There has been growing interest in sustainable investing1—that is, using an investment decision-making process that adds the analysis of financially material Environmental (E), Social (S) and Governance (G) factors to the investment process—including by employee benefit plans (“plans”) that are subject to the Employee Retirement Income Security Act of 1974 (“ERISA”), such as participant-directed individual account plans. This has raised the question of whether, and to what extent, investment fiduciaries for such plans can consider ESG factor integration consistent with their fiduciary responsibilities under applicable laws.
Over the years and through changes in presidential administrations, the US Department of Labor (“DOL”) has issued guidance on ESG investing for plan fiduciaries.2 While this guidance had appeared at times to vary in its approach to considering ESG factors in plan investment decisions, DOL’s basic position has remained the same—that ERISA plan fiduciaries should make investment decisions based foremost on prudent investment considerations, and should not sacrifice investment return or take on additional investment risk in order to promote “collateral” objectives such as social policy goals. This paper discusses DOL’s guidance, as most recently updated in November 2020, and then provides general considerations for plan fiduciaries when investing plan assets in investment funds with strategies that take ESG factors into account.
1. ESG investing
One of the difficulties in applying fiduciary standards to sustainable or ESG investing is that the term has no precise, agreed-upon definition. Roughly speaking, sustainable investing is understood to cover consideration of the following as part of an investment decision-making process:
- Environmental—the environmental impact of a firm’s products or practices, such as with regard to the mining, production or use of fossil fuels;
- Social—the social impact of a firm’s products or services, such as the firm’s labor relations or effect on local communities; and
- Governance—a firm’s corporate governance structure, such as with regard to executive leadership, executive pay and compliance.
There is an ongoing debate as to whether investing that takes into account ESG factors provides more than just the collateral benefit of furthering a sustainability goal, in the form of improved investment return and reduced risk, and whether consideration of ESG factors should in fact be mandated for institutional investors and investment fiduciaries. Ultimately, the question of whether ESG investing is an objectively better investment approach or plays an appropriate role in a diversified investment portfolio is one for investment professionals. This paper focuses instead on the legal standard that applies to the decision to take any or all ESG factors into account as part of a fiduciary’s prudent investment process.
2. DOL guidance
ERISA requires plan fiduciaries to act prudently and solely in the interest of a plan and its participants and beneficiaries in making investment decisions. As such, a plan’s investment fiduciaries are, in the first instance, required to consider only those factors relevant to the prudence of the particular investment decision, including the degree of risk, maximization of returns, diversification and furtherance of a plan’s funding objectives. On this basis, DOL’s consistent view over the years has been that ERISA’s fiduciary duty rules do not permit fi duciaries to sacrifi ce the economic interests of a plan to promote “collateral” goals.
The question as to how ERISA’s fiduciary standards apply to investments aimed at promoting “collateral” goals first arose in the early 1980s. At that time, DOL was asked to provide guidance on the application of the ERISA fiduciary responsibility rules to so-called “socially responsible” investing, which had the goal of, for example, ending apartheid in South Africa or stimulating local economies. DOL’s consideration of these questions culminated in 1994 with the issuance of Interpretive Bulletin 94-1, describing the application of the ERISA fiduciary provisions to “economically targeted investments,” or ETIs, which DOL defined as investments selected for the economic benefits they create apart from their investment return to the plan—for example, through financing projects that hire members of the union that sponsors the plan.
This guidance has been revised several times since 1994. The revisions in 2008, 2015 and 2018, like the 1994 Interpretive Bulletin, took the form of sub-regulatory guidance—guidance that did not have the force of a formal regulation. In November 2020, DOL took the additional step of codifying its guidance in the form of a formal regulation that was the result of notice-andcomment rulemaking.3 As such, the current DOL position can, under the standards established by the current Administration and case law, be cited by the government and private plaintiffs as binding authority in enforcement actions and litigation and may be given deference by courts. It can only be revised through another notice-andcomment rulemaking process, or by legislation enacted by Congress.4
The regulation becomes effective on January 12, 2021, with one exception discussed below relating to the subsection on “qualified default investment alternatives,” or QDIAs.
The DOL regulation restates the basic standard from DOL’s prior guidance, that to comply the ERISA fiduciary duty of loyalty, a “fiduciary may not subordinate the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to other objectives, and may not sacrifice investment return or take on additional investment risk to promote non-pecuniary benefits or goals.” The current DOL position is that, to meet this standard, a plan fiduciary must evaluate an investment based only on “pecuniary” factors, subject to two limited exceptions discussed below.
The regulation defines the term “pecuniary factor” as follows:
- Factor that a fiduciary prudently determines is expected to have a material effect on the risk and/or return of an
investment based on appropriate investment horizons consistent with the plan’s investment objectives and the funding policy established pursuant to section 402(b)(1) of ERISA.
In determining whether a factor is “pecuniary,” a fiduciary may, among other things, take into account prevailing views of investment professionals.
The regulation adds that the weight given in considering any pecuniary factor should “appropriately reflect a prudent assessment of its impact on risk-return.” This is intended to prevent fiduciaries from circumventing the rule by giving undue weight to what should be relatively minor considerations.
The prior guidance had described a “tie-breaker” rule—the concept that, all other things being equal based on risk and return considerations, a fiduciary is permitted to take into account non-financial considerations. Recognizing that all other things are rarely ever equal, the revised formulation of this rule permits a fiduciary to apply non-pecuniary factors, and to make an investment decision based on such non-pecuniary factors, when the fiduciary is “unable to distinguish [among investment alternatives] on the basis of pecuniary factors alone.” This should provide more flexibility in determining when the exception can be available, although DOL observed that these circumstances should, in its view, be relatively uncommon.
To rely on this exception, the fiduciary is required to document:
- why pecuniary factors were not sufficient,
- how the selected investment compares to the other comparable investments on the basis of prudence (specifically, based on the prudence factors enumerated in other parts of the same regulation, such as risk, return and diversification), and
- how the chosen non-pecuniary factors are consistent with the interests of the plan participants and beneficiaries in their retirement income or financial benefits under the plan.
In regard to the last point, DOL noted that the types of non-pecuniary factors that may be taken into consideration are subject to ERISA’s general loyalty obligation. Thus, for example, while creating jobs for current or future plan participants could be a permitted consideration, reflecting a fiduciary’s “personal policy preferences” would not. DOL noted that, in the context of a participant-directed plan, participant preferences for certain types of investments could be a permitted non-pecuniary consideration. This is an important clarification, as it has become increasingly common for plan participants to request that the plan’s investment options include ESG-themed investment funds.
This exception permits a fiduciary to consider non-pecuniary factors in the selection and oversight of designated investment alternatives for a participant-directed individual account plan. Under this exception, a fiduciary may consider investment funds that promote, seek or support non-pecuniary goals, provided the fiduciary satisfies the basic prudence and loyalty standards described in the regulation in selecting the fund and the fund is not used as, or as a component of, a “qualified default investment alternative,” or QDIA.
DOL emphasized that this is a limited exception, which applies only if the alternatives can be justified solely on the basis of pecuniary factors. Choosing investments that expect reduced returns or greater risks to secure nonpecuniary benefits would not meet this standard. Thus, fiduciaries should carefully review prospectuses and other disclosure documents to see if they include statements to that effect.
The 2018 guidance had explained that in the case of an investment platform that allows plan participants an opportunity to choose from a broad range of investment alternatives, adding one or more “ESG-themed” funds to the platform, in response to participant requests for investments that reflect their personal values, does not necessarily result in forgoing the availability of non-ESG-themed investment alternatives. Rather, in such instances, a prudently selected, well-managed and properly diversified ESG-themed investment alternative could serve to expand the available investment options on the platform, without requiring the plan to forgo making non-ESG-themed investment options available. DOL restated this rationale in explaining the limitation on QDIAs, reasoning that selecting a fund as a QDIA is not analogous to merely offering an additional investment alternative as part of a prudently constructed lineup. Thus, the assumption behind this exception is that any ESG-themed funds would be made available in addition to, and not in place of, a basic lineup of investment alternatives that do not consider non-pecuniary factors.
According to the regulation, the prohibition against using funds as QDIAs if they consider non-pecuniary factors applies only if the fund’s described investment objectives or goals, or its principal investment strategies, include, consider or indicate the use of one or more nonpecuniary factors. The purpose of this approach is to provide a test that DOL believes can be applied objectively without difficulty.
The QDIA limitation is the one part of the regulation that does not become effective in January 2021. Recognizing that some plans may need to make changes to their QDIAs to comply with the limitation, DOL postponed its effective date to April 30, 2022.
The proposal that preceded the recently adopted regulation had generally been understood as intended to restrict SG factor-based investing, in large part because it had applied its standards specifically to ESG-based/branded investments. As a result, many commenters criticized the proposal as creating a presumption that ESG investing by its nature is based on non-pecuniary factors, requiring additional steps and documentation to demonstrate otherwise. The critics countered that ESG factors can in fact be pecuniary factors, a point recognized in DOL’s 2015 guidance but subsequently questioned in DOL’s 2018 guidance (following a change in Administration).
In response this criticism, DOL eliminated all references in the regulation itself to ESG factors, instead reframing the rule as a more general standard based on pecuniary vs. non-pecuniary considerations, as described above. DOL emphasized that the final regulation does not single out ESG investing or any other investment approach for particularized treatment, recognizing that at least some ESG factors may, at times, also be pecuniary factors that a fiduciary may properly consider as such under the standards of the regulation, without the need to invoke either of the limited exceptions.
But it is still possible that the standards under the regulation could raise questions on ESG-based investing. DOL cautioned fiduciaries against “too hastily concluding that ESG-themed funds may be selected based on pecuniary factors or [under the “tie-breaker” rule] are not distinguishable based on pecuniary factors.”
One area that DOL singled out as raising questions is the approach of using investment “screens,” which screen out investments viewed as unacceptable or controversial, such as by excluding companies that manufacture fossil fuels or guns, or those doing business in foreign countries with unfavorable human rights records. DOL commented in the final regulation notice that “positive” or “negative” screens may not comply with the rule if they are based on non-pecuniary factors, reasoning that it would first be necessary to conduct a prudent analysis to determine that the exclusion would not be economically harmful to the plan. But DOL added that the regulation does not prevent selecting a negatively screened fund as a QDIA if no non-pecuniary factors are reflected in its stated investment objectives or principal strategies.
The duty of loyalty standards described in the regulation do not apply to investment options in a participant-directed individual account plan that are not “designated investment alternatives.” This has the effect—as DOL acknowledged—of excluding investments available under a self-directed brokerage window from these standards. But DOL cautioned that there would not be any exception for a plan that does not designate any “designated investment alternatives” for plan participant investment, so that a plan could not avoid these rules by providing only a brokerage window.
A 2016 DOL interpretive bulletin had said that ESG factors could be incorporated into a plan’s investment policy statement. But according to the 2018 DOL guidance, this should not be read to mean that ERISA requires investment policy statements to include ESG-based guidelines. DOL further noted that if ESG factors are included, they would have to be disregarded if their application would be imprudent or otherwise inconsistent with ERISA’s fiduciary responsibility rules. The 2016 and 2018 guidance, while not specifically superseded by the subsequent regulation, should presumably be applied in light of the standards described in the 2020 regulation, meaning that ESG factors should only be incorporated into a plan’s investment policy statement if they qualify as pecuniary factors or fit into one of the two exceptions that permit consideration of non-pecuniary factors.
3. General considerations for plan fiduciaries
Because of the pattern of each new Administration issuing its own variation on the original ETI guidance (in 2008, 2015 and now 2020), plan fiduciaries have been concerned about possible uncertainties and risks in relying on whatever has been the then-current DOL position. However, as noted above, one thing never changes—the fundamental principle that ERISA plan fiduciaries should make investment decisions based foremost on prudent investment considerations, and should not sacrifice investment return or take on additional investment risk in order to promote “collateral” or “non-pecuniary” objectives such as social policy goals. Thus, to the extent the consideration of ESG factors is part of a prudent investment analysis, such consideration can be viewed as consistent with ERISA’s fiduciary standards. If not, then the question is whether those factors are being applied to alternative available investments that, under the current formulation, cannot be distinguished on the basis of pecuniary factors alone or—in the case of designated investment alternatives for participant-directed plans—are not intended to secure non-pecuniary benefits at the expense of reduced returns or greater risks. This leaves plan fiduciaries, with the aid of investment consultants and other professionals, to draw their own conclusions as to how they understand ESG considerations to factor into their prudent investment analysis and to act accordingly.
A related consideration is how plan fiduciaries should document such an analysis. As a general matter, fiduciaries are well-advised to document that they followed a prudent investment process in making investment decisions, such as in the selection of a plan’s designated investment alternatives, to create a contemporaneous record of this process in the event of a future challenge. In the most recent DOL guidance, a fiduciary is generally required to document the basis on which it believes it is able to consider non-pecuniary factors in making an investment decision, including why pecuniary factors were not sufficient, how the selected investment compares to others on the basis of prudent investment considerations, and how the non-pecuniary factors taken into account are consistent with the interests of the plan participants and beneficiaries in their retirement income. While there are no specific documentation requirements associated with the exception for selecting and overseeing designated investment alternatives for a participant-directed plan, it may be advisable to maintain such documentation under that exception as well. Thus, ERISA plan fiduciaries should look to document their consideration of ESG factors to the extent necessary to be able to demonstrate, if challenged, that they followed the standards described in the DOL guidance.
4. Summary of key points
- To summarize the key points of this paper, the current state of the DOL guidance on ESG investing provides as follows:
- ERISA requires that plan fiduciaries not sacrifice a plan’s economic interests to promote “non-pecuniary” goals, thereby requiring that fiduciaries in the first instance make investment decisions by focusing on pecuniary factors—that is, on the basis of an investment’s expected risk and return based on appropriate investment horizons.
- ESG factors may not be “non-pecuniary,” though, but rather “pecuniary,” by reason of having a direct relationship to the economic value of the investment, in which case these factors would be appropriate considerations in a prudent investment analysis.
- Key determination—whether the ESG factors are “pecuniary”
- If not, then the ability to consider them would require coming within one of the exceptions.
- If they are, they still must be given only their appropriate weight in light of the other relevant economic factors.
- ESG factors, particularly if “pecuniary,” can be part of a plan’s investment policy statement, but are not required to be so, and would have to be disregarded if their application would be imprudent or otherwise inconsistent with ERISA’s fiduciary responsibility rules.
- ESG-themed funds may be included as designated investment options for participant-directed plans, if prudently selected based on pecuniary factors.
- Prior guidance suggested that ESG-themed funds could be appropriate if in addition to other, non-ESG themed investment options.
- However, an ESG-themed fund should not be selected if it discloses that it expects reduced returns or greater risks to secure non-pecuniary benefits.
- ESG-themed funds that, as part of their investment objectives or goals, consider or use non-pecuniary factors could not serve as a plan’s QDIA.
- In addition to documenting their actions as necessary to meet the requirements of the regulation, including the “tie-breaker” exception, plan fiduciaries should consider documenting their consideration of ESG factors to the extent necessary to demonstrate, if challenged, that they followed the standards in the DOL guidance, to help show compliance with their ERISA fiduciary obligations.