Vice President, Retirement Policy, U.S. Chamber of Commerce
December 16, 2022
For over 28 years, Democrat and Republican administrations have used retirement plans as political ping pong balls in the fight over economically targeted investments (ETIs) and using environmental, social, or governance (ESG) factors. On November 22, 2022, the Department of Labor (DOL) continued this trend by issuing a final rule on investment duties and ESG factors. Like a January 2021 rule (since repealed) on the same subject, this rule muddies the waters for fiduciaries subject to the Employee Retirement Income Security Act (ERISA), although the final rule removed a number of the most troubling provisions from the original proposal. While ERISA fiduciaries can likely live with it, it would be best to drop the back and forth and just let them do their jobs.
The big picture
To understand why none of this has been necessary, we probably should understand the actual law. Among other requirements, ERISA requires private sector plan fiduciaries act solely in the interest of plan participants for the exclusive purpose of providing benefits and to administer plans “with the care, skill, prudence, and diligence under the circumstances” that a prudent person in similar circumstance would use. These are known as the duty of loyalty and the duty of prudence. But what does that really mean?
The duty of loyalty means that the fiduciary must act solely in the interest of plan participants - not the fiduciary’s interest, not the company’s interest, and not the union’s interest.
- Say for example, a corporation announces a zero emissions policy by 2050. Does this mean that all or even any of the investments in the retirement plans must reflect this? No. In fact, that likely would be a per se breach of fiduciary duty because while such a policy might be considered in the company’s interest, it may very well not be in the interest of plan participants.
- Say the company decided it would not invest in or work with any business headquartered in a particular country. Does this mean that the retirement plan must divest from any such investments? No. Again, this likely would be a per se breach of fiduciary duty.
- What if a plan sponsored by a union decided it would only invest in companies that are unionized? Again, this likely would be a per se violation because while unionization is clearly in the union’s interest, it may have nothing to do with the interest of plan participants.
So, even without any additional guidance or regulation from DOL, investing with an eye toward the fiduciary’s, company’s, union’s, or anyone else’s interest is a per se violation of the duty of loyalty.
The final regulation mostly just follows what we all have considered the ERISA standard for nearly 50 years. Unfortunately, however, the final regulation also contains “tie-breaker” language stating that if two investments serve the financial interest of the plan equally, additional factors, also known as collateral benefits (such as promoting union jobs), can be used to make a determination in favor of one of those investments. This takes us back to 1994 language in a preamble to an Interpretive Bulletin that started the whole back and forth over fiduciary responsibilities. It’s also unneeded because it’s extremely rare that two investments are so similar that a tie-breaker would come into play. It is highly likely that one will be riskier than the other, generate a lower return, have a better reputation or some other measurable economic factor that selecting such an investment to reap collateral benefits would be unlawful.
In recent years, some plan participants have requested that fiduciaries make available alternative investment funds with particular themes, such as environmental, social or faith-based investments, in addition to, not as a replacement of, funds that are already in the plan as investment options. Fiduciaries have been concerned that including such funds could violate the 2021 rule. DOL’s new rule makes clear that taking participant preference into account does not violate the duty of loyalty. However, the regulation is clear that a fiduciary can’t just pick a random fund, but instead must use a prudent process in selecting alternative investments. In the end, such a process could result in rejecting an alternative fund if none are available that are in line with the plan’s requisite risks, returns or transparency.
So, what about prudence? Determining whether an investment is prudent must be based on the facts and circumstances at the time the investment is made (and when fiduciaries monitor current investments after the initial selection) and whether the fiduciaries used a prudent process. It is up to the fiduciaries to make this determination at the time each investment is made and while monitoring the investment. When looking to see if there is a prudent process, categorically excluding or including any particular type of investment likely would be per se imprudent.
Finally, DOL’s new rule does not specifically address default investments, namely the investment a plan participant is put in if he or she is automatically enrolled and doesn’t pick an investment. The rule’s lack of attention, however, does not mean that a fiduciary can select the default investment with reckless abandon, by, for example, only picking an ESG fund. The duties of prudence and loyalty still apply, as well as other rules specific to default investments. A fiduciary could, and likely would, be sued for picking an underperforming or high-fee ESG fund, to match his or her personal preferences.
Why it doesn’t matter
As you can see, DOL’s rule is pretty much unnecessary. The question is whether fiduciaries can live with it. The answer is probably. While the preamble of the rule is filled with a lot of rhetoric indicating the political preferences of the current administration, the text of the actual rule is far less prescriptive with respect to ESG factors. It states: “Risk and return 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.” That’s it. More often than not risk and return factors evaluated by a prudent fiduciary won’t include either an E an S or a G.
Why? Let’s take a look at a typical 401k investment lineup for a retirement plan where participants select their own investments. Regulations require that the plan include at least three investments that encompass a broad range of investment alternatives, each of which is diversified, has materially different risks and returns, and allows for aggregate risk and return characteristics within the range normally appropriate for the participant. In English, this means the fiduciary will have a menu of investment options with high, medium, and low risks and returns. And, unless it is employer stock or a brokerage window, these generally won’t be individual stocks or investments, but rather funds of funds, such as mutual funds, exchange traded funds, or collective investment trusts. For example, the two most popular investment options for 401k plans are the Vanguard Institutional Index and the Fidelity 500 Index. When fiduciaries select either of these, they are not looking at ESG at all because these are index funds that just reflect the market. When picking this as part of an investment lineup, a fiduciary is not looking at each and every underlying investment, but instead is looking at the overall returns and fees of the fund over time as compared to other funds with the same strategy. ESG factors are unlikely to come into consideration at all.
The bottom line
So, at the end of the day, DOL’s final rule is like many things in life. We didn’t want or need it, but we’ll find a way to live with it. In the meantime, fiduciaries will get on with what matters - providing good retirement plans to their plan participants without involving politics.
About the authors
Vice President, Retirement Policy, U.S. Chamber of Commerce