Legal Alert

DOL Proposes New Regulations on ESG Investments in Retirement Plans

by the Employee Benefits and Executive Compensation Group
June 25, 2020

The United States Department of Labor (DOL) has issued a new set of proposed regulations providing guidance to plan fiduciaries about investing plan assets in investment vehicles that have environmental, social, and/or corporate governance (ESG) goals. Investing in ESG vehicles is sometimes referred to as “socially responsible investing” or “economically-targeted investing.” Over the last several years, retirement plan fiduciaries have been under pressure to consider ESG investment vehicles for retirement plans assets, particularly in the 401(k) and 403(b) plan lineups. The remarkable events of 2020 will only increase this pressure. The DOL proposed regulations would provide some helpful guidance for fiduciaries in evaluating ESG investment vehicles.

Existing DOL Guidance

The proposed DOL regulations build on the DOL’s previous guidance on fiduciary investing in ESG vehicles that has been issued over the past 26 years. Beginning with DOL Interpretive Bulletin (IB) 94-1, the DOL announced what is known as the “tie-breaker” standard. Under this standard, plan fiduciaries must focus their plan investment decisions solely on the plan’s financial returns, and the interests the plan participants and beneficiaries in their retirement benefits must be paramount. However, if a fiduciary has determined that two investment options effectively have the same economic risk and return profile, the fiduciary can consider “non-pecuniary” factors, such as ESG goals, to break the tie.

Over the following decades, the DOL reiterated its position in different forms, noting that the fiduciary’s paramount interest must be the plan’s financial risk and return, and that the fiduciary cannot subordinate the interests of participants and beneficiaries in their retirement income to unrelated objectives. In the DOL’s view, a fiduciary would breach his or her ERISA fiduciary duty by accepting reduced return or greater risk in a plan investment in order to secure ESG goals.

In 2018, the DOL acknowledged, in IB 2018-01, that it is possible for ESG issues to present material business risks and opportunities, and in certain circumstances could constitute economic considerations. In those cases, ESG factors could be considered by the fiduciary in determining whether to invest plan assets in the investment vehicle, and not just as a tie-breaker. The DOL cautioned fiduciaries that even if ESG factors are economic considerations, they must be properly weighted by the fiduciary with other economic considerations.

New DOL Proposed Regulations

The new DOL proposed regulations closely track the DOL position in IB 2018-01. The DOL makes clear that a fiduciary may not invest in ESG investment vehicles when the fiduciary understands that an underlying investment strategy of the fund is to subordinate return or increase risk for the purpose of non-pecuniary ESG objectives. The fiduciary must focus solely on economic considerations that have a material effect on an investment’s risk and return characteristics, based on appropriate investment horizons and consistent with the plan’s funding and investment policies. A plan fiduciary, according to the DOL, must never sacrifice investment return, take on additional investment risk or pay higher fees to promote non-pecuniary goals.

Nevertheless, consistent with IB 2018-01, the DOL acknowledges that there may be situations where ESG factors present material economic risks and opportunities under generally accepted economic theories. One such example is a company that is improperly disposing of hazardous waste. Such a company would be harming the environment, an ESG factor, but the act of improperly disposing of hazardous waste could lead to increased regulatory scrutiny and litigation, which could have a material economic impact on the investment.

If a fiduciary determines that an ESG factor is pecuniary, the fiduciary must consider it in evaluating the investment vehicle alongside other economic factors. The fiduciary must assign a weight to the ESG economic factor, based on the fiduciary’s prudent assessment of the ESG factor’s impact on risk and return.  The DOL cautions fiduciaries not to over weigh ESG economic factors.

The DOL proposed regulations also specifically address a fiduciary’s consideration of ESG factors in the selection and monitoring of investment options offered under a 401(k) or 403(b) plan with participant-directed investments. While a 401(k) or 403(b) plan fiduciary must still abide by the general rules in considering ESG investment vehicles (and cannot accept expected reduced returns or greater risk to secure non-pecuniary goals), the DOL acknowledges that an ESG investment vehicle could be added to the investment menu without foregoing other non-ESG investment options. The DOL indicates that a fiduciary may add an ESG investment vehicle to a 401(k) or 403(b) plan investment menu if:

  • The fiduciary uses only objective risk and return criteria, such as performance benchmarks, expense ratios, fund size, long-term investment returns, volatility measures, investment manager tenure, and asset mix, in selecting and monitoring the investment options offered under the plan;
  • The fiduciary documents its evaluation of such criteria; and
  • The ESG investment vehicle is not used as, or as a component of, the 401(k) or 403(b) plan’s qualified default investment alternative (QDIA).

Ballard Spahr’s Employee Benefits and Executive Compensation Group routinely advises plan fiduciaries on their ERISA fiduciary duties, including duties relating to the investment of plan assets.

Copyright © 2020 by Ballard Spahr LLP.
(No claim to original U.S. government material.)

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This alert is a periodic publication of Ballard Spahr LLP and is intended to notify recipients of new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney concerning your situation and specific legal questions you have.

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