Today, the Department of Labor published its proposed rules on ESG investments and proxy voting within ERISA plans. The proposed rule is entitled, "Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights" and reverses, to some extent, the DOL's 2020 rulemaking on ESG investments within ERISA plans.
There are some important differences in this proposed rule from the 2020 rules issued by the previous administration. There are also important aspects that have not changed.
The following are the 4 important takeaways from the proposed rules:
1. Fiduciaries STILL cannot Subordinate the Interests of Participants for Non-Pecuniary Goals
This is the vital line in the sand that the 2020 rule and previous guidance drew, and a line that the proposed rule maintained. The existence of ESG investments within an ERISA plan is acceptable when the ESG factors are material risk-return factors. The Department accepts the notion that many common ESG factors do play a part in the risk and return analysis of an investment or a portfolio as a whole. This is an important constant between the 2020 and 2021 rules.
Let's take the following example:
A plan sponsor includes an investment that heavily weights environmental factors because everyone on the investment committee loves nature and wants to do their part to save the environment.
In this example, the motive is non-pecuniary, but there is likely a pecuniary justification for the inclusion of that investment as well. The Department acknowledged in this proposal that environmental factors can enhance value and performance, or hedge against a portfolio's risks associated with climate change.
So while the proposed rule is far more ESG friendly, it is important to note that a pecuniary tie-in is still required to satisfy the duty of loyalty. This pecuniary tie-in should be explicitly stated in a plan investment policy statement. However, there is also a scenario in which an ESG factor can be considered in a non-pecuniary sense, as collateral benefit. That leads to Observation #2.
2. "Tie-Breaker Rule" is Back to its Previous Non-Regulatory Guidance
The tie-breaker rule was a concept that was introduced by the Department in their non-regulatory guidance in 1994. The "tie-breaker rule" allowed for the selection of investments based on non-pecuniary factors so long as the rate of return "is commensurate to rates of return of available alternative investments." Unlike the considerations in Observation #1, these factors are not part of the risk return factors affecting the economic merits of the investment, they act as a tie-breaker between two investments that equally fit the needs of participants.
If we go back to the example in Observation #1, the desire of the investment committee to help the environment is a collateral benefit . That collateral benefit cannot be at the expense of return or risk. If we assume that the ESG factors of said investment provides no pecuniary justification for its inclusion, the investment could still be included so long as its risk and returns are on par with alternative available options. In that case, the ESG factors have become a de facto tie-breaker between two or more prudent options.
The 2020 ESG rule formalized the "tie-breaker rule" but required specific documentation. In the proposed rule, the DOL categorized the documentation requirement from the 2020 rule as "singl[ing] out and creat[ing] burdens specifically for investments providing collateral benefits, which many perceived as targeting ESG investing." The Department went on to clarify that a "fiduciary is not prohibited from selecting the investment, or investment course of action, based on collateral benefits other than investment returns, so long as the requirements of the proposal are met." The requirements of the proposal are met when there is no reduced return or increased risk to secure the collateral benefit.
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3. QDIAs are Back on the Table
The 2020 rule put a prohibition on ESG investments within Qualified Default Investment Alternatives. The proposed rule explicitly allows for such investments within QDIAs. This is truly a game changer for the industry who will soon have the green light to bake ESG into default investments such as target date funds, target risk funds, model portfolios and managed accounts.
However, in the case of an ESG QDIA, the plan fiduciary must ensure that the collateral-benefit characteristic of the fund, product, or model portfolio is prominently displayed in disclosure materials provided to participants.
4. The DOL provided Examples of ESG Factors
The Department provided some comfort to the industry by providing some specific examples of relevant ESG factors that could prudently be part of an investment's risk-return assessment. Those examples are as follows:
- Climate change-related factors, such as
- a corporation’s exposure to the real and potential economic effects of climate change
- exposure to the physical and transitional risks of climate change
- the positive or negative effect of Government regulations and policies to mitigate climate change
- Governance factors, such as
- board composition
- executive compensation
- transparency and accountability in corporate decision-making
- a corporation’s avoidance of criminal liability
- compliance with labor, employment, environmental, tax, and other applicable laws and regulations;
- Workforce practices, including
- the corporation’s progress on workforce diversity, inclusion
- other drivers of employee hiring, promotion, and retention
- its investment in training to develop its workforce’s skill
- equal employment opportunity
- labor relations.
The essence of this proposed rulemaking is not entirely different from the 2020 rule, but addresses the big issues from 2020 that resulted in a chilling effect on ESG investments within ERISA plans. Both rules acknowledge that ESG factors can play a role in the prudent evaluation of an investment. Both rules reject the notion of sacrificing returns or taking on more risk in the name of ESG. But unlike the 2020 rule, the proposed rule is more workable in practice and should result in more ESG investments within ERISA plans.