DOL Seeks Stricter Limits on ESG Investing Under ERISA

The proposed regulation would “confirm that ERISA requires plan fiduciaries to select investments and investment courses of action based solely on financial considerations relevant to the risk-adjusted economic value of a particular investment.”

The U.S. Department of Labor (DOL) has proposed a new rule that would, in the words of Secretary of Labor Eugene Scalia, “update and clarify” the Department of Labor’s set of investment duties and requirements enforced under the Employee Retirement Income Security Act (ERISA).

In a statement published alongside the new regulation, Scalia says the rule is intended to provide “clear regulatory guideposts” for plan fiduciaries in light of recent trends involving environmental, social and governance (ESG) investing. While it will take some time for industry experts to understand the proposed regulation, Scalia’s characterization is that this new ESG framework represents a tightening of what is permissible under ERISA.

“Private employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan,” Scalia says. “Rather, ERISA plans should be managed with unwavering focus on a single, very important social goal—providing for the retirement security of American workers.”

The full text of the proposed regulation stretches to 62 pages. The summary explains that it will modify Title I of ERISA “to confirm that ERISA requires plan fiduciaries to select investments and investment courses of action based solely on financial considerations relevant to the risk-adjusted economic value of a particular investment or investment course of action.”

According to the DOL leadership, the proposal is designed “to make clear that ERISA plan fiduciaries may not invest in ESG vehicles when they understand an underlying investment strategy of the vehicle is to subordinate return or increase risk for the purpose of non-financial objectives.”

They say the proposal would make five core additions to the regulation, as follows:

  • New regulatory text is created to codify the department’s position that ERISA requires plan fiduciaries to select investments and investment courses of action based on financial considerations relevant to the risk-adjusted economic value of a particular investment or investment course of action.
  • A new express regulatory provision states that compliance with the exclusive-purpose (i.e., loyalty) duty in ERISA section 404(a)(1)(A) prohibits fiduciaries from subordinating the interests of plan participants and beneficiaries in retirement income and financial benefits under the plan to non-pecuniary goals.
  • A new provision is created that requires fiduciaries to consider other available investments to meet their prudence and loyalty duties under ERISA.
  • The proposal acknowledges that ESG factors can be pecuniary factors, but only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories. The proposal adds new regulatory text on required investment analysis and documentation requirements in the rare circumstances when fiduciaries are choosing among truly economically “indistinguishable” investments.
  • A new provision is created on selecting designated investment alternatives for 401(k)-type plans. The proposal reiterates the department’s view that the prudence and loyalty standards set forth in ERISA apply to a fiduciary’s selection of an investment alternative to be offered to plan participants and beneficiaries in an individual account plan (commonly referred to as a 401(k)-type plan). The proposal describes the requirements for selecting investment alternatives for such plans that purport to pursue one or more environmental, social, and corporate governance-oriented objectives in their investment mandates or that include such parameters in the fund name.

At this early stage, it should be emphasized that the proposal is subject to public comment and amendment, and there is also a potential time crunch facing the DOL to get such a rule fully implemented should President Donald Trump fail to win a second term.

Furthermore, while various ESG regulations and pieces of guidance have been published by concurrent administrations going back to the 1990s, market trends and organic demand among participants are an equally important factor driving plan sponsors’ and fiduciaries’ behavior when it comes to using ESG.

In early commentary shared with PLANSPONSOR, George Michael Gerstein, co-chair of the fiduciary governance group at Stradley Ronon, says the proposed regulation, if adopted as-is, would definitely make it more challenging for retirement plan sponsors to leverage ESG-themed investments.

“This proposal comes just two years after the DOL issued Field Assistance Bulletin 2018-01,” he notes. “It is also part of a continuum of ERISA-ESG guidance over the decades, across both Democrat and Republican administrations, that has sought to address how ERISA’s stringent fiduciary duties may be satisfied when one or more ESG factors are pursued, either because they are material to investment performance or because they further some public policy or similar goal.”

Gerstein says that, should the proposal be adopted as proposed, plan sponsors, other fiduciaries and the retirement plan industry generally will face a tall order in incorporating ESG factors, especially in furtherance of policy or other non-financial goals. Still, in his view, more sophisticated ESG strategies that expressly incorporate one or more ESG factors because of materiality to investment performance would still be considered consistent with ERISA’s fiduciary duties, provided that there is documentation as to the basis for the materiality determination.

Under both the existing and proposed regulatory framework, the weight given to the ESG factor in the materiality analysis must be accurate and appropriate—a point the DOL stressed in Field Assistance Bulletin 2018-01. It is also going to be even more important that an ESG investment is measured against other available alternative investments with respect to diversification, liquidity and potential risk/return of the plan portfolio.

“Because the DOL believes a fiduciary finding that an ESG investment is economically indistinguishable from a non-ESG investment to be a rare occurrence, it does not believe the aforementioned documentation requirements will be a significant cost to the industry,” Gerstein notes. He also points out that the DOL has cautioned that fiduciaries should be skeptical of ESG rating systems—or any other rating system that seeks to measure, in whole or in part, the potential of an investment to achieve non-pecuniary goals as a tool to select qualified default investment alternatives (QDIAs), or investments more generally.

Gerstein concludes that ESG funds and products that have short track records, low assets under management, and/or are somewhat more expensive than similar non-ESG funds, will be particularly vulnerable under this proposal.