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December 20, 2022

DOL Finalizes ESG Rule for ERISA Plan Fiduciaries

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DOL FINALIZES ESG RULE FOR ERISA PLAN FIDUCIARIES

Background

The Department of Labor (the DOL) has released its final rule[1]  clarifying how and when ERISA fiduciaries may consider ESG factors in making investment decisions for a plan. The rule also offers substantial guidance on the duties and responsibilities of plan fiduciaries in exercising shareholder rights, including proxy voting. Taken as a whole, the revisions contained in the final rule provide substantial relief to investment professionals who already incorporate ESG factors into their risk and return calculations and allow plans to play a central role in advancing ESG objectives, as long as these objectives are tied directly to the prudent assessment of risk and return.

In promulgating the final rule, the DOL abandoned most of the impediments imposed by the prior administration to the consideration of ESG factors in investment decision-making and eliminated provisions from the rule adopted by the prior administration that made it easier for plan fiduciaries to avoid exercising voting rights. The final rule generally reinstates the DOL’s non-regulatory guidance on these matters dating back to 1994. As a rationale for this approach, the adopting release states that changes made to the rule by the prior administration were “a thumb on the scale against the consideration of ESG factors, even when those factors are financially material.” The final rule removes that thumb by providing fiduciaries with a framework of principles to utilize when applying ERISA’s fiduciary duties of prudence and loyalty to the consideration of ESG factors.

The final rule will be effective January 30, 2023, other than certain rules relating to proxy voting that will be effective December 1, 2023. The following provides a brief overview of the final rule.

Investing by ERISA Fiduciaries and the Role of ESG Factors

ERISA requires that plan fiduciaries discharge their duties with the exclusive purpose of providing benefits to participants and their beneficiaries and defraying reasonable expenses of administering a plan, and that fiduciaries do so with the care, skill, prudence and diligence of a prudent person.

The final rule retains the core principle that ERISA’s duties of prudence and loyalty require fiduciaries of an ERISA plan to focus on relevant risk-return factors and not subordinate the interests of participants and beneficiaries to objectives unrelated to the provision of plan benefits. Unlike state retirement plans, which are not subject to ERISA and which may, if state law permits, pursue policy objectives not directly tied to investment return (e.g., divesting or boycotting certain industries or companies), fiduciaries of ERISA plans must continue to keep investment risk and return as the exclusive principles in executing securities selection for the applicable investment mandate.

Prudence Standards

In considering an investment or investment course of action, ERISA requires fiduciaries to give “appropriate consideration” to relevant facts and circumstances that will enable the fiduciary to determine that the investment will further the purposes of the plan, taking into account the risk of loss and opportunity for gain as compared to reasonably available alternatives with similar risks. The final rule states that, depending on the individual facts and circumstances, risk-return factors may include the economic effects of climate change and other ESG factors. The weight given to any factor should appropriately reflect an assessment of its impact on risk and return.

In setting forth the above principles, the DOL removed the “chilling effect” of the current rule on ESG considerations by ERISA plan fiduciaries. In particular, the final rule eliminates the requirement that investment decisions be based solely on “pecuniary factors,” an undefined term that commentators indicated might preclude the incorporation of ESG considerations (which may have both pecuniary and non-pecuniary components) into the decision-making process, even when those considerations are relevant to a risk-return analysis. The final rule, however, eliminated the statement in the proposed rule indicating that a proper risk-return analysis “may often require” consideration of ESG factors. Thus, a fiduciary may determine that a prudent risk-return analysis does not warrant the consideration of the economic effects of ESG factors (e.g., when tracking the performance of an index). The final rules do not tip the scale in either direction when a fiduciary is assessing whether or not to incorporate ESG factors into investment decision-making.

The Duty of Loyalty; The Tie-Breaker Standard; Self-Directed Investments

The final rule details the application of ERISA’s duty of loyalty to the (1) use of “collateral factors” (such as ESG factors when not relevant to risk and return) in deciding between investments that equally serve the plan’s needs (the “tie-breaker standard”) and (2) consideration of participants’ policy, social or value preferences for investing self-directed assets in defined contribution plans.

The final rule rescinds the provision of the current rule that permits the use of “non-pecuniary factors” only when the fiduciary has determined that the investment alternatives are indistinguishable based on pecuniary factors and has documented its analysis to this effect. The final rule establishes a standard permitting the use of collateral factors once the applicable fiduciary determines that the investment alternatives “equally serve the financial interests of the plan over the appropriate time horizon,” thereby addressing commentators’ concerns that the focus on pecuniary factors required that alternate investments be precisely identical from an economic perspective before permitting consideration of other factors. By adopting the “equally serves” standard, the final rule recognizes that investments can differ in a wide range of attributes while ultimately serving the financial interests of the plan. The final rule eliminates both the current rule’s documentary requirements applicable to the tie-breaker and the proposed rule’s requirement that the collateral benefit of the chosen investment be disclosed to participants and beneficiaries.

With respect to participant-directed defined contribution plans, the final rule provides that fiduciaries will not breach their duty of loyalty if, when constructing the plan’s investment menu, the fiduciaries take into account the non-financial policy, social or value preferences of the participants in the plan. In so permitting, the DOL recognizes that accommodating participants’ preferences may lead to greater participation and deferral rates and therefore further the purposes of the plan. The final rule does not require plan fiduciaries to establish an investment menu for a self-directed defined contribution plan based upon participant preferences and is silent on what steps a fiduciary must take to establish its understanding of these preferences. Although consideration of participants’ preferences will not result in a breach of the duty of loyalty, fiduciaries must nevertheless remain mindful of their duty of prudence. The mere fact that some participants may request or prefer an investment alternative does not justify the inclusion of that alternative unless its selection is grounded in a prudent risk and return analysis.

Qualified Designated Investment Alternatives (QDIAs)

When participants in self-directed defined contribution plans fail to make an investment decision for assets allocated to their retirement accounts, ERISA permits the applicable plan to allocate those assets to one or more specified investment alternatives in the plan, until such time as the participant exercises investment control over those assets (a so-called “QDIA”). If the QDIA meets certain investment, diversification and other requirements, no person otherwise functioning as a fiduciary to the plan will be liable for the losses resulting from the automatic allocation of the assets to the QDIA. The current rule, based on changes made by the prior administration, required that, to qualify as a QDIA, an investment option could not include as its investment objectives, goals or principal strategies, non-pecuniary factors, such as ESG factors. The final rule eliminates the current rule’s prohibition on the use of a QDIA that includes an ESG (or other non-pecuniary) strategy.

Proxy Voting and Exercise of Shareholder Rights

The final rule retains the statement in the current rule that management of shareholder rights, including the right to vote proxies, is a fiduciary duty that must be carried out with the exclusive purpose of providing benefits to plan participants and beneficiaries and defraying the expenses of administering the plan. The final rule implements a number of changes that, taken together, reinforce the DOL’s long-held view that compliance with ERISA requires a proactive approach to the exercise of shareholder rights and that make it more difficult for fiduciaries to justify not exercising these rights (e.g., when the exercise of proxy voting rights may not align with the views of the plan sponsor).

The DOL eliminated language from the current rule stating that ERISA does not “require the voting of every proxy or the exercise of every shareholder right” that it believed could lead to fiduciaries being indifferent to, and therefore not exercising, shareholder rights. The final rule also states that if the fiduciary intends to rely on the advice of proxy advisers or other service providers to the plan with respect to the exercise of shareholder rights, it must ensure that it properly selects and monitors the adviser, including with respect to qualifications, fees, conflicts of interest and consistency between the adviser’s policies and actions and those established by the fiduciaries for the plan.

The final rule eliminates the requirement that fiduciaries maintain records of their exercise of these rights. In the adopting release, the DOL notes that proper record-keeping is already a fiduciary requirement and singling out the exercise of shareholder rights for special treatment may serve as a barrier to the exercise of those rights by implying they carry greater fiduciary obligations than other fiduciary activities. The DOL also eliminated the specific monitoring requirements contained in the current rule when shareholder rights are delegated to an investment manager or voting firm. Again, in the adopting release to the final rule, the DOL noted that the general selection and monitoring provisions of ERISA already provide sufficient protection to plan participants and beneficiaries, and that there was no reason to single out this instance of delegation. With respect to proxy voting guidelines, the final rule permits the adoption of voting policies that further the plan’s interests, but, consistent with the more principles-based approach of the final rule, eliminated two safe harbor policies contained within the current rule.

Note that the final rules appear to require additional diligence on the part of ERISA plan fiduciaries directing assets into pooled accounts, such as collective investment trusts. Although it is common for plans to agree during the onboarding process that the manager of the pooled account will vote any shares held by the vehicle, it may not be the case that the fiduciary has reviewed the manager’s voting policy. With the final rule, however, the DOL has stated that the fiduciary must assess whether agreeing to that policy is consistent with its fiduciary obligations under ERISA. As “negative consent” to a manger’s policy is not permitted, the DOL has provided until December 1, 2023, for plans to comply with this portion of the final rule.

Key Takeaways

The final rule enables fiduciaries of ERISA plans to incorporate ESG factors into the investment process, without the fear that doing so will result in a per se breach of fiduciary duty. The final rule is also a welcome nod to the important role that ESG factors currently play in the investment process of many investment managers who do not otherwise advertise themselves as ESG managers.

But, this may not be the last we hear from the DOL on these issues, as the interplay between fiduciary duties and ESG considerations has continued to be a political flashpoint.

The immediate task is for plan fiduciaries to consider carefully the final rule and then assess their plan investment policies and their plan delegation procedures related to the exercise of shareholder rights to ensure that these policies and procedures are aligned with plan participants interests and are in compliance with the rule.

Footnotes

[1] “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights,” published in the Federal Register on December 1, 2022. The final rule amends ERISA’s Investment Duties regulation, at 29 C.F.R. § 2550.404a-1.

Authors and Contributors

John J. Cannon III

Partner

Compensation, Governance & ERISA

+1 212 848 8159

+1 212 848 8159

New York

Doreen E. Lilienfeld

Partner

Compensation, Governance & ERISA

+1 212 848 7171

+1 212 848 7171

+1 650 838 3804

+1 650 838 3804

New York

Gillian Emmett Moldowan

Partner

Compensation, Governance & ERISA

+1 212 848 5356

+1 212 848 5356

New York

Matthew Behrens

Counsel

Compensation, Governance & ERISA

+1 212 848 7045

+1 212 848 7045

New York