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7 Things to Know About the New ESG Regulation

ESG Investing

A little more than a week ago, the U.S. Department of Labor unveiled its much-anticipated final ESG rule.  There’s a lot to unpack in that regulation (and the rest of the 236-pages that help explain its process and rationale), but here’s a few things that seem particularly important to note at the outset.

There are some (important) things that did NOT change.

First, and to my mind, foremost, the Labor Department noted that “The duties of prudence and loyalty require ERISA plan fiduciaries to focus on relevant risk-return factors and not subordinate the interests of participants and beneficiaries (such as by sacrificing investment returns or taking on additional investment risk) to objectives unrelated to the provision of benefits under the plan.

But it also included an important clarification:

“…the final rule amends the current regulation to make it clear that 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 and that such factors may (emphasis mine) include the economic effects of climate change and other environmental, social, or governance factors on the particular investment or investment course of action.”

It does away with “pecuniary” as a standard (or at least as a word claiming to be the standard).

The Trump Administration’s version defined pecuniary (a term “introduced” to the ERISA lexicon by the United States Supreme Court in the Fifth Third v. Dudenhoefer decision[i]) as “a factor that a fiduciary prudently determines is expected to 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 the funding policy established pursuant to section 402(b)(1) of ERISA.” 

However, that word choice was determined by the Labor Department to be causing “confusion” and to have a “chilling effect” — “deterring fiduciaries from taking steps that other marketplace investors would take in enhancing investment value and performance, or improving investment portfolio resilience against the potential financial risks and impacts associated with climate change and other ESG factors.”

However, and despite what some saw as an implication in the proposed regulation, the final regulation does NOT mandate consideration of ESG factors.

Quite the contrary—quoting from the Labor Department:

“The final rule makes unambiguous that it is not establishing a mandate that ESG factors are relevant under every circumstance, nor is it creating an incentive for a fiduciary to put a thumb on the scale in favor of ESG factors.” 

“Outside the ERISA context, investors may choose to invest in funds that promote collateral objectives, and even choose to sacrifice return or increase risk to achieve those objectives. Such conduct, however, would be impermissible for ERISA plan fiduciaries, who cannot sacrifice return or increase risk for the purpose of promoting collateral goals unrelated to the economic interests of plan participants in their benefits.”

It treats QDIAs just like any other investment option in the plan.

The Trump Administration in its preliminary regulation had barred funds with an ESG focus from qualifying as a qualified default investment alternative (QDIA), and then—following criticism on that front—in its final regulation modified the provision in the proposal on QDIAs to prohibit plans from adding or retaining any investment fund, product, or model portfolio as a QDIA or as a component of such a default investment alternative, if its objectives, goals or principal investment strategies include the use of non-pecuniary factors.

The new regulation removes that distinction, noting that “QDIAs would continue to be subject to the same legal standards under the final rule as all other investments, including the prohibition against subordinating the interests of participants and beneficiaries in their retirement income to other objectives. QDIAs also would continue to be subject to the separate protections of the QDIA regulation.”

That said, the Labor Department says it expects to see an increase in the number of QDIAs that are ESG funds—though, considering the number currently in the market (and there are some), that hardly seems a controversial call.

Eliminated additional disclosure/labeling requirements associated with alternative investments with collateral benefits.

The Trump era regulation imposed a requirement that competing investments be indistinguishable based solely on pecuniary factors before you could turn to collateral factors to break a tie—oh, and even then, you would have had to comply with a special documentation requirement on the use of such factors.

The final rule, on the other hand, replaces that with a standard that instead requires the fiduciary to conclude prudently that competing investments, or competing investment courses of action, equally serve the financial interests of the plan over the appropriate time horizon—and, having determined that they equally serve those goals, is not prohibited from selecting the investment, or investment course of action (like an ESG focus), based on collateral benefits other than investment returns. 

And they no longer have to document that evaluation (which, interestingly enough, turns out to be one of the cost benefits[ii] associated with the new rule). 

Participant preferences can (still) play a role in menu design.

Now, in my experience, plan sponsors (and advisors) have long considered participant preferences in menu design. Not to the subordination of prudent fiduciary standards, of course—though there have been concerns that some might not see it that way. 

Well, the new regulation contains a new and interesting provision that “clarifies” that fiduciaries “do not violate their duty of loyalty solely because they take participants’ preferences into account when constructing a menu of prudent investment options for participant-directed individual account plans. If accommodating participants’ preferences will lead to greater participation and higher deferral rates, as suggested by commenters, then it could lead to greater retirement security."

Now, notice that while such considerations don’t necessarily violate the duty of loyalty—but there is no setting aside of the standards of prudence in evaluating and monitoring those investments noted above.  More specifically, those decisions need to be evaluated “taking into consideration the risk of loss and the opportunity for gain” compared to the opportunity for gain “with reasonably available alternatives with similar risks.”   

As noted above, there’s a lot to unpack here—and we’ll continue to do so right up to the Jan. 30, 2023 effective date—and beyond.


[i] In that case, the nation’s highest court concluded that the responsibilities of an ESOP fiduciary must be directed toward the duty to provide benefits and defray expenses—and that any non-pecuniary interests, such as Congress' strong encouragement of employee stock ownership, did not warrant an alteration of the fiduciary standard.  

[ii] Noting that in view of the “large scale of investments held by covered plans, approximately $12.0 trillion, changes in investment decisions and/or plan performance may result in changes in returns in excess of $100 million in a given year,” the Labor Department estimates that 20% of defined contribution and defined benefit plans (149,300 plans with some 28.5 million participants) will be affected by the regulation “because their fiduciaries consider or will begin considering climate change or other ESG factors when selecting investments.” In the Labor Department’s estimation, for each plan, a “legal professional will need to review paragraphs (b)-(c) of the final rule, evaluate how these provisions might affect their investment practices and assess whether the plan will need to make changes to investment practices. The Department estimates that this review will take a legal professional approximately four hours to complete, resulting in an aggregate cost burden of approximately $91.5 million or a per-plan cost burden of approximately $613.[ii]”

That said, the Labor Department noted that plan fiduciaries “generally already undertake deliberative evaluations as part of their investment selection decision-making process and this final rule does not add burden to those deliberations; but rather, the final rule clarifies that the scope of those deliberations may include climate change and other ESG factors within the confines of paragraphs (b)(4) and (c)(1) of the final rule. The Department does not intend to increase fiduciaries’ burden of care attendant to such consideration; therefore, no incremental costs are estimated for these requirements.”