Sustainability Matters

ESG in Retirement Plans: 4 takeaways on the final rule

Considering ESG factors is consistent with fiduciary duty

The U.S. Department of Labor (DOL) finalized a rule last week that will remove barriers, real and perceived, to ESG investing in retirement plans governed under the Employee Retirement Income Security Act of 1974 (ERISA).

Called “Prudence and Loyalty In Selecting Plan Investments and Exercising Shareholder Rights,” the new rule replaces two hastily drawn rules rushed to the finish line at the end of the Trump Administration. Those rules were widely interpreted as discouraging retirement plan fiduciaries from considering ESG factors and from exercising shareholder rights.

Here are four key takeaways about the new rule:

Fiduciary duty includes consideration of climate change and other ESG issues

Under ERISA, a retirement plan fiduciary’s duty of prudence requires that decisions must be based on factors the fiduciary reasonably determines are financially material to the plan’s investments. That has not changed. What has changed is the new rule makes clear that these factors may include climate change and other ESG issues.

That means plan administrators may consider climate change and other ESG factors when selecting managers for defined-benefit (DB) plans or selecting funds for defined-contribution (DC) plan lineups. That also means those making direct investment decisions for a plan, like fund managers, may include climate and ESG considerations in their investment process.

The Trump-era rule being replaced seemed intentionally opaque about whether it was prudent for a fiduciary to consider climate change or other ESG issues. It said “non-pecuniary” factors could not be considered by a fiduciary and strongly suggested that ESG issues were hardly ever “pecuniary” in nature. Climate change was never so much as mentioned in the proposed or final rule.

The current DOL concluded that the Trump-era rule was deterring retirement-plan fiduciaries from acting prudently on behalf of beneficiaries in taking steps that many other marketplace investors have been taking to enhance the performance of their investments; namely, taking climate change and other ESG factors into consideration.

QDIAs get the go-ahead to consider climate change and other ESG factors

The Trump-era rule essentially banned the consideration of supposed non-pecuniary issues like climate change and other ESG factors in decisions related to qualified default investment alternatives (QDIAs) in defined-contribution plans. Under the new rule, the same standards apply to QDIAs as to investments generally.

This is important because QDIAs attract the lion’s share of DC plan contributions, mainly through the use of target-date funds. Plan administrators may now include climate change or other ESG criteria when selecting and designating QDIAs. Target-date funds may now also include ESG criteria and may include sustainable funds within their fund-of-funds structure.

A reasonable tie-breaker for collateral benefits

The concept of collateral benefits has been part of DOL guidance since the 1990s. The idea is that if an investment offers some sort of benefit above and beyond risk-adjusted returns, such as a positive impact on people and planet, that “collateral benefit” could not be given precedence over investment performance. However, “all things equal” among similarly situated investments, the collateral benefit could be used as a tiebreaker in selecting investments for retirement plans.

The tiebreaker could apply to sustainable funds and investment strategies that exclude investments in certain products or activities that they deem harmful to people or planet, or to those that include criteria focusing on positive impacts. In these cases, the investment’s focus on ESG issues is not always about financial materiality, at least in the narrow sense of having an effect on short-term stock prices. Even if the ESG issues being addressed by a fund are not immediately or obviously material, their use in a fund can be considered a collateral benefit. So long as the fund offering collateral ESG benefits is a prudent financial choice, then a plan fiduciary can consider the collateral benefits in selection.

The Trump-era rule did not out-and-out ban tiebreakers, but it set an unreasonably high bar. It required that investment performance of an investment with collateral benefits first had to be demonstrably “indistinguishable” from other similar investments, and required extra documentation of the decision-making process.

Under the new rule, the fiduciary is simply required to conclude prudently that when competing investments equally serve the financial interests of the plan, the fiduciary may decide based on a collateral benefit. There are no special documentation requirements other than ERISA’s longstanding statutory duty to prudently document plan affairs.

Importantly, the new rule also clarifies that fiduciaries do not violate their duty of loyalty to act solely on behalf of plan participants and beneficiaries when they take participants’ preferences into account in constructing a menu of prudent investment options for DC plans. This is important because a number of surveys have suggested that plan participants want sustainable funds in their lineup. Accommodating these preferences can lead to greater participation and higher deferral rates, resulting in enhanced retirement security for participants.

The prudent exercise of shareholder rights

The new rule also unwinds the Trump-era rule that discouraged plan fiduciaries from exercising their rights as shareholders. That rule permitted plans to limit proxy voting to a predetermined set of issues they deemed to be financially material and to refrain from voting when its holdings in a single issuer were small relative to the plan’s total assets. It also required extensive recordkeeping about proxy voting and any relationship a plan had with proxy advisors.

Taken together, these provisions in the Trump-era rule encouraged abstention as a normal course of action. The new rule simply states that the fiduciary duty to manage plan assets includes the management of shareholder rights related to those shares, such as the right to vote proxies. Plan fiduciaries must use prudence and loyalty in fulfilling these duties.

Out with the old…

The Trump-era rules being replaced may have been intentionally opaque but they sent a clear messages to retirement plan fiduciaries: Incorporate ESG and climate-change considerations at your own risk.

If you nonetheless include these matters in your investment selection or proxy voting activities, you must expend plan resources on excessive documentation of your decisions to mitigate the risk of lawsuits for not meeting vague standards:

• don’t over-assume that ESG risks are material,
• don’t invoke the tiebreaker in favor of funds with collateral benefits unless the choices can be documented as indistinguishable,
• don’t vote proxies unless you can demonstrate that benefits to plan outweigh the costs.

…In with the new

By contrast, the new proposal is a model of rational policymaking. Reflecting what’s happening in the real world, it says, of course climate change and other ESG issues are material and therefore something plan fiduciaries may prudently consider in their decisions.

• On the selection of funds that offer so-called collateral benefits, it says these funds can be chosen as long as they serve the financial interests of the plan equally as well as alternatives.
• On QDIAs, which are designed to be long-term investments for retirement plan participants, it says funds that incorporate climate change and ESG considerations should not be disadvantaged or disallowed.
• On proxy voting and other shareholder activities, it says use these tools in a prudent manner to enhance the long-term value of the plan.

Keep in mind the new rule does not mandate retirement plan fiduciaries to consider climate change or other ESG issues. It simply removes the barriers to doing so and says fiduciaries should treat ESG as they would any other relevant factor, based on the fiduciary standards of prudence and loyalty.