The U.S. Department of Labor recently finalized regulations that are likely to limit the use of retirement investments focused on environmental and social issues. On October 30, DOL issued a rule entitled “Financial Factors in Selecting Plan Investments.” The final rule does not specifically address, or even mention, environmental, social, or governance (ESG) investments, which were the focus of the proposed regulations. The duties of retirement plan fiduciaries are defined on the basis of a distinction between pecuniary and non-pecuniary factors.
Specifically, the final rule makes it clear that ERISA fiduciaries must evaluate investments and investment courses of action based solely on pecuniary factors, which are defined as financial considerations that a fiduciary prudently determines are 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 funding policy.” The final rule explicitly states that compliance with applicable ERISA fiduciary standards, specifically the duty of loyalty to plan participants and beneficiaries, prohibits fiduciaries from prioritizing objectives that are unrelated to the interests of participants, as well as non-pecuniary goals that represent a lower investment return or a higher investment risk.
The final rule does allow fiduciaries to take into account non-pecuniary factors but only if they are “unable to distinguish investment alternatives on the basis of pecuniary factors alone.” DOL does state that this situation is “rare.” Under the final rule, a fiduciary decision based on non-pecuniary factors must be properly documented. Documents should specify:
- Investment alternatives were not distinguishable based on pecuniary factors.
- How the investment selected compares to the alternative investments with regard to specific factors listed in the final rule (i.e., the composition of the portfolio with regard to diversification; the liquidity and current return of the portfolio relative to the anticipated cash flow requirements of the plan; and the projected return of the portfolio relative to the funding objectives of the plan).
- How the chosen non-pecuniary factor or factors are consistent with the interests of the plan participants and beneficiaries.
The final rule applies to the selection of investment choices by fiduciaries in account balance plans, such as 401(k) and 403(b) plans. As a result, DOL points out that fiduciaries should exercise caution when selecting investment choices if the disclosures or other informational materials include references to non-pecuniary factors. On the other hand, DOL does recognize that express demands or interests of plan participants may be taken into account as non-pecuniary factors.
Finally, stricter rules apply to qualified default investment alternatives (QDIAs). An investment alternative simply cannot be used as a QDIA if it, or any of its components, uses a non-pecuniary investment strategy. This effectively prevents ESG investments from being used as QDIAs. Plan fiduciaries have until April 30, 2022, to make any required changes in order to comply with the rule relating to QDIAs.
Generally, the final rule will be effective 60 days after its publication in the Federal Register and will only apply prospectively. As a result, retirement plan fiduciaries do not have to divest or cease any current investment, or otherwise change any course of action, even if the prior investment decision was based on non-pecuniary factors. There is also the possibility that the next administration will walk back the final rule.
To avoid issues during DOL audits and potential litigation based on the final rule, plan fiduciaries should review current practices and any related documentation in order to determine whether certain adjustments are needed.