DOL Releases Proposed Rule for Financial Factors in Selecting Plan Investments

Employee Benefits & Executive Compensation Update

Date: July 01, 2020

On June 22, the Department of Labor released a proposed rule (Rule) that, when finalized, will amend existing guidance governing a fiduciary’s investment duties under ERISA. The DOL’s stated purpose in adopting the Rule is to confirm that plan fiduciaries must select plan investments solely based on financial considerations that impact the economic value of the investments. The preamble makes clear that the Rule is principally designed to address concerns arising out of the proliferation of investments that are intended to serve, at least in part, non-pecuniary environmental, social and corporate governance (ESG) goals.

As further explained herein, the Rule clarifies that plan fiduciaries must base their investment decisions solely on pecuniary factors: those that have a material effect on an investment’s risk and return based on appropriate time horizons consistent with the plan’s investment objectives and funding policy. In other words, plan fiduciaries must not sacrifice performance or expose plan participants and beneficiaries to increased financial risk to serve a non-pecuniary (e.g., ESG) interest.

Background

ERISA generally requires that plan fiduciaries act prudently and diversify plan investments to minimize the risk of large losses. Additionally, plan fiduciaries must act solely in the interest of plan participants and beneficiaries for the exclusive purpose of providing benefits to plan participants and beneficiaries and defraying reasonable plan administrative expenses. For this reason, ESG investing—which involves the selection of investments at least in part to serve non-pecuniary interests—raises fiduciary concerns under ERISA.

The DOL first addressed these concerns in Interpretive Bulletin 94-1 (IB 94-1) in which the DOL stated that economically targeted investments (another term for ESG investments) were not inherently incompatible with ERISA’s fiduciary obligations. However, in selecting such investments, non-pecuniary factors should only be considered as a tiebreaker when all other factors are equal.

While restating the basic guiding principles of IB 94-1, subsequent DOL guidance has created uncertainty regarding precisely what role ESG factors may serve in the selection of plan investments. For example, in Interpretive Bulletin 2015-01, the DOL noted that ESG factors may directly impact the economic value of an investment and need not be relegated to tiebreaker status in those instances. However, just three years later in Field Assistance Bulletin 2018-01, the DOL stated that ESG factors may be economically relevant in the selection of plan investments but should not too readily be treated as such.

The Need for Additional Guidance

In the preamble to the Rule the DOL noted a dramatic increase in investments in ESG funds over the past few years. Because these funds are often accompanied by higher fees, investments in such funds may run contrary to the ERISA objective for retirement plans to maximize available funds at retirement. These concerns, together with the acknowledged confusion caused by the DOL’s sub‑regulatory guidance discussed above, prompted the DOL’s proposal of the Rule.

The Rule

The Rule’s overriding purpose is to clarify that plan fiduciaries must never subordinate the pecuniary interests of plan participants and beneficiaries to the achievement of non-pecuniary goals. According to the Rule, the ERISA duties of loyalty and prudence in connection with the selection and monitoring of plan investments are satisfied if the fiduciary:

  • gives appropriate consideration to facts and circumstances the fiduciary knows or should know are relevant to a particular investment, including the role the investment plays in a plan’s investment portfolio;
  • evaluates the investment based solely on pecuniary factors that have a material effect on return and risk;
  • does not subordinate the interests of retirement income and financial benefits of the participants and beneficiaries in the plan to unrelated objectives or goals;
  • does not otherwise subordinate the interests of the participants and beneficiaries to the fiduciary’s or another’s interests; and
  • acts accordingly after consideration of the above factors.

To discharge its obligation of appropriate consideration in this context, the fiduciary must consider how the investments in the plan compare to available alternative investments, and in doing so must consider the level of diversification, degree of liquidity, and potential risk and return in comparison to alternative investments.

The Rule also clarifies that plan fiduciaries must evaluate investments focusing only on pecuniary factors and may not sacrifice investment returns or take on additional risk to promote non-pecuniary goals. As a result, ESG factors generally may only be considered if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations. The only exception is when investments are economically indistinguishable. In that event, the fiduciary may consider non-pecuniary ESG factors in selecting an investment if the fiduciary documents why the investments are economically indistinguishable, and why the selected investment was chosen based on the purposes of the plan, diversification of investments, and the interests of participants and beneficiaries in receiving plan benefits. Notably, in the preamble to the Rule, the DOL observed that it anticipates that investments will rarely if ever be economically indistinguishable but wanted to address the theoretical possibility.

Recognizing the investment selection differences between individual account plans and other types of retirement plans—the ability for participants to select investments from among a diversified selection of investment alternatives offered within a plan—the Rule provides that inclusion of one or more ESG investments among a plan’s offerings would not violate ERISA fiduciary obligations if the fiduciary:

  • uses only objective risk-return criteria, such as benchmarks, expense ratios, fund size, long-term investment returns, volatility measures, investment manager investment philosophy and experience and a mix of asset types in selecting and monitoring the ESG investment alternative;
  • documents the selection based upon the criteria above; and
  • does not add the ESG as one of the plan’s qualified default investment alternatives.
Discussion & Action Items

As an initial matter, despite the Rule’s underlying motivation, the Rule applies to all plan investments, not just investments intended to serve a non-pecuniary ESG goal. As a result, plan fiduciaries of all plans should consider the impact of the Rule on their respective plans and the processes by which plan fiduciaries select and monitor plan investments.

Further, the Rule as written will likely have a chilling effect on inclusion of investments to serve ESG goals within plans. While the Rule theoretically leaves the door open for ESG investments that are “indistinguishable” from other investments, the Rule leaves unanswered a variety of questions that will create uncertainty and risk for plan fiduciaries unless addressed in the final Rule. For example, the Rule does not explain what it means for investments to be indistinguishable. Professional investment advisers rely on myriad performance and risk metrics to evaluate and monitor investment options over various time periods. The Rule is silent on whether an ESG investment must be indistinguishable from another investment based on all metrics and all time periods. Nor does the Rule speak to whether the ESG investment must be at least the equal of the best-performing non-ESG fund in a particular investment category (e.g., large-cap growth domestic equities) based on all metrics and time periods. As the DOL noted in the preamble, it is hard to imagine that any two funds could ever be considered indistinguishable based on all performance and risk metrics. As a result, inclusion of ESG investments is fraught with risk.

Finally, at present the Rule is only proposed and, having been published in the Federal Register on June 30, is subject to a 30-day comment period that ends on July 30, 2020. As a result, the Rule may change once finalized. However, plan fiduciaries should use this time to consider whether investments that serve ESG interests have been included within their plans and on what basis. Fiduciaries should also begin a dialogue with their independent investment advisers to consider the substance of the Rule and what impact it will have on current and future investments. If fiduciaries desire to maintain investments that serve ESG interests within their plan portfolios or lineups, they should carefully consider and document the ongoing prudence of inclusion of the investments and document their decisions.

FOR MORE INFORMATION

For more information, please contact:

Julia Ann Love
216.566.5686
Julia.Love@ThompsonHine.com

Edward C. Redder
614.469.3258
Edward.Redder@ThompsonHine.com

Mark G. Kroboth
216.566.5889
Mark.Kroboth@ThompsonHine.com

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