The DoL’s proposed rule, "Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights" (“ESG Proposal”) released on October 14, 2021, mandates that ESG investments (and all investments) in participant directed plans must prioritize risk/return factors above non-pecuniary factors such as environmental, social, governance and market health. ESG funds that seek to participate in retirement plans must use investment policies that give precedence to financial considerations to avoid placing tedious burdens on current practices of plan fiduciaries.
Use of currently available ESG, Socially Responsible and Sustainable funds with non-pecuniary objectives or policies will be permitted only by outperforming peers in their asset class on the basis of pecuniary factors. These prerequisites discourage the use of non-pecuniary investments in asset classes as constructed today but creates an opportunity for new classes of funds that facilitate adoption into ERISA plans.
The ESG Proposal requires that fiduciaries use only pecuniary factors to select and monitor investments in the respective asset class.
Two specific examples a fiduciary may not include in a menu without a pecuniary justification:
- a bond fund because it selects only bonds whose issuers are racially diverse.
- a small cap growth fund because it selects issuers based on carbon emission policies.
Complying with the ESG Proposal within existing asset classes will require new ERISA ESG funds with the primary objectives being pecuniary (risk mitigation and maximization of returns). Creating an ERISA ESG fund appears more economical than adapting existing funds to the new requirements.
New Asset Classes
The ESG Proposal specifically noted that other economic factors can be used in developing the plan’s investment policies. In other words, a fiduciary can introduce new asset classes that contribute to the retirement security of employees.
Introducing new asset classes that provide enhanced diversification and other economic benefits can be done simply by revising the plan’s policies to express the requirement for such asset classes. Pecuniary selection and monitoring are then applied only to the funds that meet the requirements of the asset class.
By introducing new asset classes, the examples noted above change from being prohibited to being permitted. A fiduciary may use new asset classes as follows:
- “racially diverse bond” investments based on the lower risk of discrimination litigation and then select and monitor the funds that qualify.
- “resource preservation” funds and then select and monitor the funds that qualify.
The rationale for adding new classes may include one or more of the following:
- Economic benefit to employees
- Enhanced diversification
- Encouraged participation and contribution
- Potentially lower risk
- Potentially higher return
Considerations for New Asset Classes
The following considerations are necessary and prudent in adding a new asset class to a plan:
- The asset class needs to be recognized as a generally accepted investment theory (“GAIT”). GAIT is established in either of two ways:
- Wide adoption in the investment community.
- A specific test among a panel of recognized investment experts, independent of the user of the new asset class.
- Economic basis can be derived on the basis of increasing the retirement security of employees. This includes accumulation and decumulation phases.
- A peer group must be constructed, against which investments in that class can be evaluated.
- Asset classes need not be exclusive based on decades of precedent. One investment may therefore fit more than one investment class required by a plan. For example, it is possible for one investment to fit all of the following and be compared in different peer groups:
- Large Cap
- Aggressive Growth
- Resource Conservation
The new peer group is adopted by updating the plan’s investment policies and selecting or monitoring the investments in the new peer group.
Asset Class Implementation
The adoption of new asset classes to comply with the ESG Proposal, with a minimum of disruption, requires coordination of four roles:
- Record Keeper
- Investment Manager
- Plan Sponsor
It is necessary for all roles to be in general agreement on the approach being taken to avoid possible confusion and conflicts. To that end, Appendix A suggests “Proposed ESG Asset Classes”.
Each of these parties must revise relevant documentation/disclosures, including statements, SPD, 408(b)(2), 404(a)(5), etc. It may also be necessary to revise applicable web sites, mobile APPs, contact center procedures, etc.
The impact and requirement for each of these roles are outlined below. This outline is general in nature and will require refinement as facts and circumstances dictate.
The primary role of the record keeper is to identify the plans that are affected and to communicate this to the affected parties. A preliminary course of action can be offered as needed.
The consultant/advisor helps the affected plan sponsor on the appropriate course of action. When appropriate, the consultant/advisor assists with changes to investment policy and investment selection.
Investment managers amend investments to better align with new asset classes and introduce products where additional needs emerge.
Plan sponsor (or investment committee) amends the plan’s investment policies and when necessary, selects and monitors investment menu on the basis of the ESG Proposal and a revised IPS (Sample IPS).
Participants are informed of changes to investment menu and any necessary decisions. Associated support is provided.
Proposed ESG Asset Classes
The regulation explicitly states that pecuniary factors apply within the context of a plan’s investment objectives and policies.
A plan’s investment objectives are generally defined in the investment policy statement that the department expects to be revised to include objectives that may be achieved through various ESG type investments. Revisions to the investment policy statement will primarily add asset classes that offer pecuniary advantages in risk or return.
The Department believes that it would be consistent with ERISA for a fiduciary to treat a given factor or consideration as pecuniary if it presents economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories.
The additions to traditional asset classes that reflect the requirements of the ESG Proposal were derived from two primary sources:
- “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights”
- World Economic Forum ESG Core Metrics
These sources were examined to identify applicable pecuniary asset classifications as called for in the regulations.
From ESG Proposal
Pecuniary factors include financial considerations that have a material effect on the risk and/or return of an investment based on appropriate investment horizons consistent with the plan’s investment objectives and funding policy. Examples are:
- Level of Diversification
- Degree of Liquidity
- Potential Risk-Return
- Effect on Participation and Contributions
Nonetheless, if a fiduciary prudently determines that an investment is appropriate based solely on pecuniary considerations, including those that may derive from ESG factors, the fiduciary may make the investment without regard to any collateral benefits.
Nothing in the ESG Proposal is intended to or does prevent a fiduciary from appropriately considering any material risk with respect to an investment.
As an example, the Department’s position with respect to investments in China was informed by consideration of specific matters relating to investment risk, including inadequate investor disclosures and legal protections, that are consistent with “pecuniary factors” described in the proposed rule.
From WEF ESG Core Metrics
The WEF Core Metrics were examined to identify instances where pecuniary factors were a consideration and defined new asset classes where applicable. The asset classes derived are:
- Strong Governance
- Majority of independents
- Prohibits material conflicts of interest
- Experienced in governance
- Anti-corruption controls
- Ethical standards
- Active risk management
- Long Term Sustainability
- Actively maintains environment
- Policies of resource conservation
- Active environmental restoration
- Human Capital Focused
- Employee health preservation
- Skill development
- Employee skill retention
- Reinvests in Itself
- Share buyback practices
- R&D Expenditure