Final Rule Limits 401(k)s from Picking Funds Based on Nonfinancial Factors

On Nov. 13, the U.S. Department of Labor (DOL) published a final rule with new regulatory guideposts for fiduciaries who select investments for 401(k) and similar defined contribution retirement plans, defined benefits pension plans and other benefits plans that include investments.

The rule, Financial Factors in Selecting Plan Investments, addresses fiduciaries' use of financial and nonfinancial factors such as environmental, social and governance (ESG) criteria when choosing mutual funds, corporate equities and other plan investments. The DOL posted a fact sheet summarizing the rule on Oct. 30, when a pre-publication version of the rule was released.

Under the final rule, sponsors of investment-based employee plans must abide by the fiduciary duties of prudence and loyalty to plan participants under the Employee Retirement Income Security Act (ERISA) when considering plan investments that promote nonfinancial objectives. It is separate from a related DOL proposal, issued Sept. 4, that would stop retirement plan fiduciaries from casting corporate-shareholder proxy votes in favor of social or political positions that don't advance the financial interests of 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 firms that are opposed to union organizing or that pay excessive executive compensation. They may favor companies that use renewable resources and are committed to gender equality, diversity and community engagement.

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 record-keeping services.

Focusing on Risk and Returns

The final rule requires plan fiduciaries to select investments based on "pecuniary" factors—in other words, "any factor that a responsible fiduciary prudently determines is expected to have a material effect on risk or return of an investment based on appropriate investment horizons, consistent with the plan's investment objectives and funding policy."

"Protecting retirement savings is a core mission of the U.S. Department of Labor and a chief public policy goal for our nation," said U.S. Secretary of Labor Eugene Scalia. "This rule will ensure that retirement plan fiduciaries are focused on the financial interests of plan participants and beneficiaries."

What the Rule Requires

The final rule amends the DOL's long-standing investment duties regulation under Title I of ERISA. Among those changes, the final rule:

• Adds provisions to confirm that ERISA fiduciaries must evaluate investments and investment courses of action based solely on pecuniary factors.
  

• Prohibits fiduciaries from subordinating the interests of participants to unrelated objectives, and bars them from sacrificing investment return or taking on additional investment risk to promote nonpecuniary goals.
  

• Sets forth required investment analysis and documentation requirements for "tie-breaker" circumstances in which plan fiduciaries use nonpecuniary factors when choosing between or among investments that the fiduciary is unable to distinguish on the basis of pecuniary factors alone.

The rule takes effect on Jan. 12, 2021, but it applies prospectively, meaning fiduciaries won't have to divest any current investments selected using nonpecuniary factors in a way that's prohibited by the final rule. However, if a plan used nonpecuniary factors as a primary investment objective in selecting a qualified default investment alternative (QDIA)—the default investment in automatic-enrollment defined contribution plans—then the QDIA must be removed from the plan by April 30, 2022.

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

Brokerage Windows

The rule's pecuniary analysis doesn't apply to brokerage windows, self-directed brokerage accounts and similar arrangements that let participants select investments beyond those designated by the plan these arrangements. However, "ERISA's overarching duties of prudence and loyalty still apply to a fiduciary's decision to make these arrangements available, taking into account the nature and quality of the services provided by the arrangements," according to HR consultancy Mercer.

Changes from Proposed Rule

The DOL issued a proposed rule in June, with a 30-day comment period. 

In its proposed regulation, "the DOL was specifically targeting ESG-based investments," wrote Chris Carosa, chief contributing editor at FiduciaryNews.com, adding, "This may have simply been a reaction to earlier DOL rules [under the Obama administration] that seemed to preternaturally promote ESG-based investing."

The DOL's final rule, in contrast, "uses ESG more as a specific example that explains its general intent," Carosa said. "The DOL, as a result, has come up with a broad 'pecuniary' mandate. … In other words, the DOL is telling plan sponsors that it's back to basics."

The final rule is "likely to cause some fund operators to focus intensely on prospectus wording in an effort to satisfy this 'pecuniary interest' standard," noted Mike Barry, a senior consultant at retirement plan advisory firm October Three.

During a press call on Oct. 30, DOL representatives outlined changes between the proposed and final rules. Based on more than 1,000 comments the DOL received, the final rule:

• Clarifies that fiduciaries must focus on whether a factor used to evaluate an investment is pecuniary, not whether it's an ESG factor. The rule permits the selection of a fund that seeks to promote one or more nonpecuniary goals if the selection satisfies the duties of prudence and loyalty to participants.
  

• Clarifies that a fiduciary only needs to compare an investment with reasonably available alternatives with similar risks.
  

• Modifies the proposed rule's "tie-breaker" language to clarify that when deciding between two investments, if the fiduciary is unable to distinguish a difference in economic value to participants based on pecuniary factors, then other factors may be considered.
  

• Provides that the duties of prudence and loyalty apply to the selection of QDIAs, and that the tie-breaker provision may be used to select QDIAs.
  

• Removes a documentation requirement for selecting a QDIA unless a QDIA is being selected under the tie-breaker rule.

Whereas the proposal contained a blanket prohibition on any fund that uses ESG factors from being a QDIA, even if those factors were used for pecuniary purposes, the final rule only excludes a fund from being a QDIA if its investment objectives, goals or principal investment strategy includes one or more nonpecuniary factors that take precedence over pecuniary factors.

"Inclusion of an ESG fund in a QDIA will be a priority for some sponsors and providers," noted Barry. "Figuring out how to come within this new standard may prove to be a challenge. In this regard, the ERISA fiduciary burden will be on the plan fiduciary."

Advocates and Opponents

The top-ranking Republicans on the House Education and Labor committees, Reps. Virginia Foxx, R-N.C., and Tim Walberg, R-Mich., said the final rule "clarifies how retirement plan fiduciaries can meet their legal obligations to serve retirement savers exclusively, free from potential ulterior motives."

"Keeping politics out of the management of other people's pension plans is an essential part of our duty of loyalty and our fiduciary obligations," wrote Christopher Burnham, president of the Institute for Pension Fund Integrity, which advocates for transparency and accountability in the management of public pension plans. "That is why the recent announcement by the [DOL] of a final rule laying out stringent guidelines for fiduciaries of retirement plans under [ERISA] is a welcome and much-needed step in the right direction."

Burnham is president of the Institute for Pension Fund Integrity, which advocates for transparency and accountability in the management of our public pension plans.

Supporters of the rule also have pointed to a new research paper from the Center for Retirement Research at Boston College. It concludes, "the evidence suggests, however, that social investing: 1) yields lower returns; and, 2) is not effective at achieving social goals."

Among the rule's opponents, Lisa Woll, CEO of the nonprofit US SIF: The Forum for Sustainable and Responsible Investment in Washington, D.C., criticized it for putting "a substantial burden on fiduciaries who consider ESG factors in their retirement plans, requiring additional documentation to justify why ESG factors are financially material." She said that "abundant data debunks the premise that utilization of ESG criteria is problematic."

Mindy Lubber, CEO and president of sustainability organization Ceres, wrote: "This is another harmful action by the Trump administration, at a time when the global climate crisis looms large as another systemic risk upending lives, livelihoods, and causing deadly devastation and damage." She said the rule "runs counter to global market trends and the mainstream U.S. and global practice of integrating ESG factors into investment decisions."

A Biden Do-Over?

Aron Szapiro, director of policy research at investment data firm Morningstar, said of the new rule that "a Biden administration would probably want to revisit this; it's just not the consensus in the Democratic party."

"Many Democrats were very critical of DOL’s original proposal and less than satisfied with the final rule," Barry wrote, adding that "a Biden administration, like every new administration since President Clinton’s, may believe it is necessary to revisit this guidance."

Related SHRM Articles:

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

DOL Proposes Less-Restrictive Fiduciary Standard for Investment Advisors, SHRM Online, July 2020

DOL Proposes Strict Scrutiny of ESG Investments in Retirement Plans, SHRM Online, June 2020