DOL Proposed Regulation Highlights the Risks of ESG Investing for ERISA Fiduciaries

On June 23, 2020, the U.S. Department of Labor (“DOL”) issued a proposed regulation outlining the duties of an ERISA fiduciary when considering an investment that incorporates environmental, social, and corporate governance (“ESG”) factors.[1] Some believe that the DOL will likely move quickly to finalize the regulation before the end of the current administration’s first term.

Preamble: The preamble to the regulation is particularly instructive because it outlines the current DOL leadership’s concerns regarding ESG investing. It notes that there has been an increase in the use of the term ESG among asset managers, an increase in the array of ESG-focused investment vehicles, a proliferation of ESG metrics, services, and ratings offered by third-party service providers, and an increase in asset flows into ESG funds.[2] The DOL believes that there is no consensus about what constitutes a genuine ESG investment, and that ESG rating systems are often vague and inconsistent, despite featuring prominently in marketing efforts. The DOL also asserts that ESG funds often come with higher fees, due to additional investigation and monitoring necessary to assess the investment from an ESG prospective. In summary, the DOL is concerned that the growing emphasis on ESG investing may prompt ERISA fiduciaries to make decisions for purposes distinct from their duties under ERISA. The preamble notes:

• “Providing 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 objectives.
• ERISA fiduciaries “must be focused solely on the plan’s financial returns and the interests of participants and beneficiaries in their plan benefits must be paramount” and fiduciaries must never “sacrifice investment returns, take on additional investment risk, or pay higher fees to promote non-pecuniary benefits or goals.”
• While public companies and their investors may legitimately pursue a broad range of objectives, retirement plans covered by ERISA “are statutorily-bound to a narrower objective: management with an ‘eye single’ to maximizing the funds available to pay retirement benefits.”

Proposed Regulation: The proposed regulation would make five basic changes to the current regulation:

1. Investment Duties. The proposed regulation adds text: (i) requiring fiduciaries to select investments based on financial considerations relevant to the risk-adjusted economic value of a particular investment, and (ii) prohibiting fiduciaries from subordinating the interests of participants in retirement income and financial benefits to non-pecuniary goals.
2. Alternatives Considered. The proposed regulation includes a new provision requiring fiduciaries to consider how the contemplated investment compares to other available investments with regard to diversification of the overall portfolio, liquidity relative to the cash flow requirements of the plan, and projected return of the portfolio relative to the funding objectives of the plan.
3. Pecuniary Factors. The proposed regulation, which requires fiduciaries to focus exclusively on pecuniary factors, acknowledges that ESG factors can be pecuniary factors, but only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories. The DOL cautions that the weight given to such factors be carefully assessed, reflecting the DOL’s concern that fiduciaries may overweight ESG factors.
4. Tiebreaker Rule. The DOL states many times in the preamble that it believes it will be “rare” for two investments to be “economically indistinguishable;” however, where that occurs and ESG factors are used as a tiebreaker to select an investment, fiduciaries must document why the investments were determined to be indistinguishable and why the investment was chosen based on the purpose of the plan, diversification of investments, and the interests of the participants in receiving benefits from the plan.
5. Designated Investment Alternatives. The proposed regulation adds a new provision clarifying that fiduciaries may select ESG funds as a designated investment alternative for 401(k)-type plans, provided (keeping in mind the above considerations) that (i) the selection is based solely on objective risk-return criteria used to select all of the plan’s investment options, (ii) the fiduciary documents the selection and monitoring of the investment, and (iii) the ESG fund is not added as, or a component of, a qualified default investment alternative (a “QDIA”).

Conclusion: The DOL’s proposal highlights risks associated with ESG investments and requires fiduciaries to diligently evaluate the merits of the investment and carefully document the process followed in making their decision before adding an ESG investment to an ERISA-governed retirement plan. Despite a substantial number of comments critical of the proposed regulation submitted during a truncated comment period, we presume the proposed regulation will be finalized. Even if it is not, however, the preamble and regulation are instructive, and following the guidance will help limit the fiduciary risk associated with DOL enforcement activities or private lawsuits.