On October 30, 2020, the DOL issued a final rule under President Trump’s administration which limits the selection of retirement plan investments in “do-good” or “environmental, social governance” (“ESG”) funds (“Final ESG Rule”). DOL, EBSA, 29 CFR Parts 2509 and 2550, Financial Factors in Selecting Plan Investments, 88 Fed. Reg. 72846 (11/13/20). The rule was structured in a manner that would amend the DOL’s “investment duties” regulation at 29 C.F.R. 2550.404a-1 (85 FR 72846 11-13-2020). The Final Rule reaffirmed the government’s longstanding position that ERISA requires plan fiduciaries to treat the financial interests of plan participants and beneficiaries as paramount when making investment decisions. The rule generally required ERISA plan fiduciaries to base investment decisions on financial factors alone and prohibits fiduciaries from selecting investments based on non-pecuniary considerations. In general, the requirement to evaluate investments based solely on pecuniary factors applied to a 401(k) plan fiduciary’s selection and retention of available plan investment alternatives. The rule generally became effective January 12, 2021.
The Final ESG Rule did not categorically prohibit including an investment option that supports non-pecuniary goals. One exception in the Final ESG Rule where plan fiduciary could have used non-pecuniary factors concerns a “tie-breaking” scenario. For a fiduciary to avail itself to this exception, the fiduciary must have been unable to distinguish investment alternatives on the basis of pecuniary factors alone. In addition, to consider non-pecuniary factors in the tie-breaker situation, a plan fiduciary must have documented:
1. why pecuniary factors were not sufficient to select the investment;
2. how the selected investment compares to the alternative investments (in light of the plan’s diversification, liquidity, cash flow requirements and funding objectives); and
3. how the applicable non-pecuniary factor(s) is consistent with the financial interests
of the plan participants and beneficiaries.
In addition to the tie-breaker exception, the Final Rule stated that ESG funds may be offered in a 401(k) plan in situations where participants direct investments. However, the selection was subject to conditions that could pose a challenge. In this regard, the following requirements must have been satisfied:
1. the plan otherwise provides a “broad range of investment alternatives”;
2. the decision to include the investment option is based on “pecuniary” factors only (outside of the tie-breaker context); and
3. a fund or model portfolio with objectives, goals or principal investment strategies that take non-pecuniary factors into account may not be used as, or as a component of, a “qualified default investment alternative” (“QDIA”).
President Biden’s administration has reversed the course of the rule. In January 20, 2021, he issued an executive order requesting the DOL to review the rule. “Executive Order on Protecting Public Health and the Environment and Restoring Science to Tackle the Climate Crisis” (1/20/21). On March 10, 2021, the Department of Labor (DOL) announced that it will not enforce its own rule on investment duties under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”). DOL News Release, U.S. Department of Labor Statement on Enforcement of Its Final Rules on ESG Investments, Proxy Voting by Employee Benefit Plans (3/10/21) [hereinafter “DOL Announcement on ESG Investments/Proxy Voting”].
Fiduciaries who invest retirement plan assets in ESG funds will not be investigated by the DOL for violating the Final ESG Rule. However, the rule still exists. Thus, fiduciaries who make such investments can still be sued by plan participants and beneficiaries.
Non-compliance with the Final ESG Rule is untested in the courts. In addition, not acting in the pecuniary interest of participants and beneficiaries significantly departs from the long-standing principles of ERISA. Thus, noncompliance with the rule is risky.
The DOL could undertake a new notice-and-comment rulemaking to implement an alternative rule. However, this would take time. It generally takes 8 to 18 months for this process to occur.
Congress has taken action in trying to craft a new rule. U.S. Senators Tina Smith, D-Minnesota, and Patty Murray, D-Washington, and U.S. Representative Suzan DelBene, D-Washington, have introduced legislation in both chambers of Congress in this regard. The bill, called the “Financial Factors in Selecting Retirement Plan Investments Act”, would amend ERISA to make it clear that fiduciaries may consider ESG factors in their investment decisions, provided they consider such investments in a prudent manner consistent with their fiduciary obligations. S. 1762, 117th Cong. 1st Sess. (5/20/21). However, the likelihood that the bill will pass is unclear.
The rule could also be challenged in courts, but the outcome of such a challenge would be uncertain. Therefore, fiduciaries should exercise caution when implementing ESG investment funds in a retirement plan.