By Mark Olsen, Managing Director at PlanPILOT
In our previous article, we discussed how retirement plan sponsors could navigate ESG investment options and what the fiduciary responsibilities look like for these types of investments. In this article, we’ll dive deeper into the conversation around ESG investing by discussing the latest guidelines from the U.S. Department of Labor. Read on to learn more about the final regulations and how incorporating ESG factors into your plan will affect your fiduciary responsibility, plan fees, and risk for litigation.
Importance of ESG Guidance
As a refresher, ESG is an investment strategy that depends on a system of ratings in three key areas: environmental, social, and governance. ESG looks at the ethical standards and practices of a company and attempts to understand how those will impact the company’s performance in the stock market.
Because there is no central uniform body of criteria that scores or indexes companies based on ESG factors, private rating firms develop their own standards. Ratings are typically based on self-reported data from the companies they are grading, which can lead to a general lack of transparency and accuracy, making ESG a complicated investment strategy for fiduciaries.
This is where guidance is needed for plan sponsors seeking to add ESG to their investment offerings. As many sponsors are aware, ERISA imposes multifaceted obligations on plan fiduciaries. There are two key fiduciary responsibilities that impact investment decisions and ESG:
- Fiduciaries are required to act in a prudent way in selecting investments, and
- Fiduciaries must act for the exclusive benefit of providing benefits and paying plan expenses.
With such important responsibilities that could lead to litigation and fines if not properly upheld, it is crucial that plan sponsors thoroughly understand the rules and regulations around how to incorporate ESG into their plans.
Overview of New Regulations
The final regulations issued by the Department of Labor offer fiduciaries concrete ways to consider ESG factors. First, ESG may be included, where appropriate, as one of the many “financial circumstances and considerations” used by prudent investors in performing a risk-reward assessment. As stated in the new final regulation:
A fiduciary’s determination with respect to an investment or investment course of action must be based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis, using appropriate investment horizons consistent with the plan’s investment objectives and taking into account the funding policy of the plan established pursuant to section 402(b)(1) of ERISA. 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. Whether any particular consideration is a risk-return factor depends on the individual facts and circumstances. The weight given to any factor by a fiduciary should appropriately reflect a reasonable assessment of its impact on risk-return.
29 C.F.R. Section 2550.404a-1(b)(4) (emphasis added)
Additionally, the final regulations allow fiduciaries to use ESG factors as a “tiebreaker.” As stated in the final regulations:
If a fiduciary prudently concludes that competing investments, or competing investment courses of action, equally serve the financial interests of the plan over the appropriate time horizon, the fiduciary is not prohibited from selecting the investment, or investment course of action, based on collateral benefits other than investment returns. A fiduciary may not, however, accept expected reduced returns or greater risks to secure such additional benefits.
29. C.F.R. Section 2550.404a-1(c)(2)
Essentially, plan sponsors are allowed to add ESG metrics to their investment decision-making, so long as other factors, namely risk and return, are also properly considered. As long as investments are not chosen solely because of ESG factors, to the detriment of risk and return, the practice will not be considered a breach of fiduciary responsibility.
Role of Participant Preferences
The new regulations also offer guidance on how fiduciaries can respond to participant preferences within ERISA’s fiduciary constraints. Remember: fiduciaries must act for the “exclusive benefit” of providing benefits and paying plan expenses. This requirement can sometimes conflict with what your plan participants want.
Under the final regulations, however, a fiduciary will not violate the ERISA “loyalty” requirement solely because the fiduciary takes into account participant preferences, as long as the fiduciary meets two requirements:
- The fiduciary reflects participant preferences in a way that is consistent with the general fiduciary requirements for using ESG factors. In other words, any ESG investments offered in response to participant preferences must still be based on the fiduciary’s risk-reward analysis applied to any investment (ESG or otherwise).
- Any ESG investment in response to participant preferences must still meet the ERISA prudence requirement.
What Does This Mean for Fiduciaries?
So, what does this mean for plan fiduciaries? Here are a few practical takeaways from the new final regulations:
- The new final regulations do not require that a fiduciary change investment decisions—or how a fiduciary makes its investment decisions.
- Look at ESG as simply one more potential financial factor to consider in assessing an investment. As noted by the DOL, “prudent investors commonly take into account a wide range of financial circumstances and considerations, depending on the particular circumstances.”
- The framework used by the DOL is anchored in fundamental fiduciary principles—fiduciaries must act 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.’’
- The new final regulations are issued in response to the current focus on ESG—but are applicable to other, new investment practices and theories that may emerge.
Do You Have Questions About Adding ESG to Your Retirement Plan?
The final regulations are a step in the right direction for helping plan sponsors navigate the changing landscape around ESG investing, but there are still many factors to consider before updating your investment offering. If you’re a retirement plan sponsor with questions about ESG, or if you would like to learn more about how PlanPILOT’s comprehensive advisory services can benefit you, call us at (312) 973-4913 or email mark.olsen@PlanPILOT.com.
About Mark
Mark Olsen is the managing director at PlanPILOT, an independent retirement plan consulting firm headquartered in Chicago. PlanPILOT delivers comprehensive retirement plan advisory services to 401(k), 403(b), and 457 plan sponsors. His specialties include plan governance, investment searches, investment monitoring, and plan oversight. Mark is recognized as a leader in the industry and speaks at national conferences, including those organized by Pensions & Investments, Stable Value Investment Association, and CUPA-HR.