EBSA Proposal Pours Some Cold Water on ESG Enthusiasm

Noting its concern “that the growing emphasis on ESG investing may be prompting ERISA plan fiduciaries to make investment decisions for purposes distinct from providing benefits to participants and beneficiaries and defraying reasonable expenses of administering the plan,” the Labor Department has proposed a new rule to clarify the standards.

“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,” said Secretary of Labor Eugene Scalia. “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 Department of Labor (DOL) also said it was “concerned that some investment products may be marketed to ERISA fiduciaries on the basis of purported benefits and goals unrelated to financial performance.” In fact, the DOL said that “ESG investing raises heightened concerns under ERISA.” 

6 Things You Need to Know

1. This is a proposed rule, not a final one.
2. DOL says it was concerned about the marketing of ESG products, alongside significant increases in ESG investments by ERISA plans. 
3. Until now, there’s really only been Interpretive Bulletins (IBs) (in 1994, 2008 and 2016) and, more recently, a 2018 Field Assistance Bulletin (FAB) on this subject. The 2016 IB was read as encouraging consideration of ESG factors (or at least discouraging the discouraging); the 2018 FAB pulled back on that stance.
4. DOL says this is a separate initiative from the one recently reported regarding inquiries to plan fiduciaries regarding ESG plan investments. 
5. The proposed rule maintains the “all things equal” test, but requires a new level of documentation. It also says that ESG is not suitable as a qualified default investment. 
6. Comments on the proposed rule are being sought for 30 days.

The DOL notes that as ESG investing has increased, it has engendered important and substantial questions and inconsistencies, with numerous observers identifying a lack of precision and rigor in the ESG investment marketplace. “There is no consensus about what constitutes a genuine ESG investment, and ESG rating systems are often vague and inconsistent, despite featuring prominently in marketing efforts. Moreover, ESG funds often come with higher fees, because additional investigation and monitoring are necessary to assess an investment from an ESG perspective.”

Financial Factors

With the proposed rule—innocuously titled “Financial Factors in Selecting Plan Investments,” the Labor Department says it hopes to “set forth a regulatory structure to assist ERISA fiduciaries in navigating these ESG investment trends and to separate the legitimate use of risk-return factors from inappropriate investments that sacrifice investment return, increase costs, or assume additional investment risk to promote non-pecuniary benefits or objectives.” 

That said, it also explains that the proposed rule “does not revise the requirements that the fiduciary give appropriate consideration to a number of factors concerning the composition of the plan portfolio with respect to diversification, the liquidity and current return of the portfolio relative to the anticipated cash flow needs of the plan, and the projected return of the portfolio relative to the funding objectives of the plan.” 

The proposed rule itself (it had been dropped off for OMB review last month) is relatively short—less than five pages of the 61-page publication. The first 27 or so pages outline the Department’s considerations and concerns leading to the rule; the next 27 provide an analysis of the potential costs and benefits (for what it’s worth, the department estimates the new reporting requirement will affect approximately 30,000 retirement plans, take 600 hours to fulfill, and consume $57,000 in compliance costs).

Core Additions

The proposal would make five core additions to the regulation:

1. New regulatory text to codify the DOL’s longstanding 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.
2. An express regulatory provision stating 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.
3. A new provision that requires fiduciaries to consider other available investments to meet their prudence and loyalty duties under ERISA.
4. The proposal acknowledges that ESG factors can be pecuniary factors,[1] but only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories. And the proposal adds new regulatory text on required investment analysis and documentation requirements in what it characterized as “the rare circumstances when fiduciaries are choosing among truly economically ‘indistinguishable’ investments.” 
5. A new provision on selecting designated investment alternatives for 401(k)-type plans. 

Cautionary Note

The DOL notes that the proposed rule is “designed in part 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-pecuniary objectives.” As for why now, the proposal explains that, “the Department understands that in the case of some ESG investment funds being offered to ERISA defined contribution plans, fund managers are representing that the fund is appropriate for ERISA plan investment platforms, while acknowledging in disclosure materials that the fund may perform differently or forgo certain opportunities, or accept different investment risks, in order to pursue the ESG objectives.”

“The fundamental principle is that an ERISA fiduciary’s evaluation of plan investments must be focused solely on economic considerations that have a material effect on the risk and return of an investment based on appropriate investment horizons, consistent with the plan’s funding policy and investment policy objectives. The corollary principle is that ERISA fiduciaries must never sacrifice investment returns, take on additional investment risk, or pay higher fees to promote non-pecuniary benefits or goals.”

Economic Environments

Not that other factors can’t be considered. The DOL notes—and has recognized in its prior guidance—that “there may be instances where factors that sometimes are considered without regard to their pecuniary import—such as environmental considerations—will present an economic business risk or opportunity that corporate officers, directors, and qualified investment professionals would appropriately treat as material economic considerations under generally accepted investment theories.”

The DOL noted that “while Public companies and their investors may legitimately and properly pursue a broad range of objectives, subject to the disclosure requirements and other requirements of the securities laws. Pension plans covered by ERISA are statutorily-bound to a narrower objective: management with an ‘eye single’ to maximizing the funds available to pay retirement benefits.”

ESG factors and other similar considerations may be economic considerations, 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 proposed rule emphasizes that such factors, if determined to be pecuniary, must be considered alongside other relevant economic factors to evaluate the risk and return profiles of alternative investments. The weight given to pecuniary ESG factors should reflect a prudent assessment of their impact on risk and return—that is, they cannot be disproportionately weighted.

Noting that, if, after such an evaluation, alternative investments appear economically indistinguishable, a fiduciary may then, in effect, “break the tie” by relying on a non-pecuniary factor. But then cautions that “the Department expects that true ties rarely, if ever, occur.”

‘Equal’ Signs

There is, of course, the matter of the “all things being equal” that arose during the Obama administration—a test that the DOL now says “could invite fiduciaries to find ties without a proper analysis, in order to justify the use of non-pecuniary factors in making an investment decision,” though it acknowledges that since “ties may theoretically occur and the Department does not presently have sufficient evidence to say they do not, the Department proposes to retain the current guidance’s ‘all things being equal’ test.”

If, after completing an appropriate evaluation, alternative investments appear economically indistinguishable, and one of the investments is selected on the basis of a non-pecuniary factor or factors such as environmental, social, and corporate governance considerations (notwithstanding the requirements of paragraph (b) and paragraph (c)(1)), the fiduciary must document the basis for concluding that a distinguishing factor could not be found and why the selected investment was chosen based on the purposes of the plan, diversification of investments, and the financial interests of plan participants and beneficiaries in receiving benefits from the plan.

No ESG Default?

The DOL said it “does not believe that investment funds whose objectives include non-pecuniary goals—even if selected by fiduciaries only on the basis of objective risk-return criteria consistent with paragraph (c)(3)—should be the default investment option in an ERISA plan.” The preamble goes on to explain that “ERISA is a statute whose overriding concern relevant here has always been providing a secure retirement for American workers and retirees, and it is inappropriate for participants to be defaulted into a retirement savings fund with other objectives absent their affirmative decision.”

Fiduciaries “must not too readily treat ESG factors as economically relevant to the particular investment choices at issue when making a decision,” as “[i]t does not ineluctably follow from the fact that an investment promotes ESG factors, or that it arguably promotes positive general market trends or industry growth, that the investment is a prudent choice for retirement or other investors.” Rather, ERISA fiduciaries must always put first the economic interests of the plan in providing retirement benefits and “[a] fiduciary’s evaluation of the economics of an investment should be focused on financial factors that have a material effect on the return and risk of an investment based on appropriate investment horizons consistent with the plan’s articulated funding and investment objectives.”

Comments Requested

The department invites comments from interested persons on all facets of the proposed rule, noting that “commenters are free to express their views not only on the specific provisions of the proposal as set forth in this document, but on any issues germane to the subject matter of the proposal.”

Comments should be submitted in accordance with the instructions at the beginning of this document. The Department believes that 30 days will afford interested persons an adequate amount of time to analyze the proposed rule and submit comments.

Asked about the apparent overlap in timing between the proposed rule and recent inquiries from the Employee Benefit Security Administration regarding plan investments in ESG options to plan sponsors, senior Labor Department officials said the two were separate, unrelated initiatives. The proposal certainly evinces a certain negativity about ESG as an investment motivation, but provides certain documentation protocols to support those decisions. 

However, asked how the Labor Department was considering enforcement of those provisions, the senior officials said that their approach was “enforcement by education,” implying that by sharing their perspective on the issue, plan fiduciaries, now educated, would respond appropriately.
More to come.

Footnote

[1] The term “pecuniary factor” means a factor that has a material effect on the risk and/or return of an investment based on appropriate investment horizons consistent with the plan’s investment objectives and the funding policy established pursuant to Section 402(a)(1) of ERISA.