DOL Proposes Strict Scrutiny of ESG Investments in Retirement Plans

Economic value trumps social-justice concerns in selecting plan investments

June 30, 2020

Update: Final Rule Issued but Not Enforced

On Nov. 13, 2020, the Trump administration's Department of Labor (DOL) published a final rule requiring fiduciaries to select investments for 401(k) and other plans based on plan participants' financial interests rather than nonfinancial matters, such as environmental, social and governance (ESG) factors.

In March 2021, however, the Biden administration's DOL said it would not enforce the Trump administration's final rule. Biden's DOL is expected to issue a new rule supportive of ESG funds as 401(k) investments.

On June 30, 2020, the Department of Labor (DOL) published in the Federal Register a proposed rule that would establish new requirements for using environmental, social and governance (ESG) funds as investment options for 401(k)-type defined contribution retirement plans or as investments for defined benefit pensions. The DOL also issued a fact sheet on the proposal a week before its publication, and will accept comments through July 30, 2020.

The proposed rule, "Financial Factors in Selecting Plan Investments," should not be confused with a separate proposal the DOL issued on June 29, dealing with the fiduciary duties of investment advisors making recommendations to retirement plan participants.

ESG, or "socially responsible," mutual funds invest in companies that meet the fund managers' criteria for environmental stewardship, social justice and fund governance. Some ESG funds exclude the stock of tobacco, fossil fuel, firearm and defense companies and of firms that are opposed to union organizing or pay excessive executive compensation. They may favor companies that use renewable resources and are committed to gender equality, diversity and community engagement.

The DOL proposal is designed, in part, to make clear that Employee Retirement Income Security Act (ERISA) plan fiduciaries may not invest in ESG funds when they understand that these investments would offer a lower return or increased risk compared to similar, non-ESG funds.

A Change from the Obama Era

The proposed rule follows a 2018 DOL Field Assistance Bulletin that cautioned retirement plan fiduciaries not to give too much weight to the social-justice mission of mutual funds when selecting investments for employee benefit plans. The Trump administration has, in general, taken a stricter position than 2015 guidance issued during the Obama administration, which held that plan fiduciaries could select ESG funds based in part on the funds' collateral benefits, as long as those funds were deemed to be prudent investments.

"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."

Scalia wrote in an opinion column, "At the heart of ERISA is the requirement that … investment decisions must be based solely on whether they enhance retirement savings, regardless of the fiduciary's personal preferences."

Financial Performance Comes First

Under the proposed regulations, a plan fiduciary must take these steps:

  • Evaluate an investment fund based solely on "pecuniary" (i.e., financial) factors.
  • Ensure that investment return is not sacrificed nor additional investment risk is taken on to promote goals unrelated to the financial interests of the plan's participants and beneficiaries.
  • Consider how a proposed investment fund compares to available alternatives with regard to the fiduciary meeting its duties of prudence and loyalty under ERISA.
  • Document specifically its conclusion that the economic value of an investment chosen for nonfinancial reasons was determined to be indistinguishable from other appropriate investments.

'Tiebreaker' Leeway

If two potential investments are economically indistinguishable, nonfinancial ESG factors can be used as a tiebreaker, Scalia noted. "While we are skeptical that such 'ties' often occur, the proposed rule would permit consideration of nonpecuniary factors to break a tie, so long as the fiduciary examines the ESG claims carefully and documents the basis for its conclusion."

He added that the proposed guidance would let a 401(k) plan include an ESG fund among its investment options "provided it is selected through appropriate diligence based on pecuniary considerations, and participants aren't enrolled in it by default."

But Bill O'Malley, senior director of Chicago-based audit, tax and consulting firm RSM US, believes that "these regulations, if finalized, with their emphasis on achieving maximum investment results for the plan above all other considerations, make it a difficult proposition for a plan to select or retain an ESG type of investment in an ERISA retirement plan."

ESG Advocates Respond

Lisa Woll, CEO of the nonprofit US SIF: The Forum for Sustainable and Responsible Investment in Washington, D.C., called the DOL proposal "out of step with professional investment managers, who increasingly analyze ESG factors precisely because of risk, return and fiduciary considerations." She added that the proposed rule would "put a substantial additional burden on fiduciaries who wish to utilize ESG investments by requiring additional investment analysis and documentation requirements."

US SIF supported the 2015 guidance under which, Woll said, "fiduciaries of ERISA-governed pension plans need not treat commercially reasonable investments as inherently suspect or in need of special scrutiny merely because they take into consideration environmental, social or other such factors."

[SHRM members-only toolkit: Designing and Administering Defined Contribution Retirement Plans]

Approaches Vary

Nevin Adams, chief of communications for the Arlington, Va.-based American Retirement Association, which represents plan service providers, noted that "interest in ESG remains high among institutional money managers, many advisors and—if surveys are to be believed—the investing public, including retirement plan participants, and particularly younger participants." Nonetheless, he added, "workable, consistent definitions of ESG remain fluid, and perhaps as a result, the adoption rate among defined contribution plans has been tepid."

Finance website Chief Investment Officer reported, "The [DOL] proposal would only affect private employer plans, which have not been as active or outspoken about ESG investing as have some of their peers in endowments and foundations or in public pension funds."

Pension plans generally have been more likely than 401(k) plans to adopt ESG strategies. A 2019 survey by the Callan Institute, a research and education forum for the investment industry, found that 49 percent of institutional investment managers for government employee plans used ESG approaches, while 19 percent of investment managers at large corporations did so. The survey was conducted from May to July 2019 and reflects input from 89 U.S. institutional investors.

But just 4 percent of 401(k) plans offered an ESG option, according to the 61st annual Plan Sponsor Council of America survey of profit-sharing and 401(k) plans, which reported on the 2017 plan-year experience of 605 plans of all sizes.

Vanguard Investments 2018 administrative data show that approximately 9 percent of defined contribution plans offered one or more "socially responsible" domestic equity fund options, based on about 1,900 plans for which Vanguard provides recordkeeping services.

Litigation Concerns

"DOL's guidance with respect to these issues has, to date, been 'sub-regulatory'—generally in the form of Interpretive Bulletins and Field Assistance Bulletins—and therefore less formal," wrote Mike Barry, a senior consultant at retirement plan advisory firm October Three. 

"A feature of this less-formal guidance has been a sort of 'duel of interpretations'—with Democratic administrations providing (marginally) more relaxed guidance and Republican administrations providing (marginally) stricter guidance," he noted. "In this context, DOL's new regulatory project can be understood as an effort to bring some stability to this situation, with a fully vetted (through the regulatory notice-and-comment process), more formal process culminating in regulation."

Barry added, "How effective these rules will be in limiting ESG investment will depend very much on how these rules are enforced. Probably the biggest concern for sponsors in this regard is the possibility of litigation based on the rules articulated in this proposal."

Related SHRM Articles:

DOL Proposes Limits on Proxy Voting by Retirement Plan Fiduciaries, SHRM Online, September 2020

DOL Affirms Fiduciary Standards for 'Socially Responsible' Funds, SHRM Online, May 2018

DOL Gives an OK to 'Socially Responsible' Funds, SHRM Online Benefits, October 2015

Socially Responsible Funds Popular in Mission-Driven 401(k)s, SHRM Online Benefits, September 2011



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