The U.S. Department of Labor has issued new final regulations, revising regulations adopted in 2020, that attempt (once again) to clarify how plan fiduciaries can consider the use of environmental, social and governance factors (“ESG”) in making plan investment decisions. The final regulations also contain guidance on fiduciary considerations in proxy voting.
Why the Fuss?
Guidance on ESG investing is important for two reasons:
- ERISA imposes multifaceted obligations on plan fiduciaries. Two key fiduciary responsibilities that impact investment decisions and ESG are (i) a requirement that fiduciaries act in a prudent way in selecting investments, and (ii) that fiduciaries act for the “exclusive benefit of providing benefits and paying plan expenses”. ESG investing implicates both of these fiduciary requirements—fiduciaries must ensure that any ESG considerations are consistent with the prudence obligations, and they must also figure out how to utilize ESG factors without running afoul of the exclusive benefit requirements.
- ESG investing is politically fraught. On the one hand, participants (and investment managers) may encourage the use of ESG factors. On the other hand, there is political pushback against the use of ESG factors; see these articles for examples of this pushback:
In light of these challenges plan fiduciaries seeking to navigate these minefields need all the help they can get.
Overview of New Regulations: Out With the Old
The goal of these new final regulations was to walk back regulations, finalized during the waning days of the Trump administration in December 2020, that placed obstacles in the way of fiduciaries considering the use of ESG factors. The new final regulations seek to remove those obstacles—to undo the provisions of the 2020 regulations that were considered as “putting a thumb on the scale against the consideration of ESG factors, even when those factors are financially material”. 87 Fed. Reg. 78326.
As stated by the DOL in the preamble to the new final regulations:
The Department intends with these edits to dispel the perception caused by the current regulation that climate change and other ESG factors are somehow presumptively suspect or unlikely to be relevant to the risk and return of an investment or investment course of action. [T]the final recognizes that, as with other factors, climate change and other ESG factors sometimes may be relevant to a risk and return analysis and sometimes not—and when relevant, they may be weighted and factored into investment decisions alongside other relevant factors, as deemed appropriate by the plan fiduciary
87 Fed. Reg. 73833, Dec. 1, 2022
In seeking to remove the obstacles to the use of ESG factors, the DOL also sought to avoid any inference that fiduciaries should use ESG factors—in other words, the DOL did not want to put a thumb on the scale in favor of using ESG factors. Rather, the DOL sought to treat ESG factors the same as any other potential factor that might be used by a fiduciary—and to rely on fundamental fiduciary considerations in assessing whether and how to use ESG factors.
The new final regulations offer fiduciaries two different ways to consider ESG factors. First, ESG may be included, where appropriate, as one of the many “financial circumstances and considerations” used by prudent investors in performing a risk/reward assessment. As stated in the new final regulation:
A fiduciary’s determination with respect to an investment or investment course of action must be based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis, using appropriate investment horizons consistent with the plan’s investment objectives and taking into account the funding policy of the plan established pursuant to section 402(b)(1) of ERISA. Risk and return factors may include the economic effects of climate change and other environmental, social, or governance factors on the particular investment or investment course of action. Whether any particular consideration is a risk-return factor depends on the individual facts and circumstances. The weight given to any factor by a fiduciary should appropriately reflect a reasonable assessment of its impact on risk-return.
29 C.F.R. Section 2550.404a-1(b)(4) (emphasis added).
Additionally, the final regulations allow fiduciaries to use ESG factors as a “tie breaker.” As stated in the final regulations:
If a fiduciary prudently concludes that competing investments, or competing investment courses of action, equally serve the financial interests of the plan over the appropriate time horizon, the fiduciary is not prohibited from selecting the investment, or investment course of action, based on collateral benefits other than investment returns. A fiduciary may not, however, accept expected reduced returns or greater risks to secure such additional benefits.
29 C.F.R. Section 2550.404a-1(c)(2).
The new final regulations made several other changes to the 2020 regulations as part of taking the DOL’s thumb off of the ESG regulatory scale. Most significantly the new final regulations removed a provision of the 2020 regulations that prohibited inclusion, in any qualified default investment alternative (“QDIA”) of any investment that utilized ESG considerations.
Role of Participant Preferences
As noted, ESG investing is of interest to some participants. The new final regulations offer guidance on how fiduciaries can respond to participant preferences within ERISA’s fiduciary constraints. Remember—fiduciaries must act for the “exclusive benefit” of providing benefits and paying plan expenses. Stated another way, a fiduciary has a duty of “loyalty” to plan participants and “may not subordinate the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to other objectives, and may not sacrifice investment return or take on additional investment risk to promote benefits or goals unrelated to interests of the participants and beneficiaries in their retirement income or financial benefits under the plan.” 29 C.F.R. Section 2550.404a-1(c)(1).
This duty of loyalty creates a challenge for fiduciaries—how to respond to participant requests for adding ESG-based investments that reflect participant social preferences?
Under the new final regulations, a fiduciary does not violate the ERISA “loyalty” requirement solely because the fiduciary takes into account participant preferences IF the fiduciary meets two requirements:
- The fiduciary reflects participant preferences in a way that is consistent with the general fiduciary requirements for using ESG factors. In other words, any ESG investments offered in response to participant preferences must still be based on the fiduciary’s risk/reward analysis applied to any investment (ESG or otherwise).
- Any ESG investment in response to participant preferences must still meet the ERISA prudence requirement.
The DOL was hopeful that accommodating participant perspectives could engage participants and lead to greater participation and greater retirement security.
Additional Provisions: Proxy Voting
The new final regulations make a number of changes to rules governing fiduciaries’ responsibilities in voting proxy. Generally speaking, the new regulations remove a number of detailed requirements contained in the 2020 regulations (such as a requirement to maintain records of proxy voting activities). Instead, the new regulations rely on general fiduciary rules determined that proxy voting did not require special rules that were greater or otherwise different than other fiduciary activities.
What Does This Mean for Fiduciaries?
Here are a few practical takeaways from the new final regulations:
- The new final regulations do not require that a fiduciary change investment decisions—or how a fiduciary makes its investment decisions.
- If a fiduciary decides that ESG is not one of the factors that it feels impact the risk/reward calculus in its investment decisions, then the fiduciary can continue using the non-ESG factors already identified and used.
- Correspondingly, if a fiduciary has previously determined that ESG considerations are legitimate factors in assessing the risk/reward of a particular investment, you can continue using ESG as part of your investment decision-making.
- Look at ESG as simply one more potential financial factor to consider in assessing an investment. As noted by the DOL, “prudent investors commonly take into account a wide range of financial circumstances and considerations, depending on the particular circumstances”.
- The framework used by the DOL is anchored in fundamental fiduciary principles—fiduciaries must act with the “care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.’’ ERISA, Section 404(a)(1)(B) (emphasis added). This means If circumstances change—for example, if research and market experience demonstrate that the use of ESG policies adversely affects corporate performance, then fiduciaries will, as always, need to operate based on prevailing circumstances.
- The new final regulations are issued in response to the current focus on ESG—but are applicable to other, new investment practices and theories that may emerge.
ESG can be a hot-button topic. The new regulations appear to be an effort to take some of the drama out of fiduciaries’ use of ESG considerations.