DOL ISSUES FINAL REGULATIONS ON PRUDENCE AND LOYALTY IN SELECTING 401(K) PLAN INVESTMENTS – ESG FUNDS GET A THUMBS-UP

On November 22, 2022, the U.S. Department of Labor (DOL) released Final Regulations on ERISA’s fiduciary duties of prudence and loyalty as it concerns retirement plan investing, focusing particularly on  environmental, social, or governance (ESG) investments. Broadly stated, the new rule generally permits retirement plan fiduciaries, such as 401(k) plan sponsors, to consider ESG factors when selecting investment options, as well as when exercising proxy voting and other shareholder rights in connection with any plan-held securities. The Final Regulations represent the latest in a continuing saga of changing views and directives regarding ESG funds on the part of the DOL, often in response to changing political winds.

The DOL simultaneously released a press release on its EBSA website, intended to help explain the major provisions of the Final Regulations in relatively nontechnical terms.

Background – ERISA Fiduciary Duty and Plan Investments.

ERISA requires that retirement plan fiduciaries manage plans solely in the interest of participants and beneficiaries, and for the exclusive purpose of providing benefits and paying plan expenses. (See our articles entitled “401(k) ERISA’s Duty of Care and Liability” and “401(k) Fiduciary and Non-Fiduciary Functions” for a general discussion on ERISA fiduciary duty.)

Particularly, the investment of plan assets — including investment choices made directly by 401(k) plan participants and beneficiaries from a pre-selected menu of funds — must meet ERISA’s high standards of care and prudence. This means that investment decisions generally must be based solely on financial considerations, taking into account appropriate economic conditions and factors, to evaluate the risk and return profiles of different investments. As such, ESG and similar factors traditionally had to be given secondary consideration, if they were given any weight at all.

DOL’s Changing Views on ESGs and “Socially Responsible” Investments.

But times change, and eventually there were calls from political observers and plan participants alike for more socially responsible investing. In 1994, the DOL cautiously gave its blessing to plan investments in “economically targeted investments” (ETIs), which often were grouped with ESG investments, provided that their expected rate of return corresponded with the rates of return for available alternative investments having similar risk characteristics.

In 2008 and again in 2015, the DOL added a cautionary note, warning that fiduciaries could be in violation of ERISA if they accept expected reduced returns or greater risks to obtain objectives when choosing investments based on ESG factors or similar public policy considerations. Nevertheless, a fiduciary could still prudently take into account ESG or similar factors when determining whether an investment is appropriate.

KEY POINT: And so, although the guidance was less than crystal clear, practitioners generally interpreted the DOL’s position as cautiously permissive with respect to the use of ESG and other “socially responsible” funds – provided that the investments were otherwise plan-appropriate, and equivalent to competing investment alternatives in terms of risk and return. 

2020 DOL Proposed Rule.

All that changed in 2020, with the issuance of proposed DOL rulemaking that put the brakes on ESG investing. (See our blog entitled “DOL Keeps its “Social Distance” from 401(k) Plan Investments in Environmental, Social and Governance Funds” for details.) In response to the Trump Administration’s largely negative stance on “non-pecuniary goals or policy objectives,” the proposed rule generally required plan fiduciaries to select investments and make investment-related decisions based solely on financial considerations.

In particular, the proposed rule would have, among other things: (i) required fiduciaries to consider available investments other than ESGs; (ii) imposed new analysis and documentation requirements in certain “tie-breaker” situations; and (iii) effectively prohibited plans from using ESG funds as their “qualified default investment alternative” (QDIA) (see our reference article entitled “401(k) QDIA” for details).

KEY POINT: Although the 2020 proposed rule did not outright prohibit plans from investing in ESG funds, most practitioners and observers agreed that it would certainly have a chilling effect — perhaps discouraging many 401(k) plans from investing in ESG funds altogether.

DOL Declines to Enforce its Own Rule.

But in yet another turn of events, in anticipation of executive action by the Biden administration, the DOL announced in March 2021 that it would not enforce its 2020 Proposed Rule – which by then had become finalized. (See our blog entitled “DOL’s Non-Enforcement Policy for 401(k) ESG Investments” for details.) Generally stated, the DOL confirmed that, pending the publication of further guidance, the DOL would not pursue enforcement actions against any plan fiduciary based on a failure to comply with the final regulations based on the 2020 Proposed Rule. Although many in the employee benefits community welcomed the announcement, it hardly created a clear picture of what the rules with respect to ESG investment were at the moment — or would be in the foreseeable future.

Final Regulations.

With the release of the Final Regulations, the DOL appears to be switching the signal from yellow to green when it comes to ESG investments, with certain caveats.

KEY POINT: While retaining the central principle that the duties of prudence and loyalty require plan fiduciaries to focus on relevant risk-return factors, the Final Regulations explicitly permit 401(k) plan sponsors to consider climate change and other ESG factors when selecting investment options and exercising shareholder rights. Nevertheless, in this regard, fiduciaries must never subordinate the interests of participants and beneficiaries to objectives unrelated to the provision of benefits under the plan.

The major highlights of the Final Regulations for 401(k) plans are as follows:

• ESG Considerations Included in Relevant Factors to Be Considered. The Final Regulations clarify that a fiduciary’s duty of prudence must be based on factors that he or she reasonably determines to be relevant to a risk and return analysis. Such factors may include the economic effects of climate change and other ESG considerations on the particular investment under consideration.
• Qualified Default Investment Alternatives. Whereas the 2020 Proposed Rule outright prohibited the use of an ESG fund as a plan’s QDIA (see above), the Final Regulations clarify that standards applicable to the selection of QDIAs are the same as those applicable to other investments.
• “Tie-Breakers.” Whereas the 2020 Proposed Rule severely limited the consideration of ESG factors in certain “tie-breaker” situations, when two or more similar investments were under consideration, the Final Regulations permit fiduciaries to select an investment based on “collateral factors” (which may include ESG factors) in such situations. A related special documentation requirement contained in the 2020 Proposed Rule is also eliminated.
• Investment Alternatives in Participant-Directed 401(k) Plans. The Final Regulations add a new provision explicitly permitting fiduciaries to consider ESG factors when constructing a menu of investment options for participant-directed 401(k) plans. (See our article entitled “401(k) ERISA Section 404(c) Relief” for details about participant-directed plans.)
• Shareholder Rights and Proxy Voting. Broadly stated, the Final Regulations generally eliminate a prior requirement that fiduciaries may not participate in proxy voting unless the fiduciary prudently determines that the matter has an economic impact on the plan, and also eliminates certain monitoring and recordkeeping requirements regarding proxy voting. All in all, the Final Regulations stress that when a plan’s assets include shares of stock, the fiduciary duty to manage those assets includes the duty to manage any shareholder rights related to those shares (such as the right to vote proxies).

Effective Date.

The Final Regulations will generally become effective 60 days following their official publication in the Federal Register.

An exception applies to the provisions relating to proxy voting, which will become applicable one year after the date of publication in the Federal Register. The delayed applicability date is meant to allow fiduciaries and investment managers additional time to gear up for the necessary changes (for example, to systems, software, and participant communications).

COMMENT: Following the protracted history and confusing “back-and-forth” of the last several years regarding ESG investing, the Final Regulations should be welcome news to 401(k) plan sponsors, fiduciaries, investment managers and participants alike. They should also be satisfying to persons who favor “social investing” and wish to extend these principles to 401(k) plans. However, it remains clear that the overriding principles of prudence and loyalty that underlie ERISA’s fiduciary responsibilities remain solid and are in no way diminished by the new guidance, which is relatively narrow in scope. Further, nothing in the Final Regulations precludes the enforcement of any requirement under ERISA or any other applicable statute or regulation.

DISCLAIMER: This article is intended only as a brief overview of the final DOL Regulations released on November 22, 2022 as they apply to most 401(k) plans. It is not intended to address the details of fiduciary duty under ERISA, 401(k) plan investments generally, prior DOL or other guidance having a potential effect on ESG investments, additional legal requirements for 401(k) plans, or similar topics. As always, please consult your own ERISA attorney or advisor for individualized advice concerning your own 401(k) plan.

The information and content contained in this blog post are for general informational purposes only, and does not, and is not intended to, constitute legal advice. As always, for specific questions concerning your 401(k) retirement plan, or for help in operating your plan during the current COVID-19 crisis, please consult your own ERISA attorney or professional advisor.