ESG in Retirement Plans – Regulatory Update November 2021

As the Biden administration finds its footing, the Department of Labor (DOL) has revisited the status of ESG (environmental, social, governance) investing in retirement plans. The DOL issued proposed changes in mid-October which are subject to a 60-day comment period ending December 13, 2021. At that time the DOL will evaluate the comments and will likely make adjustments before publishing a final rule in 2022, but here are two highlights of the current proposal.

• Consideration of ESG factors in employer-based retirement plans may not only be permissible, they seem to be encouraged. The proposal makes clear that for the entire fund lineup – including designated investment alternatives (DIAs) and qualified default investment alternatives (the QDIA or default fund) – fiduciary duty “may often require” an evaluation of the economic effects of climate change and other ESG factors.
• The proposal combines ESG investment duties and proxy voting. Prior sub-regulatory guidance and the 2020 Regulations from the Trump administration handled ESG investing and proxy voting separately. The current proposal combines the two and eliminates the documentation requirement and safe harbors previously required.

What’s Changed Since 2020
In 2020, under the Trump administration, the DOL published a final rule on Financial Factors in Selecting Plan Investments as well as Fiduciary Duties Regarding Proxy Voting and Shareholder Rights (known together as the 2020 Regulations). Both became final regulations, but generated considerable uncertainty which many argue had a chilling effect on ESG investing in retirement plans.

This dynamic changed with the arrival of the Biden administration and climate change quickly became a priority. The new president issued an executive order in January 2021 directing federal agencies to review the Trump regulations and ensure they were aligned with improving public health and protecting the environment. In March the DOL issued a non-enforcement policy for the 2020 Regulations. This meant that non-compliance with the 2020 Regulations wouldn’t result in penalties from the DOL – but it didn’t prevent private litigation, such as class action lawsuits.

The Biden administration then issued a second, more specific executive order in May 2021 requiring the DOL to publish a proposed rule to suspend, revise, or rescind the 2020 Regulations. After extensive review, the proposed rule was published on October 14, 2021 to address the uncertainty prompted by the 2020 Regulations regarding ESG investing. It also addressed the concern that the ruling discouraged fiduciaries from considering “climate change and other ESG factors in investment decisions, even in cases when it is in the financial interest of plans to take such considerations into account.”

Please note: This is currently only a proposed rule which must go through the 60-day comment period before it is finalized in the Federal Register, but changes from the 2020 Regulations are detailed below.

ESG Investing Criteria
While the word “pecuniary” is not included in the proposed regulation, its meaning is retained in two of the four core ERISA fiduciary principles for investing:

• Fiduciaries must follow a prudent process
• Fiduciaries owe a duty of loyalty to participants and beneficiaries, which means putting the financial interests of participants and beneficiaries first

In following a prudent process under the proposal, the important change from the 2020 Regulations is the distinction that for all investment options in the plan (both DIA and QDIA) a fiduciary’s duty of prudence may often require an evaluation of the economic effects of climate change and other ESG factors on the particular investment.

Material Risk
It also specifies that when considering ESG factors in investment selection, fiduciaries should focus on material risk and return factors. Materiality is the assessment of which ESG factors are directly relevant to the long-term financial outcome of an investment. Fiduciaries are expected to focus on material ESG factors rather than objectives that may be unrelated to the long-term financial interests of participants and beneficiaries in the plan.

The new proposal does retain one instance when considering the collateral benefits of ESG investing may be permissible, however: in breaking a tie between competing investment options. In a situation when several investment options are equivalent based on the material financial factors, collateral benefits (ESG or other factors) could be used in making a final decision.

What About Proxy Rules?
These are arguably less relevant to plan sponsors, but the proxy voting rules have been updated and streamlined from the 2020 Regulations. The guidance directs fiduciaries to follow a prudent process and the duty of loyalty in alignment with the direction of the ESG investing guidance.

ESG Action Items for Plan Sponsors

• Keep in mind that this is only a proposed regulation and there may be differences in the final version.
• Review the existing framework for investment selection in your investment policy statement (IPS), and determine whether you are operating in line with that IPS today. You don’t need a separate IPS for ESG investing – you just need to make sure your policy aligns with what you are actually doing to review investments.
• Review your investment lineup and seek the help of an investment professional if you aren’t doing so already.
• Be on the lookout for the final rule during 2022.

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