Seyfarth Synopsis: On June 23, 2020, the Department of Labor (“DOL”) issued a proposed regulation amending the fiduciary regulations governing investment duties under Employee Retirement Investment Security Act of 1974 (“ERISA”). This proposed regulation provides guidance when an ERISA fiduciary is selecting an investment or investment strategy based on “non-pecuniary” factors such as environmental, social or corporate governance (“ESG”) sustainability or religious factors. The DOL indicated that its proposal is in response to increasing interest in ESG and sustainability investing.
Over the last several years concerns over global warming, economic disparity, gender and racial equality, and social injustice have been on the rise. (Our corresponding blog post on this topic [link here] discusses several examples of ESG and sustainability investing.) One way that people have of combating those concerning developments is by investing their money in worthy ventures. Much of people’s money available for investing is in their employers’ retirement plans. It is reported that at the end of the first quarter of 2020, total US retirement plan assets stood at $28 trillion, of which approximately $7.7 trillion is held in defined contribution plans and $11 trillion is held in pension plans.
Retirement plans are generally subject to the Employee Retirement Income Security Act of 1974 (“ERISA”), and those responsible for investing the assets held in those plans are subject to ERISA’s fiduciary duties and responsibilities. ERISA requires that fiduciaries act as a prudent expert, solely in the interest of the plan participants and beneficiaries, and for the exclusive purpose of providing benefits and defraying plan expenses. So, how do those obligations translate to investing an ERISA plan’s assets — can or should plan investment fiduciaries look to achieve social good when investing a plan’s assets?
Evolution of DOL Guidance on ESG
The DOL is responsible for interpreting and enforcing these fiduciary standards. Over the years, the DOL has provided guidance concerning ERISA’s fiduciary duties and responsibilities, including the role of non-pecuniary factors (like ESG or sustainability factors) in those decisions. The DOL’s guidance on this topic has evolved and varied over time as the economic environment and administrations have changed. The DOL has positioned the recent proposed regulation as reiterating and codifying the long-establish principles of fiduciary standards for selecting and monitoring investments.
In Interpretive Bulletin 2015-01 (issued during the prior administration), the DOL recognized that a fiduciary could make investment decisions using non-pecuniary factors, such as ESG, as “tie breakers” — i.e., the expected risk-return characteristics of alternative proposed investments are the same. In that bulletin, the DOL also acknowledged that in some cases ESG may have a direct relationship with the economic and financial value of the plan’s investment. In those instances, ESG factors are not merely collateral considerations or tie breakers, but rather are a proper component of the fiduciary’s analysis of the economic merits of competing investment choices. Further, the DOL acknowledged that when the fiduciary prudently determined that the investment is justifiable based solely on its economic considerations, then there is no need to evaluate collateral factors as tie breakers.
In Field Assistance Bulletin 2018-01 (FAB 2018-01), which was issued by the current administration, the DOL appeared to limit IB 2015-1 by warning fiduciaries against taking an expansive view on whether ESG factors are economically relevant to a prudent investment selection. That trend continues in the new proposed regulation.
The DOL indicated that its new proposal is in response to increasing interest in ESG and sustainability investing, and the lack of an industry standard for what constitutes such an investment. The DOL’s concern about such investing under ERISA is reflected in the preamble to the proposed regulation. The DOL specifically stated: “[p]roviding a secure retirement for American workers is the paramount, and eminently-worthy, ‘social’ goal of ERISA plans; plan assets may not be enlisted in pursuit of other social or environmental objects”.
The proposed regulation identifies a number of items an ERISA fiduciary must consider when reviewing a proposed investment or investment strategy to satisfy the fiduciary’s duties of loyalty and prudence under ERISA. Those items include:
- Considering the relevant facts and circumstances, including the role the investment will play in the plan’s investment portfolio, the investment’s risk of loss and opportunity for gain, how the proposed investment compares to other available investments;
- Evaluating the investment based solely on pecuniary factors that have a material impact on the risk and return of the investment; and
- Not subordinating the plan’s financial interests to unrelated objectives, sacrificing investment return, or taking risk to promote interest unrelated to the financial interest of the plan.
Following the DOL’s prior guidance, the proposed regulation provides for the “all things being equal” or “tie breaker” test, but warns fiduciaries they could violate ERISA if they accept reduced expected returns or greater risks to secure social, environmental, or other policy goals. Under the proposal, fiduciaries must always prioritize the economic interests of the plan in providing benefits to participants. The proposal recognizes that after an evaluation of alternative investments that appear economically indistinguishable, a fiduciary may “break the tie” by relying on non-pecuniary factors. The DOL, however, expects that true ties will rarely, if ever, occur. The proposed regulation requires fiduciaries relying on this “all things equal” test to adequately document their decision-making process in order to avoid decisions being made based on non-pecuniary factors without analysis. Specifically, the fiduciary would be required to document:
- Why that investment was economically indistinguishable;
- Why the investment was chosen based on all the relevance facts and circumstances specified in the proposed regulations; and
- How the investment is in the interest of the plan and its participants.
In the proposal, the DOL cautioned that fiduciaries must not too readily treat non-pecuniary factors (such as ESG factors) as economically relevant when making a particular investment decision. The DOL does acknowledge in the proposal that ESG and similar factors could be pecuniary factors but only if they present “. . . economic risks or opportunities that a qualified investment professional would treat as material economic considerations under accepted investment theories”. For example, BlackRock’s CEO, Larry Fink, posited in his 2020 annual letter to shareholders that sustainability is a required factor when looking for economically prudent investments.
Defined Contribution Plans
The proposed DOL regulation includes special guidance on applying the proposal to investment options that are offered under participant-directed defined contribution plans. Under the regulation, such a plan can offer a prudently selected, well managed and properly diversified ESG option if:
- The fiduciary uses only objective risk-return criteria (e.g., benchmarks, expenses, volatility measures, etc.) in selecting all of the plan’s investment options, including any ESG investment option. In the preamble to the proposed regulations, the DOL consistently stated that a fiduciary cannot sacrifice returns or increase investment risks when compared to similar investments (e.g., similar asset classes and strategies) to achieve non-pecuniary goals (e.g., ESG, impact investing, economically targeted investing).
- The fiduciary documents its selection and monitoring of the option in accordance with the objective criteria discussed above.
- The ESG option is not the qualified default investment alternative (“QDIA”) or a component of the QDIA.
In the preamble, the DOL acknowledged that adding a fund to a participant-directed defined contribution plan does not necessarily mean that the plan is foregoing a non-ESG investment alternative. The DOL, however, then specifically stated that a fiduciary must comply with the obligations under the proposed regulation and “not to sacrifice returns or increase investment risk compared to other similar asset classes or funds in the same category in order to achieve non-pecuniary goals” such as ESG goals. This does appear to be a further change from the DOL’s position in its FAB 2018-01 concerning economically targeted investments. In that Bulletin, the DOL suggested that a prudently selected, well managed, and properly diversified ESG-themed fund could be part of the defined contribution plan’s investment line-up.
The proposal could also impact fiduciaries struggling with investing ERISA plan assets in accordance with religious laws. For example, devote Muslims are required to invest in compliance with Sharia Law (also referred to as Shariah Law). Under Sharia Law, a Muslim may not invest in certain types of investments, including for example, investments that derive a majority of their income from the sale of alcohol, pork products, gambling, weapons and military equipment. Further, Sharia Law prohibits receiving interest income or dividends. To ensure compliance with the myriad of requirements under Sharia Law, a Sharia board is required to approve all investments. So not only are Sharia-compliant investments limited in type, but also come with an increased cost structure (e.g., the Sharia board fees). Applying the DOL’s proposed regulation to these religious tenets makes religious law compliant investing difficult, if not impossible, under an ERISA plan.
But . . .there may be a way!
While plan fiduciaries would be hard pressed to consider religious tenets, much less ESG factors, when selecting investment options under an ERISA participant-directed defined contribution plan, query whether such funds (or companies) could be made available through a brokerage window. In fact, there are numerous Sharia-compliant mutual funds and ETFs available for individuals who wish to invest their personal assets in compliant funds, so why couldn’t a plan offer a brokerage window and give devout plan participants the ability to invest their plan accounts in accordance with their religious beliefs? Brokerage windows have their pros and cons. In addition, a fiduciary’s duties and responsibilities with respect to a brokerage window are not settled. So while a brokerage window may provide a path to allowing participants to invest based on non-pecuniary factors (such as ESG or religious-based factors) under a participant-directed plan, the width of that path is not entirely clear.
Plans Covered by Proposal
It is important to remember that this proposal only applies to plans that are subject to ERISA’s fiduciary duties and responsibilities for investing plan assets. As a result, this proposal does not apply to: plans excluded from ERISA (e.g., governmental plans, church plans that have not elected to be covered under ERISA); plans without assets (e.g., unfunded welfare plans); and plans that are not subject to ERISA’s fiduciary rules (e.g., supplemental retirement plans or “top hat” deferred compensation type plans).
In summary, we are left with the question: is it ill-advised for plan fiduciaries to engage in ESG investing? Under the proposed guidance, it would be difficult to defend an investment based only on ESG considerations as appropriate under an ERISA plan, but the guidance does leave some room for ESG principles to be considered. Nevertheless, plan investment fiduciaries are advised to proceed with caution when considering ESG or other non-pecuniary factors. With the proliferation of class-action litigation attacking plan fees and investment selections for participant-directed defined contribution plans, a properly structured fiduciary process (including necessary documentation) is a must.
 The remainder, another $9.2 trillion, is currently invested in IRAs.