DOL Issues Final Rule For ERISA Fiduciaries Considering Socially Conscious Investments – Employee Benefits & Compensation

Employers offering 401(k) and similar retirement plans should
familiarize themselves with a new rule published by the Employee
Benefits Security Administration of the U.S. Department of Labor,
Prudence and Loyalty in Selecting Plan Investments
and Exercising Shareholder Rights, which takes effect on
January 30, 2023. This final rule clarifies how and when
fiduciaries of retirement plans subject to the Employee Retirement
Income Security Act (ERISA) can make investment decisions that
promote environmental, social, or governance (ESG) goals or
otherwise reflect ESG considerations.

ERISA Imposes High Standards on Retirement Plan
Fiduciaries

Most retirement programs, like 401(k) and 403(b) plans (other
than government or church-sponsored plans), are subject to ERISA.
One of ERISA’s notable features is its imposition of fiduciary
duties on those deemed to be a “fiduciary” under the
statute. ERISA fiduciaries include employers that sponsor
retirement plans and the individuals selected to serve on the
committee that makes investment decisions for the plan.

ERISA’s fiduciary duties include duties of prudence and
loyalty to the plan, its participants and their beneficiaries.
These duties include a requirement that fiduciaries exercise
reasonable care when selecting investment options available to plan
participants. They require fiduciaries to make selections that are
in the best interest of plan participants and beneficiaries.
Fiduciaries are also required to monitor diligently the performance
of any selected investment options on an ongoing basis to ensure
those investments remain prudent and to eliminate them and/or
replace them with other investment options if they cease to be
appropriate for the plan.

Fiduciaries Must Engage in Prudent Investment Analysis that
Serves the Best Interests of the Plan

Complying with ERISA’s fiduciary duties when determining
whether an investment option is acceptable for inclusion in a
retirement plan requires complex analysis of a variety of factors.
Fiduciaries must consider each potential investment’s prior
returns, the expenses associated with each investment, and whether
other cheaper and/or better-performing investment options are
available on the market. As these inquiries suggest, the necessary
analysis is typically confined to evaluating an investment’s
economic profile.

Put differently, fiduciaries have historically been encouraged
to look at financial performance, focusing on an investment’s
relative performance and risk and not its environmental or social
impact when determining whether it should be offered as an
investment option to plan participants. Indeed, prior DOL rules
enacted under the prior administration in 2020 heavily discouraged
the consideration of ESG factors in investment selection, stating
that non-financial considerations should never be placed higher on
the list of priorities than financial considerations when
investing.

The New Rule Eases Language Around the Consideration of
Collateral Factors in Selecting Plan Investments

The DOL’s new Prudence and Loyalty in Selecting Plan
Investments and Exercising Shareholder Rights rule clarifies how
ERISA’s fiduciary duties of prudence and loyalty apply to the
selection of investments, acknowledging that ESG considerations can
affect an investment’s value and long-term investment returns
for retirement investors. The final rule clarifies that, to satisfy
the duty of prudence, a fiduciary’s decision must be based on
factors that the fiduciary reasonably determines are relevant to a
risk and return analysis, and that such factors may include the
economic effects of climate change and other ESG
considerations.

In addition, the new rule makes changes to the prior
“tiebreaker” standard, under which ERISA’s fiduciary
duty of loyalty prohibited a fiduciary from considering collateral
factors-like ESG goals-to make investment decisions unless two
funds were economically indistinguishable. The prior standard
imposed special documentation requirements to establish the
existence of a tie that needed breaking before collateral factors
could be considered. The DOL’s new rule softens this language,
requiring only that a fiduciary prudently conclude that competing
investments or courses of action equally serve the financial
interests of the plan over the appropriate time horizon before
considering collateral benefits other than investment returns in
making an investment decision. It also removed the special
documentation requirements previously associated with the
“tiebreaker” rule.

While this shift in treatment of ESG factors provides increased
flexibility for plan fiduciaries, it does not alter the
longstanding principle that investment decisions be driven
primarily by risk and return. Indeed, the DOL’s new rule
specifies that fiduciaries cannot “sacrifice return or take on
additional investment risk to promote benefits or goals unrelated
to” the retirement or financial goals of employees
participating in the retirement plan. To that end, fiduciaries must
still consider all factors a “fiduciary knows or should know
are relevant to [a] particular investment[,]” including the
role each investment decision will play in a retirement plan’s
overall investment portfolio. And, the plan’s investment fund
menu must still be “reasonably designed” such that the
selected investment funds within it “further the purposes of
the plan” while considering the “risk of loss and
opportunity for gain” created by the risks and rewards
associated with alternative investment options. In short, the rule
allows fiduciaries to consider ESG factors as a secondary piece of
the analysis conducted to select investment funds, but does not
allow them to prioritize these collateral factors over financial
performance or limit their investment analysis to such factors
alone.

Takeaways

The DOL’s new rule clarifies that ESG factors can affect an
investment’s long-term value and may, in some circumstances, be
prudently considered as a factor relevant to a fund’s risk and
return analysis. It likewise softens language around the use of
collateral factors to make selections between funds that are
otherwise prudent selections to serve the interests of the plan and
its participants over the appropriate time horizon. Together, these
changes ease prior restrictions on a fiduciary’s ability to
consider ESG factors when making investment decisions.

Plan sponsors and fiduciaries, however, should understand that
this new rule does not permit them to elevate ESG considerations
over a fund’s financial risk and return when evaluating whether
to include or retain an investment option in a plan’s
investment lineup. Fiduciaries must continue to ensure that any
investment option offered or retained in a plan’s investment
lineup is fundamentally sound from a financial perspective, fits
the plan’s investment strategy, and that no superior
alternatives are available.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.