It has been widely reported that the Department of Labor (DOL) has published its new Environmental, Social, and Governance (ESG) final regulation. Depending on one’s perspective, that characterization ranges from somewhat accurate to quite inaccurate. Of course, one’s perspective on ESG may be heavily influenced by one’s political leaning. This month’s QPA Advocate offers an apolitical view of what is – and what is not – included in the DOL’s final regulation.

Notably, you’re reading the second version of this newsletter article. Despite the final regulation being quite short and largely including a recitation of generally accepted fiduciary principles, there is a lot to unpack when we consider the widely swinging ESG pendulum. After drafting an article that would have been far too long to hold most readers’ attention, we pivoted to this version in an attempt to really highlight what you need to know right now. We hope you’ll tune into next week’s Fiduciary 15 webinar and read our upcoming White Paper for additional details.

Historical Background. ERISA section 404 sets forth the fiduciary duties of prudence, loyalty, and diversification. For many years, the DOL has interpreted those duties to dictate that plan fiduciaries place paramount importance on a plan’s financial returns and risks. Through “sub-regulatory” guidance, the DOL had recognized that ERISA does not preclude fiduciaries from making investment decisions that reflect ESG considerations or choosing economically targeted investments selected in part for benefits in addition to the impact those considerations could have on investment returns. However, as the DOL confirmed in the Preamble to the new final regulation, the DOL “has a longstanding position that ERISA fiduciaries may not sacrifice returns or assume greater investment risks as a means of promoting collateral social policy goals.”

2020 Regulation. The last few years have seen increased interest in the availability of ESG funds within employer-sponsored retirement plans and the concern that some employers might do just what the DOL has admonished: sacrifice returns or accept greater investment risks through ESG funds as a means of promoting social policy goals. In the waning weeks of the Trump administration, the DOL published a final regulation with the clear intention of stifling that thinking. This regulation overrode the historical approach with a new requirement that plan fiduciaries select investments based solely on consideration of “pecuniary factors”. It also imposed an explicit prohibition on the designation of any investment solution as a qualified default investment alternative (QDIA) if the solution included even one non-pecuniary objective in its investment objectives or principal investment strategies.

2022 Regulation: What It Says. The new regulation replaces the 2020 regulation referenced above, as well as a tandem 2020 regulation relating to proxy voting and exercising other shareholder rights. We’ll focus today on the portion relating to “Prudence and Loyalty in Selecting Plan Investments” and save the proxy voting discussion for another day.

The DOL used nearly 22 pages of discussion within the final regulation’s Preamble to address its thought process regarding the prudence and loyalty portion of the regulation, which ultimately occupies only 2/3 of a page in the Federal Register. The regulation includes these key passages:

1. A reminder of the duties of loyalty and prudence within ERISA section 404.
2. A plan fiduciary will breach its duty of prudence if it fails to determine that a particular investment is reasonably designed to further the purposes of the plan, taking into consideration the risk of loss and the opportunity for gain compared to reasonably available alternatives.
3. A plan fiduciary will breach its duty of prudence if its determination with respect to an investment is not based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis. Importantly, risk and return factors may include the economic effects of climate change and other ESG factors on the particular investment, and the weight given to any factor by a fiduciary should appropriately reflect a reasonable assessment of its impact on risk-return.
4. A plan fiduciary will be considered to breach its duty of loyalty if it were to subordinate the interests of the participants and beneficiaries to their retirement income or financial benefits under the plan to other objectives. The regulation prohibits fiduciaries from sacrificing investment returns or taking on additional investment risk to promote benefits or goals unrelated to participants’ interests in their retirement income or financial benefits under the plan.
5. If a fiduciary prudently concludes that competing investments equally serve the financial interests of the plan over the appropriate time horizon, the fiduciary is not prohibited from selecting the investment based on collateral benefits other than investment returns. Importantly, though, a fiduciary may not accept expected reduced returns or greater risks to secure such additional benefits.
6. A plan fiduciary will not violate the duty of loyalty solely because it takes into account participants’ preferences, provided that it does so in a manner consistent with the duty of prudence.

Commentary. The journey to the new regulation is best viewed through the swings of the ESG pendulum. As described above, the DOL has long held that ERISA fiduciaries may not sacrifice returns or assume greater investment risks as a means of promoting collateral social policy goals. As interest in ESG investment options has grown over the last several years, we have seen greater concern that fiduciaries would be inclined to violate that longstanding DOL position.

The Trump administration responded to that concern by swinging the pendulum away from ESG with its “pecuniary factors” restriction. In the Preamble to the new regulation, the DOL emphasized that the 2020 regulation “puts a thumb on the scale against ESG factors”. It also believes that the 2020 regulation “chills fiduciaries from consideration of any ESG factors even when they are relevant to a risk-return analysis.”

When the DOL proposed to replace the 2020 regulation with a proposed regulation in 2021, it swung the pendulum back in the other direction. The proposal included most of the language in the key passages above, much of which is neutral and relatively unobjectionable. However, the proposal included additional language that would reasonably be viewed as swinging the pendulum “left of center”.

Now, in the Preamble to the final regulation, the DOL demonstrated self-awareness and emphasized its preference for neutrality and flexibility over any mandate or prohibition. The DOL expressed a preference for a final regulation that does not put a thumb on the scale for or against the consideration of ESG factors. In order to accomplish a more pendulum-neutral position, within the final regulation the DOL:

• Retains the longstanding principle that the duties of prudence and loyalty require that fiduciaries focus on relevant risk-return factors and not sacrifice returns or take on additional risk in order to promote collateral social goals.
• Deletes the mandate that fiduciaries consider only “pecuniary factors.”
• Removes the strict QDIA rules that would prohibit the use of any ESG fund.
• Removes the tiebreaker rule and corresponding disclosure requirements, replacing those provisions with the requirement that any selected investment option must “equally serve the financial interests of the plan over an appropriate time horizon”.
• Removes language from the proposed regulation that could have been construed as endorsing ESG funds by stating that the risk and return analysis “may often require” the consideration of several enumerated examples of climate change and other ESG factors. The final regulation language notes that the risk and return analysis “may include” – but will not require – the economic effects of climate change and other ESG factors on the particular investment.
• Removes the list of those enumerated examples.
• Confirms that a fiduciary “remains free under the final rule to determine that an ESG-focused investment is not in fact prudent.”

What Now? We acknowledge that the final regulation is not perfectly neutral with respect to fiduciaries’ ability to consider ESG factors. However, it reflects the DOL’s commitment to a better compromise between the 2020 regulation (which chilled fiduciaries’ abilities to consider ESG factors) and the 2021 proposed regulation (which included a handful of passages widely interpreted as endorsing the consideration of ESG factors).

We now have a roadmap that largely sustains the DOL’s longstanding principles, but also helps fiduciaries to better understand how they might consider ESG factors – to the extent they desire to do so. They’re no longer prohibited from doing so. But they’re also not required or encouraged to do so. As we mentioned above, we hope you’ll join next week’s Fiduciary 15 webinar, which will focus heavily on the application of that roadmap to your organization’s plan.

– Matthew Eickman, J.D., AIF®