On November 22, 2022, the Department of Labor (“DOL”) released its final rule entitled, “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights.” 87 Fed. Reg. 73822 (Dec. 1, 2022) (the “New Rule”). The New Rule becomes effective January 30, 2023, and replaces and modifies parts of the DOL’s 2020 regulation entitled, “Financial Factors in Selecting Plan Investments,” 85 Fed. Reg. 72846 (Nov. 13, 2020) (the “Prior Rule”). The DOL notes that the purpose of this New Rule is, in part, to address “the chilling effect and other potential negative consequences caused by the Prior Rule with respect to the consideration of climate change and other environmental, social, and governance (“ESG”) factors.”
We see the New Rule as falling within a pattern of prior ESG regulations and guidance. Going back at least 30 years, there has been a ping-ponging between administrations regarding DOL ESG regulations and guidance.[1] The media tends to portray Republican regulations and guidance as restricting ERISA plans’ ability to make ESG investments and tends to portray Democratic regulations and guidance as making it easier to make ESG investments. Although the discussion in the media highlights the atmospherics of the issue, the actual legal impact of these regulations and guidance is quite small. Ultimately, the binding rule governing ERISA fiduciary investment management decisions comes from ERISA itself, as interpreted by the Supreme Court. Both the ERISA statute and Supreme Court precedent are clear that fiduciary investment management decisions should be made for the exclusive purpose of maximizing financial returns on a risk-adjusted basis in order to provide the benefits due under the plan and to defray the reasonable costs of administering the plan.
The New Rule falls within this statutory framework. It provides that consideration of ESG factors may be appropriate when reasonably determined to be relevant to a risk-return analysis — but generally not for a non-financial collateral purpose. It also removes language from the proposed rule that could have been read as putting a thumb on the scale in favor of ESG investing.[2]
We see two key takeaways from the New Rule. First, employer plan fiduciaries may want to consider updating their investment policy statements and proxy voting policies to conform with provisions of the New Rule, even if doing so merely documents long-standing practices for how financial factors are considered in investment and proxy voting decisions. Second, employer plan fiduciaries should avoid potential traps for the unwary in the New Rule when considering making an ESG investment or adding an ESG investment option. While employer plan fiduciaries may consider adding an ESG investment option because of participant preferences, plan fiduciaries should be wary of misleading media reports that it is now permissible to justify doing so because of such preferences. Relatedly, we see significant risk in adopting an ESG investment or option for a collateral purpose to break a perceived tie with another investment. Instead, the clearest path to adopting an ESG investment or option, most safely and without unnecessary legal risk and uncertainty, is to do so for the express purpose of maximizing risk-adjusted financial returns and to contemporaneously document the reasons for that determination.
Summary of the New Rule
The New Rule provides guidance on the fiduciary duties of prudence and loyalty as they apply to the selection of plan investments. With respect to the duty of prudence, the New Rule provides that a fiduciary must give “appropriate consideration to those facts and circumstances that . . . the fiduciary knows or should know are relevant to the particular investment or investment course of action.” 29 CFR § 2550.404a-1(b)(1)(i). The rule defines appropriate consideration to include a “determination by the fiduciary that the particular investment or investment course of action is reasonably designed, as part of a portfolio . . . or menu, to further the purposes of the plan, taking into consideration the risk of loss and the opportunity for gain . . . compared to the opportunity for gain (or other return) associated with reasonably available alternatives with similar risks.” Id. § 2550.404a-1(b)(2)(i). Moreover, the rule stresses that a “fiduciary’s determination with respect to an investment or investment course of action must be based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis.” Id. § 2550.404a-1(b)(4). As the New Rule provides, “[r]isk and return factors may include the economic effects of climate change and other environmental, social, or governance factors on the particular investment or investment course of action.” Id. But “[w]hether any particular consideration is a risk-return factor depends on the individual facts and circumstances.” Id.
With respect to the duty of loyalty, the New Rule provides that 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 benefits or goals unrelated to interests of the participants and beneficiaries in their retirement income or financial benefits under the plan.” Id. § 2550.404a-1(c)(1). The New Rule also retains a modified version of the tiebreaker rule from prior guidance, stating that if a fiduciary “prudently concludes that competing investments, or competing investment courses of action, equally serve the financial interests of the plan over the appropriate time horizon, the fiduciary is not prohibited from selecting the investment, or investment course of action, based on collateral benefits other than investment returns.” Id. § 2550.404a-1(c)(2). But a fiduciary may not “accept expected reduced returns or greater risk to secure additional benefits.” Id. The New Rule also contains a new provision that provides that a “plan fiduciary of a participant-directed individual account plan does not violate the duty of loyalty . . . solely because the fiduciary takes into account participants’ preferences in a manner consistent” with the duty of prudence. Id. § 2550.404a-1(c)(3). As a result, this provision affords fiduciaries some protection from a duty of loyalty challenge for considering participants’ preferences, but does not operate to waive a fiduciary’s duty of prudence, which independently requires the selection of investment options to be “grounded in the fiduciary’s prudent risk and return analysis.” 85 Fed. Reg. at 73842.
The New Rule also confirms that these fiduciary duties extend to the “management of shareholder rights,” including “the right to vote proxies.” Id. § 2550.404a-1(d)(1). Specifically, the New Rule notes that when exercising these rights, “fiduciaries must carry out their duties prudently and solely in the interests of the participants and beneficiaries.” Id. § 2550.404a-1(d)(2)(i). As with selecting investments, the plan fiduciary must “act solely in accordance with the economic interest of the plan” and “consider any costs involved.” Id. § 2550.404a-1(d)(2)(ii). Moreover, before adopting a practice of following the recommendations of a proxy advisory firm, a plan fiduciary must determine that the firm’s proxy voting guidelines are consistent with the fiduciary’s duties under the rule. Id. § 2550.404a-1(d)(2)(iii). The New Rule allows fiduciaries to adopt proxy voting guidelines consistent with their obligations but requires those guidelines to be reviewed periodically. Id. § 2550.404a-1(d)(3).
Comparing the New Rule to the Prior Rule and Proposed Rule
The New Rule differs, in important ways, from both the Prior Rule and the Biden Administration’s proposed rule. The New Rule, in keeping with the proposed rule, eliminates the Prior Rule’s prohibition against “adding or retaining any investment fund, product, or model portfolio as a qualified default investment alternative (QDIA) . . . if the fund, product, or model portfolio reflects non-pecuniary objectives in its investment objectives or principal investment strategy.” Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights, 86 Fed. Reg. 57272, 57272 (Oct. 14, 2021). The New Rule also loosens the criteria from the Prior Rule for when the tiebreaker rule can be used. The Prior Rule required that a fiduciary be “unable to distinguish [investment alternatives] on the basis of pecuniary factors alone” and meet certain documentation requirements in order to implement the tiebreaker rule. 85 Fed. Reg. at 72884. The New Rule eliminates those documentation requirements and allows use of the tiebreaker rule where competing investment alternatives “equally serve the financial interests of the plan over the appropriate time horizon.” 29 CFR § 2550.404a-1(c)(2).
The New Rule also eliminates much of the language in the proposed rule that some commentators viewed as a de facto mandate to consider ESG factors. For example, the New Rule eliminates language stating that appropriate consideration of the projected return of the portfolio “may often require an evaluation of the economic effects of climate change and other environmental, social, or governance factors on the particular investment or investment course of action.” 86 Fed. Reg. at 57302. Additionally, the New Rule eliminates the proposed rule’s detailed description of potentially relevant ESG factors. The DOL explained that it made these changes to avoid creating an apparent regulatory bias in favor of ESG factors. 87 Fed. Reg. at 73830.
Further, the New Rule eliminates language in the Prior Rule that the fiduciary duty to manage shareholder rights appurtenant to shares of stock held by a plan “does not require the voting of every proxy or the exercise of every shareholder right.” 87 Fed. Reg. at 73828. The New Rule also eliminates two “safe harbor” examples of proxy voting policies that the DOL believed encouraged abstention as a normal course. Id. The New Rule eliminated a specific monitoring requirement for the use of investment managers and proxy voting firms in favor of a more general monitoring obligation. Id.
Although the New Rule represents a smaller change from the Prior Rule than the proposed rule would have, there are still important aspects of the New Rule that employer plan fiduciaries should consider:
Updates to Investment Policy Statements
Employer plan fiduciaries may want to consider documenting in their investment policy statements how investment managers should analyze financial factors with respect to different investment strategies. For example, fiduciaries may want to make explicit that (A) financial factors considered by fiduciaries could include the economic effects of ESG factors depending on individual facts and circumstances, and (B) when implementing a mandate to ensure diversification at lower costs through investing a portion of the plan’s assets in passive, broad-based indices that track major asset classes,[3] it is unnecessary to expend resources analyzing further financial factors (including ESG factors).
Requirements for Including ESG Funds in 401(k) Plans
Much of the reporting on the New Rule has suggested that it greenlights the inclusion of ESG funds and strategies in defined benefit retirement plan portfolios as well as in defined contribution plan investment menus. As a result, there may be an increased push from some plan participants and asset managers to include ESG funds in the menu of investment alternatives in defined contribution plans. Employer plan fiduciaries should remember that, although the rule clarifies that ESG factors may be relevant for the risk and return analysis, the rule does not allow a fiduciary to choose any investments or investment alternatives unless they meet the financial risk and return analysis required by the duty of prudence. When choosing to include an ESG investment option in a Plan, employer plan fiduciaries should engage in a prudent process documenting why the investment is likely to produce superior risk-adjusted returns, just as they would for any non-ESG investment option.
Employing the Tiebreaker Rule
The New Rule, in keeping with prior guidance, maintains a tiebreaker rule that allows non-financial collateral considerations to be taken into account when two competing investment alternatives “equally serve the financial interests of the plan.” Notwithstanding DOL’s longstanding position authorizing the use of tiebreaker rules, employer plan fiduciaries should be cautious in relying on them. Some commenters have noted that the tiebreaker rule is inconsistent with ERISA’s exclusive financial benefit purpose, leaving this provision potentially subject to legal challenge. To avoid this and other risks, fiduciaries may wish to distinguish between investment alternatives through the standard risk-return analysis without reliance on the tiebreaker rule.
Reviewing and Updating Proxy Voting Policies
The New Rule makes changes to the DOL’s proxy voting guidance from the Prior Rule that the current DOL felt encouraged abstention on the part of fiduciaries. This change and other, similar statements reflect DOL’s attention to fiduciary responsibilities related to shareholder rights, such as proxy voting. This attention extends to the New Rule’s requirement that fiduciaries periodically review their proxy voting policies, to the extent they have them. Given these statements, fiduciaries should consider reviewing and updating their proxy voting policies to ensure that they comply with the New Rule’s guidance on the exercise of shareholder rights.
If you have any questions concerning the material discussed in this advisory, please contact the members of our Employee Benefits and Executive Compensation and ESG practice groups.
[1] While the labels and underlying policy concerns have changed over time (e.g., anti-apartheid, anti-tobacco, economically targeted investments, social investing, and now ESG), the ultimate question remains the same: To what extent can employer plan fiduciaries account for concerns other than purely financial factors when selecting investments or investment alternatives and exercising shareholder rights with assets of ERISA plans? The current ESG label is broader and largely subsumes the past, more focused labels; it also makes a more explicit claim of financial materiality than earlier iterations of this phenomenon. But regardless of labels, the fundamental issue remains: What is the line between investment and shareholder activities that are permitted under ERISA and those that are prohibited? For convenience of reference, we have referred above to the current ESG iteration and past iterations as being encompassed by the ESG label.
[2] The DOL’s move toward the statutory center from the proposed rule to the final rule mirrors a similar move made by the DOL in the prior administration when promulgating its proposed and final rules on fiduciary duties.
[3] Of course, any such mandate should itself be established and maintained in compliance with ERISA fiduciary duties.
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