Fiddich Review Centre
Alternative Investment

DOL Issues Final Rule for ERISA Fiduciaries Considering Socially Conscious Investments

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. 

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