DOL Updates Factors For Selecting Plan Investments

On October 30, 2020, the U.S. Department of Labor (the “DOL”) released a Final Rule to “provide clear regulatory guideposts for fiduciaries of private-sector retirement and other employee benefit plans in light of recent trends involving environmental, social and governance (ESG) investing.”  The Final Rule amended the regulations (29 C.F.R. §2550.404a-1; hereinafter referred to as the “Regulations”) enunciating fiduciary investment duties under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”).  This article will review the primary provisions added to the Regulations.

Over the last 30 years, the DOL has considered the use of environmental, social and corporate governance considerations (i.e., non-pecuniary benefits or “ESC Factors”) in connection with the selection of pension plan investments.  See Interpretive Bulletin 94-1, Interpretive Bulletin 2008-01, Interpretive Bulletin 2015-01 and Field Assistance Bulletin 2018-01.  The DOL’s prior guidance has consistently indicated that the use of ESG Factors in the selection of pension plan investments must comply with the requirements imposed by ERISA Section 404.

Generally, ERISA Section 404 requires a plan fiduciary to act prudently, to act solely in the interest of the plan’s participants and beneficiaries for the exclusive purpose of providing benefits, and to diversify plan investments to minimize the risk of large losses.

In prior guidance [Interpretive Bulletin 2015-01; hereinafter “IB 2015-01”], the DOL recognized two situations which may support a fiduciary’s use of ESG Factors in the selection of investments.  First, “fiduciaries may consider such collateral goals as tie-breakers when choosing between investment alternatives that are otherwise equal with respect to return and risk over the appropriate horizon”  (i.e., the “tie-breaker factor”).  Second, in situations where ESG Factors have a direct relationship to the economic value of the investment, such factors “are not merely collateral considerations or tie-breakers, but rather are proper components of the fiduciary’s primary analysis of the economic merits of competing investment choices.”

The prior guidance enunciated DOL’s view that ESG Factors have a very limited application to the selection of investments in ERISA Plans.  Notwithstanding the DOL’s views on ESG Factors, “[a]vailable research and data show a steady upward trend in the use of the term ‘ESG’ among institutional managers, an increase in the array of ESG-focused investment vehicles available, a proliferation of ESG metrics, services, and ratings offered by third-party service providers, and an increase in asset flows to ESG Funds”.  The Final Rule states that, “according to MorningStar, the assets in sustainable funds were nearly four times larger in 2019 than in 2018.”

The Regulations are the DOL’s response to this rapid expansion in the use of ESG Factors.  The Regulations make six changes to the investment duty requirements of ERISA Section 404.  First, the Regulations states “that ERISA fiduciaries must evaluate investments …based solely on pecuniary factors” (emphasis added).  The Regulations define “pecuniary factors” as “a factor that a fiduciary prudently determines is expected to have a material effect on the risk and/or return of an investment based on appropriate investment horizons consistent with the plan’s investment objectives and the funding policy.”

This language is largely a restatement of the DOL’s view, in IB 2015-01, that when ESG Factors rise to the level of a pecuniary factor (i.e., have a direct relationship to the economic value of an investment), the ESG Factor can be considered in the selection of an investment.  But, when the ESG Factors are not a pecuniary factor, they should not be considered in the selection analysis for an investment, except as a tie-breaker (discussed below in the fourth change to the ERISA investment duty requirements).

Second, the Regulations expressly state “that compliance with the exclusive purpose (loyalty) duty in ERISA Section 404(a)(1)(A) prohibits fiduciaries from subordinating the interests of participants to unrelated objectives, and bars them from sacrificing investment return or taking an additional investment risk to promote non-pecuniary goals.”  This provision is largely a restatement of the exclusive purpose/loyalty principles articulated in IB 2015-01.

Third, the Regulations “requires fiduciaries to consider reasonably available alternatives to meet their prudence and loyalty duties under ERISA.”  In the Final Rule, the DOL clarified that “reasonably available alternatives” does not “require fiduciaries to scour the market or to consider every possible alternative.”  As a practical matter, this additional requirement will have a limited impact on most investment selection decisions (which typically involve a selection among competing alternative investments).

Fourth, in the case where a fiduciary is unable to select an investment solely on the basis of pecuniary factors and applies non-pecuniary factors in selecting an investment, the Regulation sets forth certain “required investment analysis and documentation requirements.”  In the case where the ESG Factor is used as a tie-breaker factor, the Regulations require the fiduciary to document:  (1) “why pecuniary factors were not sufficient to select the investment;” (2) “how the selected investment compares to the alternative investments;” and (3) “how the chosen non-pecuniary factor or factors are consistent with the interests of participants and beneficiaries in their retirement income or financial benefits under the plan.”

Fifth, the Regulations “state that the prudence and loyalty standards set forth in ERISA apply to the fiduciary’s selection of designated investment alternatives to be offered to plan participants and beneficiaries in a participant-directed individual account plan.”  Given the special rules applicable to and the wide range of investments typically held in Section 404(c) participant-directed plans, the DOL apparently felt the need to specifically state that these rules applied to investments selected for participant-directed plans.

Finally, the Regulations prohibits fiduciaries from adding or retaining any investment as a Qualified Default Investment Alternative (QDIA) “if its objectives or goals or its principal investment strategies include, consider, or indicate the use of one or more non-pecuniary factors.”  The Final Rule provides a transition period (until April 30, 2022) for the removal of such QDIA investments.

In summary, the Final Rule restates the DOL’s view that ESG Factors have a very limited application to the selection of ERISA plan investments and confirms that the DOL believes that some fiduciaries are misapplying these ESG Factors.  As such, fiduciaries should carefully consider these Regulations in the selection or retention of investments with ESG Factors for ERISA plans.

Posted in: Federal Tax
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