clinton Administration. It would permit fiduciaries to select plan investments based on economic or non-economic benefits other than investment returns so long as prudence and loyalty obligations are met, and the fiduciary does not sacrifice returns or accept additional risk to obtain the collateral benefits. The threshold test that competing investments must “equally serve” the plan’s financial interests appears to be a more flexible standard than provided in previous iterations of DOL guidance, but the proposed standard will present interpretive challenges of its own.
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ESsentials: Many investment managers already incorporate some form of ESG considerations in their decision-making process as one of many financial factors taken into account. This is different than an ESG-themed fund, which explicitly attempts to ensure investments satisfy one or more ESG factors. The former has been and will continue to be permitted under ERISA and the applicable guidance; the latter is more the focus of the regulatory debate.
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ESsentials: The principles-based approach of ERISA and the regulations thereunder to investment decision-making by plan fiduciaries has been successful in part because of its lack of either specific prescription or proscription; for almost fifty years and in a variety of circumstances across changing investment environments, plan participants and national retirement security both have been well served by this approach. And since the enactment of ERISA, there certainly is no substantial documentation of plan fiduciaries slanting investment decisions to advance the political or societal preferences of those decision makers. Now, in successive Administrations, DOL is going beyond general principles with specific references to actions that should not or should be undertaken by fiduciaries regarding ESG factors. In light of the longstanding success of a principles-based regime, DOL should give serious consideration to refocusing this guidance in more general terms, rather than specific references that may become outdated or create a target subject to further revision by a future Administration.
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Next steps
The 2020 Regulations continue in effect at this time, subject to DOL’s non-enforcement policy announced on March 10, 2021, which applies only to DOL enforcement, not plan participant lawsuits. Accordingly, for the time being, the landscape has not changed overnight.
The DOL requested comments on the 2021 Proposal, and several of the DOL’s questions indicate that the administration is considering changes that would further incorporate ESG into fiduciary considerations. Plan fiduciaries and investment providers with an interest in these rules should give serious consideration to providing comments, as this area is likely one in which the DOL has a strong interest in the views of the regulated community. Some of the question asked by DOL include:
- Whether it would be helpful to have other or fewer examples of factors fiduciaries may consider in evaluating investment alternatives to avoid regulatory bias?
- Whether the tie-breaker approach is sufficiently clear and appropriate in light of the investment practices and strategies used by plan fiduciaries (and whether other approaches might better reflect plan practices)?
- Whether more specificity should be provided in connection with collateral benefits a fiduciary may consider to break a tie?
Comments are requested by December 13, 2021.
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