December 13, 2022

Final Department of Labor (DOL) regulations address ERISA fiduciaries’ ability to consider environmental, social and governance (ESG) factors in investment selection and proxy voting. The final rule amends regulations issued in late 2020 to clarify that ESG factors may be relevant to a fiduciary’s investment decisions. However, the revised rule omits proposed language suggesting that fiduciaries often may be required to account for climate change and other ESG considerations. Besides eliminating restrictions on the incorporation of ESG factors in qualified default investment alternatives (QDIAs), the final rule gives defined contribution (DC) plan fiduciaries more flexibility to weigh participant preferences when selecting investment offerings. DOL also removed the 2020 rule’s proxy-voting policy safe harbors and cumbersome written documentation requirements. Most provisions of the final rule will take effect Jan. 30, 2023, but plan fiduciaries will have until Dec. 1, 2023, to comply with two proxy-voting requirements carried over from the 2020 rule.

Change in administration spurs review of ESG rules

The final rule modifies two sets of 2020 DOL regulations issued during the Trump administration on investment selection and proxy voting:
 

  • The investment-selection rule provided a safe harbor for investment decisions based on “pecuniary factors” that a fiduciary prudently determines will have a material effect on an investment’s risk and return. While the rule didn’t explicitly prohibit considering ESG factors, many stakeholders viewed it as casting doubts on whether ESG considerations (including the market impacts of climate change) could qualify as pecuniary factors. Fiduciaries could make investment decisions using nonpecuniary factors, but only as tiebreakers when investment alternatives were indistinguishable based solely on pecuniary factors.

  • The proxy-voting rule required fiduciaries to exercise shareholder rights in accordance with the plan’s economic interest. However, the rule stipulated that fiduciaries don’t have to vote every proxy and included other provisions that stakeholders viewed as discouraging fiduciaries from exercising shareholder rights.

After President Joe Biden issued an executive order (EO 13990) directing federal agencies to review regulations inconsistent with his climate-change agenda, DOL announced that it wouldn’t enforce the 2020 rules. A later executive order (EO 14030) specifically directed DOL to reevaluate those rules. DOL proposed changes last fall to alleviate what some perceived as an anti-ESG bias — including removal of the pecuniary factors terminology — and to make the tiebreaker standard more consistent with pre-2020 guidance. The proposal also modified the proxy-voting provisions to avoid any implication that fiduciaries should be indifferent about exercising shareholder rights.
 

Some stakeholders criticized the proposed rule as promoting ESG too strongly, particularly language suggesting that fiduciaries often may be required to consider climate change and other ESG factors. In addition, though many stakeholders supported loosening the tiebreaker standard, they were largely opposed to the proposal’s special notice requirement. That requirement called for DC plan fiduciaries to notify participants when investment options were selected based on “collateral” factors (the proposed rule’s analogous terminology for nonpecuniary factors). This article highlights key changes the final rule makes to the 2020 rules and identifies aspects of last year’s proposed rule that DOL excluded from the final rule.
 

Fiduciaries may consider relevant ESG factors

The final rule’s updated investment-selection safe harbor allows fiduciaries to consider any factor they reasonably determine to be relevant to the risk or return of an investment. Unlike the 2020 rule, the final rule expressly states that the economic effects of climate change and other ESG considerations may be risk and return factors, depending on the circumstances. But the final rule stops short of mandating consideration of ESG factors in all investment decisions, instead allowing fiduciaries to exercise discretion in determining the relevance of any factor. DOL also continues to caution fiduciaries that ERISA’s duties of prudence and loyalty prohibit subordinating participants’ interests to objectives unrelated to plan benefits, such as sacrificing investment returns or taking additional investment risk.
 

From pecuniary factors to relevant factors. In response to perceptions that the 2020 rule’s “pecuniary factors” terminology has discouraged fiduciaries from incorporating ESG considerations into their decision-making, DOL eliminated that term from the final rule. However, the final rule’s operative language remains nearly identical to the 2020 rule’s definition of pecuniary factors, with one notable change: The final rule uses the word “relevant” instead of “material.” DOL explains that this change ensures consistency with other provisions of the final rule and addresses potential confusion with the narrower materiality standards under federal securities laws and accounting rules.
 

No mandate to consider ESG factors. The final rule omits the proposal’s language suggesting evaluating an investment’s projected return relative to the plan’s funding objectives “may often require” fiduciaries to consider the economic effects of climate change and other ESG factors. DOL says it removed this language to clarify that the final rule doesn’t mandate consideration of ESG factors in all investment decisions or create a regulatory bias in favor of ESG investing. DOL explains that fiduciaries shouldn’t treat ESG considerations differently than other relevant investment factors. The weight a fiduciary gives to any factor should reflect its effect on risk and return.
 

Elimination of list of ESG factors. The final rule eliminates the proposal’s detailed listing of different ESG factors that might be relevant to a risk–return analysis. DOL notes that the proposed rule’s examples were only illustrative and intended to clarify that ESG factors may be more than mere tiebreakers. However, the agency indicates that removing the examples “should not be viewed as limiting a fiduciary’s ability to take into account any risk and return factor that the fiduciary reasonably determines is relevant to a risk/return analysis.” DOL says relevant factors could include the economic effects of climate change and other ESG examples from the proposal, as well as an array of other non-ESG considerations described in the final rule’s preamble.
 

Additional flexibility for DC plans

DOL added several new provisions aimed specifically at participant-directed DC plans, such as 401(k) and 403(b) plans. The changes increase fiduciaries’ flexibility to accommodate participants’ nonfinancial preferences and adjust the investment-selection provisions to better reflect DC plan menu construction. The final rule also eliminates the 2020 rule’s restrictions on the incorporation of nonpecuniary factors in QDIAs.
 

DC fiduciaries may consider participant preferences. Plan fiduciaries won’t violate their duty of loyalty solely because they take into account participants’ nonfinancial preferences — such as policy, social or value preferences — when selecting investment options for participant-directed individual account plans. DOL believes accommodating participant preferences can enhance plan participation and contribution rates, furthering the purposes of DC plans. But DOL cautions that fiduciaries must still comply with their duty of prudence and “may not add imprudent investment options to menus just because participants request or would prefer them.” The final rule doesn’t restrict the types of participant preferences to ESG or other factors: Fiduciaries have flexibility to make these decisions by considering the facts and circumstances of the plan and its participant population.
 

Clarifications for DC plan menu construction. DOL made two changes in response to comments indicating that several of the proposal’s provisions — which were carried over from DOL’s 1979 investment duties regulation — reflect appropriate considerations for defined benefit (DB) plans but aren’t relevant to participant-directed DC plans. While cautioning that DC plan fiduciaries aren’t subject to lower standards when selecting investment options for participant-directed individual account plans, DOL made the following modifications to the investment-selection provisions:
 

  • The word “menu” now appears in two provisions to recognize a fiduciary’s selection of investment options for a DC plan (as opposed to investment strategies for a DB plan’s “portfolio”). In the preamble, DOL indicates that DC plan fiduciaries should consider how a particular fund fits within the plan’s investment lineup “to enable plan participants to construct an overall portfolio suitable to their circumstances.” DOL says DC fiduciaries should also consider how a fund compares to “a reasonable number of alternative funds to fill the given fund’s role in the overall menu.”

  • DOL clarified that three investment-selection factors don’t apply to participant-directed individual account plans: the portfolio’s composition with regard to diversification, liquidity and current return relative to the plan’s anticipated cash flow requirements, and projected return relative to the plan’s funding objectives. These factors will continue to apply to all DB plans and any DC plans that don’t allow participants to direct their investments.

QDIA collateral benefit restrictions eliminated. The final rule eliminates the 2020 rule’s blanket restriction on QDIA status for any investment that considers collateral benefits as part of its investment objectives, regardless of a fiduciary’s reasons for selecting the investment. DOL says such a restriction would have effectively prevented fiduciaries from selecting QDIA offerings that incorporate ESG factors, even when the fund is otherwise prudent and superior to competing options. This change means that QDIAs are subject to the same legal standards as other DC plan investments.
 

Relaxation of tiebreaker standard

The final rule allows fiduciaries to use collateral factors unrelated to risk or return as tiebreakers when choosing between competing investments that equally serve the plan’s financial interests. The 2020 rule’s tiebreaker provision was less flexible, permitting fiduciaries to consider collateral goals only when competing investments were indistinguishable based on pecuniary factors alone. However, the final rule continues to forbid fiduciaries from settling for lower returns or accepting increased risk.
 

Return to historic tiebreaker standard. DOL explains that the final rule’s tiebreaker provision is more closely aligned with prior subregulatory guidance than the 2020 rule. The final rule doesn’t restrict the types of collateral benefits that fiduciaries may consider. However, DOL cautions plan fiduciaries not to violate ERISA’s prohibited transaction rules (for example, by choosing an investment to benefit the fiduciary or another party in interest). DOL also emphasizes that fiduciaries aren’t required to choose investments using the tiebreaker standard, noting that for participant-directed individual account plans in particular, “adding additional investment options is not necessarily a zero-sum game, such that the fiduciary may choose only one option.”
 

Documentation requirements lifted. The final rule also eliminates the 2020 rule’s burdensome documentation requirements. DOL agreed with commenters who asserted that this requirement would discourage plan fiduciaries from using the tiebreaker. Fiduciaries will only need to document tiebreaker decisions following the same general prudence obligation that applies to all investment decisions.
 

No additional disclosure for DC plans. The final rule omits the proposed participant disclosure when fiduciaries for participant-directed DC plans select investment options using the tiebreaker standard. Commenters noted that failure to comply with this requirement would have violated ERISA’s duty of loyalty since the tiebreaker standard, unlike the rule’s investment-selection provisions, isn’t a safe harbor. DOL also acknowledged other commenters’ concerns, ranging from uncertainty about the mechanics of the proposed disclosure to fears that it could dissuade DC plan fiduciaries from using the tiebreaker to avoid potential lawsuits. However, DOL is monitoring several Securities and Exchange Commission (SEC) regulatory projects on ESG-related matters and may take further action in the future, depending on the SEC’s findings.
 

Exercise of shareholder rights

DOL continues to view the exercise of shareholder rights, including proxy voting, as a fiduciary act. Accordingly, fiduciaries must exercise shareholder rights prudently and solely in accordance with the plan’s economic interests. The final rule allows the consideration of all factors — including ESG considerations — that a fiduciary prudently determines are relevant to the value of the plan’s investments. DOL also confirms that fiduciaries may consider the effects of the plan’s exercise of shareholder rights — either alone or together with other shareholders — and won’t violate the duty of loyalty merely because exercising the plan’s rights could also benefit other shareholders.
 

Encouraging exercise of shareholder rights

The final rule rescinds several provisions of the 2020 rule that DOL believes encourage fiduciaries to abstain from exercising shareholder rights:
 

  • Exercise of shareholder rights when in plan’s best interest. The final rule removes a provision that says ERISA fiduciaries don’t have to vote every proxy or exercise every shareholder right. But DOL indicates this doesn’t mean fiduciaries must always vote proxies or engage in shareholder activism. The new rule retains prior provisions on what a fiduciary must consider when deciding whether to exercise shareholder rights, such as the costs involved. However, DOL encourages fiduciaries to implement efficient structures — like adopting proxy-voting guidelines or retaining proxy advisors or managers in accordance with the rule’s requirements — instead of abstaining.

  • No special documentation. The final rule eliminates the requirement for fiduciaries to maintain records on proxy voting and exercises of shareholder rights. This change avoids any implication that those activities are disfavored or subject to greater scrutiny. Proxy voting is subject to the same recordkeeping standards that apply to other fiduciary decisions.

  • No special monitoring. The final rule removes the special monitoring obligations when fiduciaries delegate proxy-voting authority or retain a third party for proxy-voting advice. Again, ERISA’s general fiduciary standards apply in these situations and require fiduciaries to assess the provider’s qualifications, quality of services and reasonableness of fees, while also taking steps to avoid self-dealing, conflicts of interest or other improper influence. DOL confirms that a fiduciary generally doesn’t have to monitor each vote or second-guess a provider’s decisions, but should review the provider’s proxy-voting policies or guidelines and implementing activities. A fiduciary should also take appropriate action after determining the provider isn’t acting consistently with those policies or guidelines.

  • Proxy-voting safe harbors eliminated. The final rule also removes the 2020 rule’s two safe harbor proxy-voting policies, which DOL believes would encourage abstention from proxy voting.

Delayed effective date for some proxy-voting provisions

While the final rule generally applies starting Jan. 30, 2023, DOL has provided an extended effective date for two proxy-voting provisions carried over from the 2020 rule. One provision requires a fiduciary to review a third party’s proxy-voting guidelines for consistency with ERISA before following the third party’s voting recommendations. The other provision addresses the exercise of shareholder rights by mangers of pooled investment funds (like collective investment trusts) holding the assets of more than one plan. To provide adequate time for compliance, these two proxy-voting provisions won’t take effect until Dec. 1, 2023. Until then, DOL’s existing nonenforcement relief will continue to apply to those provisions.
 

Future outlook and ongoing partisan divide over ESG

After more than a decade of shifting investment guidance from DOL, the final rule promises to be well received by an investment industry largely supportive of ESG considerations. DOL’s carefully crafted preamble to the final rule builds a record of stakeholder feedback that will likely blunt — but may not completely deter — potential court challenges.
 

However, the final rule isn’t placating congressional Republicans, who contend that the use of ESG factors in retirement plan investment decisions is politically motivated and could allow fiduciaries to subordinate participants’ financial interests. “The Biden administration’s new rule jeopardizes the financial security of many retirement savers, especially workers and retirees who may be put into ESG investments by default,” key House Republicans said in a statement shortly after the rule’s release. A GOP senator quickly offered legislation (SJR 65) to overturn the rule. Other GOP members had already introduced legislation earlier this year to enshrine the 2020 rule’s pecuniary factors standard within ERISA. One such bill — the Safeguarding Investment Options for Retirement Act (HR 9198) — would also prohibit fiduciaries from selecting default DC plan investments on the basis of nonpecuniary factors and mandate that qualified, 403(b) and 457(b) plans include investment options selected using only pecuniary factors.
 

Legislation to counter the new DOL rule may advance next year in the Republican-controlled House and will likely be the subject of committee hearings and oversight activity. Nonetheless, the Democrat-led Senate and President Biden’s veto power will be a barrier to legislative changes for at least the next two years. A future Republican administration could also attempt to revisit the rule.
 

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Matthew Calloway
by Matthew Calloway

Principal, Mercer’s Law & Policy Group

Margaret Berger
by Margaret Berger

Partner, Mercer’s Law & Policy Group

Brian J. Kearney
by Brian J. Kearney

Principal, Mercer’s Law & Policy Group


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