Key Takeaways:

• The economic effects of climate change and other ESG factors can be considered in a risk and return analysis of plan investments options and investment courses of action.
• Investment decisions can be based on ESG or other collateral benefits when competing investments equally serve the financial interests of the plan.
• 401(k) plan fiduciaries can consider participant preferences in choosing the plan’s menu of investment options.
• ESG funds can be used as qualified default investment alternatives (QDIAs).

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The U.S. Department of Labor (“DOL”) has issued a final rule (the “Final Rule) addressing how ERISA fiduciaries may consider environmental, social and governmental (ESG) factors in making investment decisions for retirement plans. The Final Rule is intended to alleviate what the DOL calls the “chilling effect” of certain prior rules on the ability and willingness of retirement plan fiduciaries to consider climate change and other ESG factors in discharging their duties under ERISA, and may result in plan sponsors adding ESG investment options to 401(k) investment choices.

Most of the provisions of the Final Rule will apply to investments made and investment courses of action taken after January 30, 2023, but certain provisions with respect to proxy voting will not apply until December 1, 2023.

The Final Rule is described in greater detail below.
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The Final Rule, entitled “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights,” is the outcome of the DOL’s reexamination of its “investment duties” regulation (the “Current Regulation”), which began in early 2021 at the direction of the Biden administration. The DOL determined that aspects of certain 2020 amendments to the Current Regulation could deter plan fiduciaries from considering climate change and other ESG factors in making plan investment decisions and exercising shareholder rights, even when such considerations were relevant to the risk and return analysis of a particular investment or investment course of action. The Final Rule is intended to clarify a fiduciary’s duties under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), when making plan investment decisions, including selecting qualified default investment alternatives (QDIAs), exercising or delegating the exercise of shareholder rights, and adopting proxy voting policies and guidelines.

General and Investment Prudence Duties

General Rule. The Final Rule, like the Current Regulation, incorporates ERISA’s core duties of loyalty and prudence, which require a fiduciary to act (i) solely in the interest of plan participants and beneficiaries and for the exclusive purpose of providing benefits to participants and their beneficiaries and defraying reasonable administrative expenses; and (ii) with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.

Elimination of Pecuniary / Non-Pecuniary Factors Distinction. The Final Rule eliminates the Current Regulation’s requirement that investment decisions generally be made solely on the basis of “pecuniary” factors. The DOL was concerned that the distinction between pecuniary and non-pecuniary factors could discourage fiduciaries from considering climate change and other ESG factors even in cases where they were directly relevant to a risk and return analysis. Under the Final Rule, fiduciaries can base investment decisions on any factor the fiduciary reasonably determines to be relevant to a risk and return analysis, including the economic effects of climate change and other ESG factors, as long as the fiduciary does not subordinate the interests of participants and beneficiaries in their plan benefits to unrelated objectives.

No Mandate to Consider ESG Factors. The Current Rule and the Final Rule both require a fiduciary to give appropriate consideration to, among other things, the plan’s projected return relative to its funding objectives. The proposed rule would have added that this may often require an evaluation of the economic effects of climate change and other ESG factors, and it would have included specific examples of how such factors could be relevant to a risk and return analysis. The DOL eliminated this language and the related examples from the Final Rule to avoid giving the mistaken impression that fiduciaries are required to consider climate change and other ESG factors in all risk and return analyses.

Collateral Benefits

Tie-Breaker Rule. The DOL’s sub-regulatory guidance has long recognized that fiduciaries are permitted to use collateral benefits to break ties between investments without breaching ERISA’s general duties of prudence and loyalty. Under the 2020 amendment, a fiduciary could not base any investment decision on non-pecuniary factors unless the alternatives were indistinguishable on the basis of pecuniary factors alone, and the fiduciary satisfied certain documentary requirements. Under the Final Rule, a plan fiduciary can base investment decisions on collateral benefits other than investment return if the fiduciary prudently concludes that competing investment decisions equally serve the financial interests of the plan over the appropriate time horizon, and the fiduciary does not accept reduced returns or greater risks to secure such collateral benefits. The Final Rule also removes the Current Regulation’s documentary requirements. According to the DOL, the Final Rule’s formulation of the tie-breaker rule better addresses the realities of fiduciary decision making and is more closely aligned with the DOL’s prior guidance.

Investment Options in Participant-Directed Individual Accounts; QDIAs

Use of Participant Preferences. The Final Rule specifically provides that a fiduciary of a participant-directed individual account plan does not violate ERISA’s duty of loyalty solely because the fiduciary takes into account participant preferences in choosing the plan’s investment options, consistent with ERISA’s duty of prudence. This provision does not permit a fiduciary to select an imprudent investment option based on participant requests or preferences, nor does it require fiduciaries to take participant preferences into account when selecting the plan’s investment options.

No Special Documentation. The proposed rule would have required a fiduciary of a participant-directed individual account plan to satisfy certain disclosure requirements when a plan investment option was selected on the basis of collateral benefits. The DOL removed this requirement from the Final Rule pending the outcome of rulemaking currently being conducted by the SEC on investment company names and ESG disclosures. The DOL noted that it may revisit the need for collateral benefit reporting or disclosure depending on the findings of the SEC.

ESG Funds as QDIAs. The Final Rule also eliminates the provision of the 2020 amendment that prohibited plan fiduciaries from designating an investment option as a QDIA if the investment option had investment objectives, goals or principal investment strategies that included, considered or indicated the use of one or more non-pecuniary factors. The DOL notes that this provision would have prohibited a fiduciary from designating an ESG fund as a QDIA even if it was economically superior to competing non-ESG funds. The DOL further notes that the prohibition in the 2020 amendment is not needed to protect participants because the selection of a QDIA is already subject to special protections under the existing QDIA regulation, as well as ERISA’s general duties of prudence and loyalty.

Proxy Voting and Exercise of Other Shareholder Rights

The Final Rule makes the following changes to the Current Rule’s provisions on proxy voting and the exercise of other shareholder rights:

• General Duty to Vote Proxies. It eliminates the statement that “the fiduciary duty to manage shareholder rights appurtenant to shares of stock does not require the voting of every proxy or the exercise of every shareholder right.”  The DOL is concerned that this language promotes indifference to proxy voting and is inconsistent with the DOL’s longstanding view that ERISA requires proxies to be voted unless a fiduciary determines that doing so might not be in the plan’s best interest.
• No Special Documentation Requirement. It eliminates the requirement to maintain records on proxy voting activities and other exercises of shareholder rights, which the DOL thinks could create a misperception that these activities are disfavored or carry greater fiduciary obligations.
• Promotion of Non-Pecuniary Benefits. It eliminates the language prohibiting fiduciaries from promoting non-pecuniary benefits or goals unrelated to the financial interest of the plan’s participants and beneficiaries when voting proxies or exercising other shareholder rights. The DOL is concerned that this language could be easily misconstrued to imply that plan fiduciaries have a duty to ensure that their votes or other actions do not promote objectives or goals unrelated to the financial interests of the plan, on top of their duties to act solely in accordance with the economic interests of the plan and not to subordinate the interests of participants and beneficiaries to any other objectives.
• No Heightened Monitoring. It eliminates the specific monitoring obligations applied when the authority to vote proxies or exercise shareholder rights is delegated to an investment manager, proxy voting firm or other person. The DOL is concerned that this provision could be mistakenly thought to create a higher standard for monitoring proxy voting activities than applies to other fiduciary activities.
• No Safe Harbors. It eliminates the two “safe harbor” proxy voting policies that fiduciaries could use to satisfy their responsibilities under ERISA in deciding whether to vote. The first safe harbor permitted fiduciaries to adopt a policy of limiting voting resources to particular types of proposals that the fiduciary prudently determined are substantially related to the issuer’s business activities or are expected to have a material effect on the value of the investment. The second safe harbor permitted a policy of not voting on proposals or particular types of proposals when the plan’s holdings in a single issuer relative to the plan’s total investments assets are below a specified threshold. The DOL considers these safe harbors to be unhelpful and unnecessary, and is concerned that they could be construed as regulatory permission for plans to abstain from proxy voting without properly considering the plan’s interests as a shareholder.   

Effective Date

Except as noted below, the Final Rule will apply to all investments made and investment courses of action taken after January 30, 2023.
 
The provisions addressing the requirements for adopting a practice of following the recommendations of a proxy advisory firm or other service provider, as well as the provisions relating to the selection of proxy voting policies applicable to plan assets invested in pooled investment vehicles, which are both parts of the Current Regulation, will not apply until December 1, 2023.

The DOL determined that it was appropriate to delay the application of the Final Rule in the latter cases to give plan fiduciaries time to review their arrangements with proxy advisory firms and managers of pooled investment vehicles.