U.S. Department of Labor proposes ESG investment regulation

Jun 24, 2020
Jun 24, 2020
0 min. read

The U.S. Department of Labor (the Department) has proposed a new regulation focused on the duties of retirement plan fiduciaries with respect to a decision to include investments based on the certain environmental, social and corporate governance considerations (ESGs) rather than solely on the potential for maximum returns. 

The proposal is an amendment to 29 CFR 2550.404a-1. The existing regulation is the foundation of a fiduciary’s duties under the Employee Retirement Income Security Act (ERISA). That regulation provides that fiduciaries must discharge their duties with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims. 

With respect to a fiduciary’s selection of plan investments, the current regulation provides that a fiduciary will successfully apply the prudent man standard described above if the fiduciary considers a number of factors concerning the composition of the plan’s portfolio. Specifically, the fiduciary needs to consider how a potential investment fits with respect to diversification, the liquidity and current return of the portfolio relative to the anticipated cash flow needs of the plan, and the projected return of the portfolio relative to the funding objectives of the plan. This guidance recognizes that some investments are inherently riskier than other investments, and that it is not a fiduciary violation to select a riskier investment as a part of well-diversified long-term plan investment portfolio. The proposed regulation applies to defined benefit plans and for, purposes of selecting an ENG as a plan investment choice in a defined contribution plan, such as a 401(k) plan.

The proposed addition to the regulation makes it clear, in a manner consistent with a number of the Department’s earlier Interpretative Bulletins and Field Assistance Bulletins, that the paramount focus of plan fiduciaries must be the plan’s financial returns and risk to participants and beneficiaries. The prior guidance also cautioned that fiduciaries violate ERISA if they accept reduced expected returns or greater risks to secure social, environmental or other policy goals.

Notably, the proposed regulation retains Department’s so-called ‘tie-breaker’ or ’all things being equal’ standard, but requests comments on whether the standard should be modified. The tie-breaker rule refers to the Department’s prior guidance that an ENG investment may be permissible, to the extent that it is “economically indistinguishable” from non-ESG alternative investment.  The Department speculates that, even if the funds are economically indistinguishable, a fiduciary’s selection of the ENG investment may violate the fiduciary rules because it may be necessarily based on non-pecuniary factors. 

Thus, the purpose of the proposed regulation is to elevate the Department’s previous sub-regulatory guidance to the regulatory level.

The most relevant proposed additions to the regulation are that a fiduciary:

  • Must evaluate investments and investment courses of action based solely on pecuniary factors that have a material effect on the return and risk of an investment based on appropriate investment horizons and the plan’s articulated funding and investment objectives (if such objectives are consistent with the provisions of Title I of ERISA).
  • Must not subordinate the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to unrelated objectives, or sacrifice investment return or take on additional investment risk to promote goals unrelated to those financial interests of the plan’s participants and beneficiaries or the purposes of the plan.
  • Must consider how a proposed investment compares to available alternative investments or investment courses of action with regard to the fiduciary meeting its duties of prudence and loyalty. 
  • Must specifically document its conclusion that an investment chosen for non-pecuniary reasons (e.g. an ESG investment) was determined to be indistinguishable from other appropriate investments and how the selected investment was chosen based on the purposes of the plan, diversification of investments, and the interests of plan participants and beneficiaries in receiving benefits from the plan. 
  • Must, comply with sections 403 and 404 of ERISA in order to select an ESG investment fund as a designated investment alternative for a 401(k) type plan. ERISA section 403 provides that plan assets must be for the exclusive purposes of providing benefits to participants in the plan and their beneficiaries and ERISA section 404 sets for the general duties of a fiduciary. With regard to this requirement, the fiduciary must document its selection and ongoing monitoring of any ESG fund its selects for the fund lineup. 

In addition, the proposed regulations make it clear that a defined contribution plan cannot select an ESG fund as its Qualified Default Investment Alternative.

These regulations, if finalized, with their emphasis on achieving maximum investment results for the plan above all other considerations make it a difficult proposition for a plan to select or retain an ESG type of investment in an ERISA retirement plan.

RSM contributors

Subscribe to tax updates and insights

Choose from timely legislation and compliance alerts to monthly perspectives on the tax topics important to you.