The U.S. Department of Labor has unveiled its much-anticipated final ESG rule that it says will allow “plan fiduciaries to consider climate change and other environmental, social and governance factors when they select retirement investments and exercise shareholder rights, such as proxy voting.”
The operative word for plan fiduciaries is MAY, not must consider ESG factors—a concern that had arisen in the wake of the proposed regulation previously issued.
The rule, “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights,” specifically and pointedly sets aside the “pecuniary-only” standard at the center of the regulation set out in the waning days of the Trump Administration—a standard that Assistant Secretary of Labor Lisa Gomez said had had a “chilling effect” on plan investment decisions, even when those considerations were deemed to be in the best interests of participants and beneficiaries—causing them to miss out on opportunities, and failing to guard against risks.
“Today’s rule clarifies that retirement plan fiduciaries can take into account the potential financial benefits of investing in companies committed to positive environmental, social and governance actions as they help plan participants make the most of their retirement benefits,” said Secretary of Labor Marty Walsh. “Removing the prior administration’s restrictions on plan fiduciaries will help America’s workers and their families as they save for a secure retirement.”
In releasing the final rule, the Labor Department noted that it did NOT change two longstanding principles; 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, and that the fiduciary duty to manage plan assets that are shares of stock includes the management of shareholder rights appurtenant to those shares, such as the right to vote proxies.
Participant Preferences
A new and interesting provision “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." Thus, in this way, giving consideration to whether an investment option aligns with participants’ preferences can be relevant to furthering the purposes of the plan.
It appears this provision is intended to clarify that ESG-type investments can be added to a 401(k) menu based on the interests of participants, provided they satisfy the applicable fiduciary standards.
The final rule:
- Amends the current regulation to delete the “pecuniary/non-pecuniary” terminology based on concerns that the terminology causes confusion and a chilling effect to financially beneficial choices.
- 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 include the economic effects of climate change and other environmental, social, or governance factors on the particular investment or investment course of action.
- Amends the current regulation to remove the stricter rules for QDIAs, such that, under the final rule, the same standards apply to QDIAs as to investments generally.
- Amends the current regulation’s “tiebreaker” test, which permits fiduciaries to consider collateral benefits as tiebreakers in some circumstances. This is different than the test that applied prior to the 2020 rule – while that regulation imposed a requirement that competing investments be indistinguishable based on pecuniary factors alone before fiduciaries can turn to collateral factors to break a tie and imposes a special documentation requirement on the use of such factors, the final rule replaces those provisions 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. In such cases, the fiduciary is not prohibited from selecting the investment, or investment course of action, based on collateral benefits other than investment returns.
- Removes the current regulation’s special regulatory documentation requirements in favor of ERISA’s generally applicable statutory duty to prudently document plan affairs.
- Amends the current regulation to eliminate the statement in paragraph (e)(2)(ii) of the current regulation that “the fiduciary duty to manage shareholder rights appurtenant to shares of stock does not require the voting of every proxy or the exercise of every shareholder right.” The final rule eliminates this provision because it may be misread as suggesting that plan fiduciaries should be indifferent to the exercise of their rights as shareholders, even if the cost is minimal.
- Amends the current regulation to remove the two “safe harbor” examples for proxy voting policies permissible under paragraphs (e)(3)(i)(A) and (B) of the current regulation. One of these safe harbors permitted a policy to limit voting resources to types of proposals that the fiduciary has prudently determined are substantially related to the issuer’s business activities or are expected to have a material effect on the value of the investment. The other safe harbor permitted a policy of refraining from voting on proposals or types of proposals when the plan’s holding in a single issuer relative to the plan’s total investment assets is below a quantitative threshold. Taken together, the Department believes the safe harbors encouraged abstention as the normal course and the Department does not support that position because it fails to recognize the importance that prudent management of shareholder rights can have in enhancing the value of plan assets or protecting plan assets from risk. Because of this failure, the Department believes these safe harbors do not adequately safeguard the interests of plans and their participants and beneficiaries.
“The American Retirement Association appreciates the Department’s willingness to recognize the concerns we raised with the proposed rule,” said Brian H. Graff, CEO of the American Retirement Association. “We have had this for a very short amount of time but at first glance this looks like a victory for plan fiduciaries. The final rule makes it clear that ESG factors do NOT have to be considered for every plan investment but rather that they ‘may’ be considered if the plan fiduciary determines them to be relevant as part of a principles-based fiduciary analysis.”
This rule will be effective 60 days after publication in the Federal Register. The rule will also be applicable on that date except for a delayed applicability until one year after publication for certain proxy voting provisions to allow fiduciaries and investment managers additional time to review any proxy voting policies and guidelines and make any necessary changes.
