Retirement plans and sustainable investing—current guidance for plan fiduciaries

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 October 2021, 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 or exposure of a firm’s products or practices, such as with regard to the impact of mining, production or use of fossil fuels or exposure to business locations or activities in areas subject to climate risks;
  • Social—the social impact of a firm’s products or services, such as with regard to workforce practices (for example, diversity and inclusion3), 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. The most recent DOL rulemaking, a proposed regulation from October 2021, cites studies on all sides of this debate—finding benefits to ESG investing, no benefits to ESG investing and no discernable difference. 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 fiduciaries to sacrifice the economic interests of a plan to promote “collateral” goals.

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 and 2021), 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 additionalinvestment risk in order to promote “collateral” or “non-pecuniary” objectives such as social policy goals. The October 2021 proposed changes, if they go forward, would (using slightly different language) follow this basic pattern, by not permitting plan fiduciaries to sacrifice investment return or take on additional investment risk to promote “benefits or goals unrelated to the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan.” Thus, as the October 2021 changes would further emphasize through adding examples to the regulation, 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 November 2020 DOL guidance, a fiduciary would generally be required to document with specificity 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. (These documentation requirements would be removed under the October 2021 proposal, on the basis that it is unnecessary to single out these types of investments for special treatment when fiduciaries, based on their general ERISA prudence obligation, commonly document and maintain records about their investment decisions to demonstrate they have acted prudently.) 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, as pending changes would further emphasize.
  • 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 (although this restriction would be repealed by pending changes, leaving QDIA selection subject to the general standard for selecting ESG-themed funds as plan investment options)
  • In addition to documenting their actions as necessary to meet the requirements of the regulation (unless those specific documentation requirements are repealed, in which case as necessary to demonstrate prudence), 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