The US Department of Labor (the “DOL”) released a final rule on November 22, 2022 addressing the circumstances under which fiduciaries of plans governed by the Employee Retirement Income Security Act of 1974, as amended (“ERISA”) may consider environmental, social and governance (“ESG”) factors when making investment decisions. The final rule also addresses fiduciary responsibilities with respect to proxy voting and other shareholder rights. While the rule generally will be effective on January 30, 2023, some of the proxy voting provisions will not take effect until December 1, 2023.
The new rule, entitled Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights (the “Final Rule”), clarifies the role ESG factors may play within the traditional investment decision-making framework set out in ERISA. The Final Rule supports the conclusion that ESG factors may be economically material to an investment’s financial performance and recognizes that ESG factors can, in some circumstances, be just as relevant to an investment decision as more traditional financial and accounting factors. It de-emphasizes prior guidance’s focus on ESG and provides a broad gloss on fiduciary investment decision-making in general.
The Final Rule is a sharp about-face from prior DOL guidance published in 2020 (the “2020 Rule”). While the 2020 Rule did not explicitly ban ERISA-regulated fiduciaries from considering ESG factors, it cautioned fiduciaries against ESG funds, warning they should not “too hastily conclude that ESG funds may be selected …”
The 2020 Rule also imposed procedural requirements and additional restrictions for defined contribution plans that permit participant-directed investments. Many ERISA plan fiduciaries were concerned that this framework created significant additional risk of ERISA fiduciary liability if a fiduciary were to consider ESG factors, even where such factors were financially relevant.
Below we highlight three key changes instituted by the Final Rule:
1. Clarifies that ERISA-regulated fiduciaries may consider ESG factors that are relevant to an investment’s expected financial performance.
While the Final Rule is much more supportive of ESG than the 2020 Rule, the Final Rule does not mandate that ERISA fiduciaries must consider ESG factors. Rather, ESG factors can take their place among the myriad of financially relevant factors that fiduciaries may consider when making investment decisions on behalf of the plan, without any required additional documentation or justification.
In the preamble to the Final Rule, the DOL describes its concern that “the current regulation [the 2020 Rule] created a perception that fiduciaries are at risk if they include any ESG factors in the financial evaluation of plan investments.” At the same time, the DOL walked back language it had proposed implying that ESG factors must be considered in certain circumstances, stating it never intended to “improperly place a thumb on the scale in favor of ESG investing.”
2. Allows for consideration of participant preference, in certain circumstances.
The Final Rule adds a new provision stating that a fiduciary of a participant-directed individual account plan does not violate its duty of loyalty simply by taking participant preference into account, as long as it does so in a manner consistent with the requirements of the duties of loyalty and prudence. This new provision appears to be driven by comments regarding the impact of participant preference on participation in defined contribution plans. The preamble states that “if accommodating participants’ preferences will lead to greater participation and higher deferral rates, then it could lead to greater retirement security.”
The DOL notes that this position is not novel, but rather is intended to provide clarity on a position the DOL described when adopting the 2020 Rule.
3. Eases consideration of “collateral benefits” by changing the standard for the “tie-breaker.”
DOL guidance on “social” or “economically targeted” investing has long included a “tie-breaker test,” whereby a fiduciary could consider collateral, or non-financial, factors to “break the tie” between investment options that are otherwise identical from a risk-return perspective. The 2020 Rule stated that a fiduciary could consider collateral benefits, including ESG factors, to distinguish only between otherwise “economically indistinguishable” investments, although such situations were seen to be unlikely. If a fiduciary did rely on the tie-breaker exception to consider collateral benefits, the 2020 Rule imposed specific documentation requirements.
The Final Rule changes the standard from “economically indistinguishable” to instances where “competing investments… equally serve the financial interests of the plan” and removes the documentation requirements. In the preamble, the DOL referenced comments stating that the 2020 Rule’s version of the tie-breaker singled out certain factors over other factors, “contrary to the principles of neutrality.” Notably, the DOL’s discussion in the preamble de-emphasizes ESG, listing several more general examples of possible collateral benefits.
In sum, the Final Rule imposes a significant change on the regulatory context surrounding ESG investing with ERISA plan assets. It also provides a broader look at what factors, in addition to ESG, an ERISA-regulated fiduciary may consider. Fiduciaries interested in these issues may wish to consult with consultants, attorneys and/or industry organizations on whether or how to adjust their fiduciary decision-making processes going forward.
Distributed by UBS Financial Services Inc. in collaboration with Morgan, Lewis & Bockius LLP.