In its finalized rule amending ERISA, the DOL makes financial factors paramount in a fiduciary’s responsibility to investors.
By Paul A. Davies, Nicola Higgs, Kristina S. Wyatt, and Deric Behar
On October 30, 2020, the US Department of Labor (DOL) published Financial Factors in Selecting Plan Investments (the Rule) and a related Fact Sheet, a codification of the spirit, if not the exact words, of a controversial proposal issued by the DOL in June 2020 (the Proposal). The Rule adopts amendments to certain provisions of the “investment duties” regulation under Title I of the Employee Retirement Income Security Act of 1974, as amended (ERISA), and requires fiduciaries of pension plans (and other benefit plans covered by ERISA) to choose investments “based solely on pecuniary factors” relevant to a particular investment. The net effect is to restrict plan fiduciaries from making investment decisions guided by goals or policies other than achieving the highest possible return for investors. Non-financial goals would ostensibly include any environmental, social, or governance (ESG) factors that many investors consider important to their investment decision-making.
Despite an overwhelming number of opposing comments submitted in the 30-day comment period after the Proposal was issued, the DOL quickly finalized the Rule substantially as it was proposed. The Rule preamble largely dismisses the materiality of ESG factors in investment decisions, and adopts the controversial idea that consideration of ESG factors are somehow at odds with financial factors and fiduciary responsibilities of plan sponsors. But rather than mandate a heightened standard of care for non-pecuniary factors in investment decisions, the DOL chose to prohibit them outright, providing that plan fiduciaries must select investments and investment courses of action based solely on financial considerations relevant to the risk-adjusted economic value of a particular investment or investment course of action. The Rule pivots on two ERISA duties imputed to fiduciaries:
- Fiduciary Duty of Prudence: Under the Rule, a fiduciary is required to perform a financial analysis of reasonably available alternative investment options, and make decisions solely on the basis of risk of monetary loss and opportunity for monetary gain, diversification, liquidity, and projected returns. Only when a comparison among these factors yields no discernible difference in investment decision can non-pecuniary factors be considered, and then only to the extent that they are consistent with investors’ financial interests. Fiduciaries, however, are encouraged by the DOL to decide tiebreakers using their best judgment based on pecuniary factors alone. Fiduciaries that choose funds with higher fees, lower historic or projected returns, or greater risk, regardless of any other objectives or factors, would therefore violate the Rule.
- Fiduciary Duty of Loyalty: The Rule language focuses on whether an investment factor is considered pecuniary or nonpecuniary, with pecuniary being defined as any factor that a fiduciary determines will have a material effect on risk and return based on an investment’s time horizons. A fiduciary has a duty of loyalty to investors to determine an investment course of action solely on the basis of pecuniary factors, and may not subordinate the financial interests of participants to non-financial objectives. Fiduciaries that choose funds using non-pecuniary objectives would therefore violate the Rule.
Key Differences From the Proposal
The Rule differs from the Proposal in a number of ways:
- The core text of the Rule was revised to remove all references to ESG, ESG-themed funds, and specific ESG factors, although ESG is discussed extensively in the Rule’s prefatory materials.
- The Rule omits the Proposal’s language about what could make ESG considerations pecuniary in nature, but requires that Plan fiduciaries perform and document a careful investment analysis in the limited circumstances that they do consider ESG factors.
- The Rule includes new regulatory text prescribing investment analysis and documentation requirements for those limited circumstances in which non-pecuniary factors are used in decision tiebreakers that cannot be determined based on pecuniary factors alone.
- The Rule maintains the Proposal’s provision that requires fiduciaries to consider reasonably available alternatives to meet the duty of prudence under ERISA, but omits wording suggesting that fiduciaries must “scour the market” or “consider every possible alternative” as part of their evaluation.
What the Rule May Mean in Practice
The Rule will become effective 60 days after publication in the Federal Register. The compliance deadline for retirement plans related to the selection of a qualified default investment alternative (QDIA) is April 30, 2022.
While fiduciaries are not absolutely prohibited from considering ESG factors if they are relevant to an investment’s financial analysis and are “pecuniary in nature,” market participants are rightfully concerned that the Rule will curb investment choice and specifically ESG investing in retirement plans. Fiduciaries may simply opt to steer clear of ESG factors when making investment decisions — even if they are justifiably pecuniary in nature — to avoid the additional documentation and compliance requirements, and possible regulatory scrutiny of adherence to fiduciary obligations under the Rule. The DOL’s heavy-handed approach to “safeguard the interests of [ERISA plan] participants and beneficiaries” does not bode well for increased commitments by North American pension funds to achieve net-zero carbon emissions across their portfolios, as is happening in Europe and Asia.
For those who consider ESG factors as fundamentally material to their investing decisions as pecuniary factors, the Rule is an unwelcome, if not unforeseen, development. Whether the rule will be enshrined in practice, or whether a new administration with opposing policy positions will curtail its impact, remains to be seen.
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