Insights for fiduciaries

Retirement plans and sustainable investing—current guidance for plan fiduciaries

There has been growing interest in sustainable investing¹—that is, using an investment decision-making process that adds the analysis of financially material Environmental (E), Social (S) and Governance (G) factors to the investment process—including by employee benefit plans (“plans”) that are subject to the Employee Retirement Income Security Act of 1974 (“ERISA”), such as participant-directed individual account plans. This has raised the question of whether, and to what extent, investment fiduciaries for such plans can consider ESG factor integration consistent with their fiduciary responsibilities under applicable laws.

Over the years and through changes in presidential administrations, the US Department of Labor (“DOL”) has issued guidance on ESG investing for plan fiduciaries.² While this guidance had appeared at times to vary in its approach to considering ESG factors in plan investment decisions, DOL’s basic position has remained the same—that ERISA plan fiduciaries should make investment decisions based foremost on prudent investment considerations, and should not sacrifice investment return or take on additional investment risk in order to promote “collateral” objectives such as social policy goals. This paper discusses DOL’s guidance, as most recently updated in November 2020 and October 2021, and then provides general considerations for plan fiduciaries when investing plan assets in investment funds with strategies that take ESG factors into account.

1. ESG investing

One of the difficulties in applying fiduciary standards to sustainable or ESG investing is that the term has no precise, agreed-upon definition. Roughly speaking, sustainable investing is understood to cover consideration of the following as part of an investment decision-making process:

Environmental—the environmental impact or exposure of a firm’s products or practices, such as with regard to the impact of mining, production or use of fossil fuels or exposure to business locations or activities in areas subject to climate risks;
Social—the social impact of a firm’s products or services, such as with regard to workforce practices (for example, diversity and inclusion³), the firm’s labor relations or effect on local communities; and
Governance—a firm’s corporate governance structure, such as with regard to executive leadership, executive pay and compliance.

There is an ongoing debate as to whether investing that takes into account ESG factors provides more than just the collateral benefit of furthering a sustainability goal, in the form of improved investment return and reduced risk, and whether consideration of ESG factors should in fact be mandated for institutional investors and investment fiduciaries. The most recent DOL rulemaking, a proposed regulation from October 2021, cites studies on all sides of this debate—finding benefits to ESG investing, no benefits to ESG investing and no discernable difference. Ultimately, the question of whether ESG investing is an objectively better investment approach or plays an appropriate role in a diversified investment portfolio is one for investment professionals. This paper focuses instead on the legal standard that applies to the decision to take any or all ESG factors into account as part of a fiduciary’s prudent investment process.

2. DOL guidance

ERISA requires plan fiduciaries to act prudently and solely in the interest of a plan and its participants and beneficiaries in making investment decisions. As such, a plan’s investment fiduciaries are, in the first instance, required to consider only those factors relevant to the prudence of the particular investment decision, including the degree of risk, maximization of returns, diversification and furtherance of a plan’s funding objectives. On this basis, DOL’s consistent view over the years has been that ERISA’s fiduciary duty rules do not permit fiduciaries to sacrifice the economic interests of a plan to promote “collateral” goals.

Background to current DOL guidance

The question as to how ERISA’s fiduciary standards apply to investments aimed at promoting “collateral” goals first arose in the early 1980s. At that time, DOL was asked to provide guidance on the application of the ERISA fiduciary responsibility rules to so-called “socially responsible” investing, which had the goal of, for example, ending apartheid in South Africa or stimulating local economies. DOL’s consideration of these questions culminated in 1994 with the issuance of Interpretive Bulletin 94-1, describing the application of the ERISA fiduciary provisions to “economically targeted investments,” or ETIs, which DOL defined as investments selected for the economic benefits they create apart from their investment return to the plan—for example, through financing projects that hire members of the union that sponsors the plan.

This guidance has been revised several times since 1994. The revisions in 2008, 2015 and 2018, like the 1994 Interpretive Bulletin, took the form of sub-regulatory guidance—guidance that did not have the force of a formal regulation. In November 2020, DOL took the additional step of codifying its guidance in the form of a formal regulation that was the result of notice-and-comment rulemaking.⁴ As such, the current DOL position can, under the standards established by the current Administration and case law, be cited by the government and private plaintiffs as binding authority in enforcement actions and litigation and may be given deference by courts. It can only be revised through another notice-and-comment rulemaking process, or by legislation enacted by Congress..⁵

The November 2020 regulation became effective on January 12, 2021, but the new Administration that came into office eight days later took a non-enforcement position in March 2021, pending a DOL review. DOL proposed significant changes to the regulation in October 2021, which are discussed below in conjunction with the description of the current regulation. The one exception to the general effective date related to the regulation’s special rule on “qualified default investment alternatives,” or QDIAs, which the proposed changes would repeal.

Basic rule—primacy of “pecuniary” factors

The DOL regulation restates the basic standard from DOL’s prior guidance, that to comply the ERISA fiduciary duty of loyalty, a “fiduciary may not subordinate the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to other objectives, and may not sacrifice investment return or take on additional investment risk to promote non-pecuniary benefits or goals.” The current DOL position is that, to meet this standard, a plan fiduciary must evaluate an investment based only on “pecuniary” factors, subject to two limited exceptions discussed below.

The regulation defines the term “pecuniary factor” as follows:

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.

In determining whether a factor is “pecuniary,” a fiduciary may, among other things, take into account prevailing views of investment professionals.

The regulation adds that the weight given in considering any pecuniary factor should “appropriately reflect a prudent assessment of its impact on risk-return.” This is intended to prevent fiduciaries from circumventing the rule by giving undue weight to what should be relatively minor considerations.

The October 2021 proposed changes would delete the term “pecuniary factor” from the regulation, but would retain the basic approach by integrating the concept of focusing on “risk/return” factors directly into the regulation’s operative language. The more significant changes would be to the two exceptions.

First exception—“Tie-Breaker” rule

The prior guidance had described a “tie-breaker” rule—the concept that, all other things being equal based on risk and return considerations, a fiduciary is permitted to take into account non-financial considerations. Recognizing that all other things are rarely ever equal, the revised formulation of this rule permits a fiduciary to apply non-pecuniary factors, and to make an investment decision based on such non-pecuniary factors, when the fiduciary is “unable to distinguish [among investment alternatives] on the basis of pecuniary factors alone.” This should provide more flexibility in determining when the exception can be available, although DOL observed that these circumstances should, in its view, be relatively uncommon.

To rely on this exception, the fiduciary is required to document:

why pecuniary factors were not sufficient,
how the selected investment compares to the other comparable investments on the basis of prudence (specifically, based on the prudence factors enumerated in other parts of the same regulation, such as risk, return and diversification), and
how the chosen non-pecuniary factors are consistent with the interests of the plan participants and beneficiaries in their retirement income or financial benefits under the plan.

In regard to the last point, DOL noted that the types of non-pecuniary factors that may be taken into consideration are subject to ERISA’s general loyalty obligation. Thus, for example, while creating jobs for current or future plan participants could be a permitted consideration, reflecting a fiduciary’s “personal policy preferences” would not. DOL noted that, in the context of a participant-directed plan, participant preferences for certain types of investments could be a permitted non-pecuniary consideration. This is an important clarification, as it has become increasingly common for plan participants to request that the plan’s investment options include ESG-themed investment funds.

The October 2021 proposed changes would retain the “tie-breaker” concept but replace the current language with a standard that, according to DOL, more closely aligns with its pre-November 2020 guidance. It would instead describe the triggering consideration as whether the plan fiduciary prudently concludes that competing investments “equally serve the financial interests of the plan over the appropriate time horizon,” in which case the fiduciary would not be prohibited from selecting the investment “based on collateral benefits other than investment returns.” The reason given for proposing this change is the concern that the current formulation could be interpreted too narrowly. No special documentation would be required.

Second exception—designated investment alternatives for participant-directed plans.

This exception permits a fiduciary to consider non-pecuniary factors in the selection and oversight of designated investment alternatives for a participant-directed individual account plan. Under this exception, a fiduciary may consider investment funds that promote, seek or support non-pecuniary goals, provided the fiduciary satisfies the basic prudence and loyalty standards described in the regulation in selecting the fund and the fund is not used as, or as a component of, a “qualified default investment alternative,” or QDIA.

DOL emphasized that this is a limited exception, which applies only if the alternatives can be justified solely on the basis of pecuniary factors. Choosing investments that expect reduced returns or greater risks to secure non-pecuniary benefits would not meet this standard. Thus, fiduciaries should carefully review prospectuses and other disclosure documents to see if they include statements to that effect.

The 2018 guidance had explained that in the case of an investment platform that allows plan participants an opportunity to choose from a broad range of investment alternatives, adding one or more “ESG-themed” funds to the platform, in response to participant requests for investments that reflect their personal values, does not necessarily result in forgoing the availability of non-ESG-themed investment alternatives. Rather, in such instances, a prudently selected, well-managed and properly diversified ESG-themed investment alternative could serve to expand the available investment options on the platform, without requiring the plan to forgo making non-ESG-themed investment options available. DOL restated this rationale in explaining the limitation on QDIAs, reasoning that selecting a fund as a QDIA is not analogous to merely offering an additional investment alternative as part of a prudently constructed lineup. Thus, the assumption behind this exception is that any ESG-themed funds would be made available in addition to, and not in place of, a basic lineup of investment alternatives that do not consider non-pecuniary factors..

According to the regulation, the prohibition against using funds as QDIAs if they consider non-pecuniary factors applies only if the fund’s described investment objectives or goals, or its principal investment strategies, include, consider or indicate the use of one or more non-pecuniary factors. The purpose of this approach is to provide a test that DOL believes can be applied objectively without difficulty.

The QDIA limitation is the one part of the regulation that did not become effective in January 2021. Recognizing that some plans may need to make changes to their QDIAs to comply with the limitation, DOL postponed its effective date to April 30, 2022.

.The October 2021 proposal would remove this exception, folding the standards for selecting ESG-themed investment alternatives into the general “tie-breaker” standard as it would be revised. The only difference would be an additional requirement that, if the plan fiduciary selects an investment as a designated investment alternative based on collateral benefits other than investment returns, the collateral benefit characteristic of the fund must be prominently displayed in the disclosures provided to plan participants, such as in the plan’s 404a-5 disclosure document.

Status of ESG factor-based investing under November 2020 regulation and October 2021 proposed changes

The proposal that preceded the November 2020 regulation had generally been understood as intended to restrict ESG factor-based investing, in large part because it had applied its standards specifically to ESG-based/branded investments. As a result, many commenters criticized the proposal as creating a presumption that ESG investing by its nature is based on non-pecuniary factors, requiring additional steps and documentation to demonstrate otherwise. The critics countered that ESG factors can in fact be pecuniary factors, a point recognized in DOL’s 2015 guidance but subsequently questioned in DOL’s 2018 guidance (following a change in Administration).

In response this criticism, DOL eliminated all references in the regulation itself to ESG factors, instead reframing the rule as a more general standard based on pecuniary vs. non-pecuniary considerations, as described above. DOL emphasized that the final regulation does not single out ESG investing or any other investment approach for particularized treatment, recognizing that at least some ESG factors may, at times, also be pecuniary factors that a fiduciary may properly consider as such under the standards of the regulation, without the need to invoke either of the limited exceptions.

But it is still possible that the standards under the regulation could raise questions on ESG-based investing. DOL cautioned fiduciaries against “too hastily concluding that ESG-themed funds may be selected based on pecuniary factors or [under the “tie-breaker” rule] are not distinguishable based on pecuniary factors.”

One area that DOL singled out as raising questions is the approach of using investment “screens,” which screen out investments viewed as unacceptable or controversial, such as by excluding companies that manufacture fossil fuels or guns, or those doing business in foreign countries with unfavorable human rights records. DOL commented in the final regulation notice that “positive” or “negative” screens may not comply with the rule if they are based on non-pecuniary factors, reasoning that it would first be necessary to conduct a prudent analysis to determine that the exclusion would not be economically harmful to the plan. But DOL added that the regulation does not prevent selecting a negatively screened fund as a QDIA if no non-pecuniary factors are reflected in its stated investment objectives or principal strategies.

In proposing changes in October 2021, DOL gave as a reason the concern that the November 2020 regulation had, despite the language acknowledging that ESG factors may in certain instances be properly taken into account, led to a perception that fiduciaries would be at risk if they consider ESG factors, even where those factors are “financially material,” thereby requiring special justifications. The proposed changes would clarify that a prudent fiduciary may consider “any factor …that, depending on the facts and circumstances, is material to the risk-return analysis,” including, by way of example, the following ESG factors:

Climate change-related factors, such as a corporation’s exposure to the effects of climate change and government regulations and policies to mitigate climate change;
Governance factors, such as those involving board composition, executive compensation, decision-making accountability, and compliance with labor, employment and other applicable laws; and
Workforce practice, including diversity and inclusion, training and labor relations

DOL explained that these examples are intended to establish that material climate change and other ESG factors are no different from “traditional” material risk-return factors, and to remove any prejudice to the contrary. Another proposed change to the regulation would further emphasize that an evaluation of the economic effects of climate change and other ESG factors may be necessary as part of considering the effect of an investment on the projected return of a portfolio relative to the plan’s funding objectives.

Status of brokerage windows

The duty of loyalty standards described in the regulation do not apply to investment options in a participant-directed individual account plan that are not “designated investment alternatives.” This has the effect—as DOL acknowledged—of excluding investments available under a self-directed brokerage window from these standards.

But DOL cautioned that there would not be any exception for a plan that does not designate any “designated investment alternatives” for plan participant investment, so that a plan could not avoid these rules by providing only a brokerage window.

This exception would not be affected by the October 2021 proposed changes.

Including ESG factors in a plan’s investment policy statement.

A 2016 DOL interpretive bulletin had said that ESG factors could be incorporated into a plan’s investment policy statement. But according to the 2018 DOL guidance, this should not be read to mean that ERISA requires investment policy statements to include ESG-based guidelines. DOL further noted that if ESG factors are included, they would have to be disregarded if their application would be imprudent or otherwise inconsistent with ERISA’s fiduciary responsibility rules. The 2016 and 2018 guidance, while not specifically superseded by the subsequent regulation, should presumably be applied in light of the standards described in the 2020 regulation (as amended, if subsequently amended), meaning that ESG factors should only be incorporated into a plan’s investment policy statement if they qualify as pecuniary factors (or the standard applied in the amended regulation) or fit into an exception that permits consideration of non-pecuniary factors.

3. General considerations for plan fiduciaries

Because of the pattern of each new Administration issuing its own variation on the original ETI guidance (in 2008, 2015 and now 2020 and 2021), plan fiduciaries have been concerned about possible uncertainties and risks in relying on whatever has been the then-current DOL position. However, as noted above, one thing never changes—the fundamental principle that ERISA plan fiduciaries should make investment decisions based foremost on prudent investment considerations, and should not sacrifice investment return or take on additionalinvestment risk in order to promote “collateral” or “non-pecuniary” objectives such as social policy goals. The October 2021 proposed changes, if they go forward, would (using slightly different language) follow this basic pattern, by not permitting plan fiduciaries to sacrifice investment return or take on additional investment risk to promote “benefits or goals unrelated to the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan.” Thus, as the October 2021 changes would further emphasize through adding examples to the regulation, to the extent the consideration of ESG factors is part of a prudent investment analysis, such consideration can be viewed as consistent with ERISA’s fiduciary standards. If not, then the question is whether those factors are being applied to alternative available investments that, under the current formulation, cannot be distinguished on the basis of pecuniary factors alone or—in the case of designated investment alternatives for participant-directed plans—are not intended to secure non-pecuniary benefits at the expense of reduced returns or greater risks. This leaves plan fiduciaries, with the aid of investment consultants and other professionals, to draw their own conclusions as to how they understand ESG considerations to factor into their prudent investment analysis and to act accordingly.

A related consideration is how plan fiduciaries should document such an analysis. As a general matter, fiduciaries are well-advised to document that they followed a prudent investment process in making investment decisions, such as in the selection of a plan’s designated investment alternatives, to create a contemporaneous record of this process in the event of a future challenge. In the November 2020 DOL guidance, a fiduciary would generally be required to document with specificity the basis on which it believes it is able to consider non-pecuniary factors in making an investment decision, including why pecuniary factors were not sufficient, how the selected investment compares to others on the basis of prudent investment considerations, and how the non-pecuniary factors taken into account are consistent with the interests of the plan participants and beneficiaries in their retirement income. (These documentation requirements would be removed under the October 2021 proposal, on the basis that it is unnecessary to single out these types of investments for special treatment when fiduciaries, based on their general ERISA prudence obligation, commonly document and maintain records about their investment decisions to demonstrate they have acted prudently.) While there are no specific documentation requirements associated with the exception for selecting and overseeing designated investment alternatives for a participant-directed plan, it may be advisable to maintain such documentation under that exception as well. Thus, ERISA plan fiduciaries should look to document their consideration of ESG factors to the extent necessary to be able to demonstrate, if challenged, that they followed the standards described in the DOL guidance.

4. Summary of key points

To summarize the key points of this paper, the current state of the DOL guidance on ESG investing provides as follows:

ERISA requires that plan fiduciaries not sacrifice a plan’s economic interests to promote “non-pecuniary” goals, thereby requiring that fiduciaries in the first instance make investment decisions by focusing on pecuniary factors—that is, on the basis of an investment’s expected risk and return based on appropriate investment horizons.
ESG factors may not be “non-pecuniary,” though, but rather “pecuniary,” by reason of having a direct relationship to the economic value of the investment, in which case these factors would be appropriate considerations in a prudent investment analysis, as pending changes would further emphasize.
Key determination—whether the ESG factors are “pecuniary”
- If not, then the ability to consider them would require coming within one of the exceptions.
- If they are, they still must be given only their appropriate weight in light of the other relevant economic factors.
- ESG factors, particularly if “pecuniary,” can be part of a plan’s investment policy statement, but are not required to be so, and would have to be disregarded if their application would be imprudent or otherwise inconsistent with ERISA’s fiduciary responsibility rules.
ESG-themed funds may be included as designated investment options for participant-directed plans, if prudently selected based on pecuniary factors.
- Prior guidance suggested that ESG-themed funds could be appropriate if in addition to other, non-ESG themed investment options.
- However, an ESG-themed fund should not be selected if it discloses that it expects reduced returns or greater risks to secure non-pecuniary benefits.
ESG-themed funds that, as part of their investment objectives or goals, consider or use non-pecuniary factors could not serve as a plan’s QDIA (although this restriction would be repealed by pending changes, leaving QDIA selection subject to the general standard for selecting ESG-themed funds as plan investment options)
In addition to documenting their actions as necessary to meet the requirements of the regulation (unless those specific documentation requirements are repealed, in which case as necessary to demonstrate prudence), including the “tie-breaker” exception, plan fiduciaries should consider documenting their consideration of ESG factors to the extent necessary to demonstrate, if challenged, that they followed the standards in the DOL guidance, to help show compliance with their ERISA fiduciary obligations

¹ While this paper uses the term “sustainable investing,” much of the guidance cited in this paper uses the term “ESG investing” to describe the same type of investment process, highlighting the focus on the “E” (environmental), “S” (social) and “G” (governance) factors.

² While this guidance is applicable by its terms only to employee benefit plans that are governed by ERISA, it is also viewed as an appropriate standard for fiduciaries of non-ERISA plans, such as state and local governmental plans. Governmental plans in particular often operate under laws similar to ERISA, and may incorporate ERISA fiduciary standards by reference into their investment management or consulting agreements.

³ As described further below, in its most recent release (from October 2021), DOL offers a company’s progress on workforce diversity and inclusion as one of its examples of an ESG factor that an ERISA plan fiduciary may consider as material to an investment risk-return analysis. The DOL release adds, as part of its cost-benefit analysis of its proposed changes to the current regulation, that “Many compelling studies show the material financial benefits of diverse and inclusive workplaces,” with a list of studies that focus on three main areas—employee recruitment and retention, performance and productivity, and litigation.

⁴ The 2020 regulation is actually an amendment to a 1979 regulation that describes how the ERISA fiduciary duty to act prudently applies to plan investment decisions. The 2020 amendment retains the original prudence rule with only a few changes.

⁵ In addition, as of this writing, there have been bills introduced in Congress that would amend ERISA to counteract the November 2020 DOL regulation changes by specifically permitting plan fiduciaries to consider ESG factors when they are expected to have an impact on investment outcomes, although no significant action has been taken on them.

This publication is provided by UBS Financial Services Inc. and includes content provided by Morgan, Lewis & Bockius LLP. UBS Financial Services Inc. has not verified the accuracy or completeness of such information. This publication is provided for informational purposes only, contains a brief summary of the topic discussed and does not represent a comprehensive discussion or list of questions or considerations necessary for making effective decisions. You should seek appropriate professional advice regarding the matters discussed in this publication in light of your specific situation. Neither UBS Financial Services Inc. nor any of its employees provide tax or legal advice. You should consult with your legal and/or tax advisors and the provider of your plan administration services regarding your retirement plan.

The information contained in this material is provided as a general informational service. It should not be construed as, and does not constitute, legal advice on any specific matter, nor does this message create an attorney-client relationship.

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Exp.: 10/31/2022, IS2105575

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Insights for fiduciaries

Retirement plans and sustainable investing—current guidance for plan fiduciaries

1. ESG investing

2. DOL guidance

3. General considerations for plan fiduciaries

4. Summary of key points

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