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DOL Final Rule Rolls Back Restrictions on Retirement Plans' Use of ESG Factors

Debate likely to continue over climate considerations and fossil fuel investments

Graphic of smokestacks as bars in a graph with one smokestack containing a plant that a man is watering

This article was updated.

The U.S. Department of Labor (DOL) issued a final rule that permits retirement plan fiduciaries, such as 401(k) plan sponsors, to consider climate change and other environmental, social and governance (ESG) factors when they select investment options and exercise shareholder rights, such as proxy voting for plan-held securities.

The rule issued on Nov. 22, Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights, follows an executive order signed by President Joe Biden in May 2021 that directed federal agencies to consider policies to protect against the threats of climate-related financial risk. The DOL also posted a related fact sheet.

The DOL concluded that regulations issued in 2020 and subsequently blocked by the Biden administration had unnecessarily restrained plan fiduciaries' ability to weigh ESG factors when choosing investments. Critics contend that ESG considerations are outside the traditional financial safety and return-on-investment criteria that should be fiduciaries' sole consideration as required by the Employee Retirement Income Security Act (ERISA).

"This rule removes restrictions imposed during the previous administration that made it difficult for 401(k) and other retirement plan sponsors to include climate-aligned and other ESG funds in the list of options available to participants," said Steven M. Rothstein, managing director of the Ceres Accelerator for Sustainable Capital Markets at Ceres, a nonprofit organization working on sustainability challenges.

"Fiduciaries have an obligation to provide investment options that take the physical and transition risks of climate change into account," he added.

The DOL "emphasizes that ESG is not a mandate," said Carol McClarnon, a partner in the Washington, D.C., office of law firm Eversheds Sutherland. "Nevertheless, it is clear that this DOL views E, S and G components as economically significant factors that are an important part of a prudent evaluation of risk and return."

The rule will be effective 60 days after its upcoming publication in the Federal Register except for a delayed applicability until one year after publication for certain proxy-voting provisions, to allow fiduciaries and investment managers additional time to prepare.

ESG Considerations

The administration said the new regulations are within the ERISA framework by treating ESG factors as financial risks.

"Today's rule clarifies that retirement plan fiduciaries can take into account the potential financial benefits of investing in companies committed to positive environmental, social and governance actions as they help plan participants make the most of their retirement benefits," said Secretary of Labor Marty Walsh. "Removing the prior administration's restrictions on plan fiduciaries will help America's workers and their families as they save for a secure retirement."

According to the DOL's fact sheet, an important change adopted in the final rule is "the addition of regulatory text clarifying that a fiduciary's duty of prudence must be based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis and that such factors may include the economic effects of climate change and other ESG considerations on the particular investment or investment course of action."

Fiduciary Duties

"While the DOL has a long history of back-and-forth on the extent to which fiduciaries could consider ESG-type factors, it has been consistent in affirming that plan fiduciaries must make investment decisions in accordance with ERISA's fiduciary duties of loyalty and prudence," said Elizabeth Goldberg, partner in the Pittsburgh office of Morgan Lewis and co-leader of the firm's ESG and sustainability advisory practice.

The final rule "moves the ball away from a 2020 DOL rulemaking … and toward a position that is more supportive of ESG investing," she noted, and "provides fiduciaries with an interpretation of ERISA's fiduciary standards that could allow for the consideration of ESG factors without violating those duties."

Rule opponents, however, warned that plan fiduciaries could now feel pressured to consider what have traditionally been viewed as nonfinancial social and political agendas when making investment choices.

What Are ESG Investments?

ESG 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 fossil fuel, tobacco, 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.

Duty of Prudence

On the issue of plan sponsor's liability, Mike Barry, a senior consultant at retirement plan advisory firm October Three, noted that the final rule "includes a new provision that fiduciaries do not violate ERISA's duty of loyalty by taking into account participant preferences in constructing a participant-directed [defined contribution] fund menu."

Even so, he reminded plan sponsors that "the duty of prudence would, however, still apply. Thus, an 'imprudent' investment could not be included in the plan fund menu even if participants wanted it," and plan sponsors could be sued for adding ESG funds that fail to otherwise be in the best interest of plan participants.

Attorneys at Morgan Lewis observed that "there remain open questions about how [the rule's] consideration of participant preference will be put in practice. For example, what about competing participant preferences? And how much weight will courts give to a fiduciary's consideration of participant preference when the investment is challenged as imprudent?"

Retirement finance advisor Chris Caruso, in his Forbes column, wrote: "A simple reading of the rule will tell you that the DOL appears to have removed a major fiduciary roadblock to including ESG-focused investments on retirement plan menus.... The door to the conversation may now be open, but the 800-pound gorilla remains in the room. The onus of fiduciary duty continues to restrain plan sponsors."

Default Investments

The final rule reverses the prior rule's prohibition on using ESG funds as qualified default investment alternatives (QDIAs), which are types of mutual funds that plan sponsors can select as the default option in automatic enrollment 401(k)-type defined contribution plans. Under the rule, standards applied to QDIAs are no different from those applied to other investments.

QDIAs can be target-date retirement funds, which automatically reset their asset mix to become less risky as the specified target retirement year nears. Mutual fund companies have begun marketing target-date funds made up of investments that meet specified ESG criteria.

Proxy Voting

A second 2020 DOL regulation had aimed to stop what the prior administration viewed as retirement plan fiduciaries casting corporate-shareholder proxy votes in favor of social or political positions that didn't advance the financial interests of retirement plan participants.

Among other changes, the new final rule eliminates the earlier rule's requirement that fiduciaries not participate in proxy votes unless the fiduciary prudently determines that the matter has an economic impact on the plan.

The DOL said the prior regulation created "a misperception that proxy voting and other exercises of shareholder rights are disfavored or carry greater fiduciary obligations than other fiduciary activities."

According to McClarnon, "the 2020 rule, at least in tone, suggested that fiduciaries often should not be voting proxies. The final rule flips that notion and seems to indicate that in some situations at least, fiduciaries may be required to exercise shareholder rights when that is necessary to protect participants' interests."

Debate Over Climate Risks

The issue of fossil fuel investments, in particular, has been a point of contention in the debate over ESG factors. The shareholder advocacy group As You Sow, for instance, has criticized what it calls "fossil-filled 401(k) plans." In a February press release, the group charged that "company retirement plans are out of alignment with corporate climate goals, forcing employees to invest in oil, coal and deforestation."

Others have criticized attempts by ESG advocates to deter investments in oil and gas companies. "While climate activists believe they know best, the U.S. can't maintain its security while depending on foreign dictators and oligarchs to supply its energy," Mark Brnovich, attorney general of Arizona, wrote in a March Wall Street Journal opinion column critical of ESG-driven policies.

As the DOL prepared to release its final rule, Republicans in Congress introduced the Safeguarding Investment Options for Retirement Act, which would amend ERISA and the Internal Revenue Code to limit fiduciary consideration of nonfinancial factors in investment decision-making for defined contribution plans.

ESG Fund Concerns

Some have raised concerns about the cost and performance of ESG investment funds. In response to a related Securities and Exchange Commission request for public input on climate change disclosures by public companies, Jean-Pierre Aubry, assistant director of research at the Center for Retirement Research (CRR) at Boston College, wrote in a 2021 comment letter about his concern over regulations that "would give credence to the army of asset managers currently promoting ESG investing to retail and institutional investors…."

ESG research by the CRR, he added, found "the major state and local government pension plans that have incorporated ESG factors into their investment policies underperformed those that did not. The study also finds that most retail ESG funds have higher fees and worse performance than similar index funds."


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