Department Of Labor Finalizes Regulation Requiring Fiduciary Investment Decisions To Be Based Solely On Pecuniary Factors

On October 30, 2020, the Department of Labor (“DOL”) released its final amended regulation on investment duties under Section 404(a)(1)(A) and (B) of ERISA.^[1] The final regulation substantially reworks the DOL’s original proposal, but retains its intended effect of suppressing the consideration of non-pecuniary environmental, social, governance and similar (“ESG”) issues by investment fiduciaries.^[2]

The final regulation achieves it goal primarily by rewriting the general standards of prudence and loyalty applicable to all fiduciary investment decisions. These standards apply not just at the plan-level, but also the “plan asset” fund or product level, and across all investment decision-making (e.g., in developing and maintaining investment policies or strategies and selecting specific investments and investment options for participant-directed individual account plans).

While inapplicable to registered investment companies (“RICs”) and private funds that do not hold “plan assets,” for the reasons explained below, the rule may nevertheless effect their marketability if they expressly pursue ESG-themed strategies or strategies with ESG components (e.g., positive or negative ESG screens). RICs and private funds that either pursue a true “double bottom line” (i.e., that pursue both returns and social outcomes without necessarily tying those outcomes to returns or related risks), or simply fail in their fund disclosures to expressly tie any ESG considerations to investment risk and reward, may see a dramatic drop in interest from ERISA investors, particularly participant-directed individual account plans selecting RICs for their investment menus.

The final regulation also does not apply to governmental plans, as they are not subject to ERISA. Still, many governmental plans require their investment managers, whether of separately managed accounts or pooled funds, to follow ERISA or ERISA-like standards as a matter of contract (e.g., through investment management agreements or side letters). Whether the final regulation will affect those requirements will turn on the specific language used in the relevant agreement.

Under the final regulation, the duties of prudence and loyalty will require that all investment decisions must be based solely on “pecuniary” factors — i.e., factors that a prudent fiduciary determines are expected to have a material effect on risk and reward.^[3] In the words of the regulation, the only factors that may be considered are those that the 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 the funding policy established pursuant to section 402(b)(1) of ERISA.” It is not clear whether the DOL intends the term “material effect” to impose a minimum quantitative standard on investment considerations, rather than merely requiring some relevance to risk and reward. By referring favorably to “soft” factors like “a fund manager’s brand or reputation” (where the effect on risk and reward would be difficult to quantify), the preamble supports the latter (relevance) view. Under either view, fiduciaries may not take into account considerations having no arguable effect on risk and reward (e.g., generalized concerns about climate change).^[4]

The final regulation does provide an exception to the general rule, however. Where a fiduciary cannot pick a “winner” from among reasonably available investment alternatives solely on “pecuniary” factors, the fiduciary may select an alternative based on non-pecuniary factors (e.g., ESG concerns that do not otherwise meet the pecuniary test). While the DOL states a belief that such occasions will be rare, that statement conflicts with real-world investment practice. Investment fiduciaries are often presented with multiple, equally prudent options for any given investment need (e.g., a fiduciary may consider multiple, well-run, similarly priced actively managed US large cap growth funds for its plan menu), and they make final decisions based on factors that may not necessary have quantifiable economic effects (e.g., they may pick the alternative with slightly more experienced management, even though the effect of that additional experience on risk and reward cannot be quantified). Thus, the circumstances addressed by the exception would seem to be more prevalent than the DOL expects.

Further, the final regulation sets forth a number of potentially burdensome conditions that a fiduciary seeking to use this exception must meet. To rely on the exception, the fiduciary must document (i) why it could not pick a winner on pecuniary factors alone, (ii) how the selected investment compares to reasonably available alternatives, and (iii) how its non-pecuniary considerations are “consistent with the interests of participants and beneficiaries in their retirement income or financial benefits under the plan.” The first condition is troublesome for the reasons stated above — there are often multiple prudent choices for any given investment decision. The second condition is troublesome because, as explained further below, the term “reasonable available” is undefined and subject to broad, impractical interpretations.

The third condition is perhaps the most troubling, however. It requires the fiduciary to affirmatively tie its non-pecuniary considerations back to the economic interests of the participants and beneficiaries. In other words, considerations that lacked enough economic relevance to rise to the level of “pecuniary” considerations must nevertheless relate in some way to the financial interests of plan participants and beneficiaries under their plan.^[5] This condition would seem to effectively prohibit the consideration of all generalized ESG factors (e.g., negative screens for fossil fuel, tobacco, weapons or gaming industries or positive screens for climate change, fair pay or diversity and inclusion concerns, in each case without regard to the effect of the screens on risk and reward), even if such considerations do not adversely impact a portfolio, investment or investment option’s risk/reward profile. This condition would seem to permit, however, a narrower band of considerations with at least some potential for positively effecting plan economics. For example, it would seem to permit non-quantifiable good governance considerations or, as explained by the DOL in the preamble to the final regulation, pension contributions flowing from union job creation. 

The final regulation helpfully clarifies that investment fiduciaries need not always pick the least expensive investment option (e.g., low cost or passively managed funds, as suggested in the original proposal). It also helpfully provides that fiduciaries need not consider every single investment alternative in the market before making a decision. Unfortunately, it does not limit the universe of alternatives in a way that is helpful or practical. Rather, it requires consideration of all “reasonably available alternatives with similar risks,” without defining or providing other color on the meaning of “reasonably available” or “similar risks.” The absence of any such definition or color would seem to invite particularly broad interpretations by anyone wishing to challenge a fiduciary’s decisions (e.g., challenges to a fiduciary’s selection of 401(k) plan options where the fiduciary does not consider every publicly marketed mutual fund, collective trust and separate account alternative following the desired strategy).

The final regulation applies the general approach and sole exception (and its burdensome conditions) to the selection of investment options for participant-directed individual account plan menus. The final regulation expressly forbids the inclusion of funds with ESG themes or strategies (or components thereof) as qualified default investment alternatives (“QDIAs”). As a practical matter, this approach will pressure plan fiduciaries to exclude any fund and other option with an express reference to ESG considerations from their plan menus. Helpfully, the final regulation does not apply to funds available for investment through a brokerage window, which is consistent with the fact that such investments are not “designated investment alternatives” and not subject to ERISA’s fiduciary standards.

The change in administration in January 2021 could lead to decreased enforcement interest by the DOL and may even result in efforts to further revise the regulation. Because the final regulation departs dramatically from the principles-based approach of ERISA itself and appears to rest on relatively thin justifications, it may also be challenged in court. As long as it remains on the books, however, the final regulation will add substantial risk to fiduciary decision-making, particularly for fiduciaries selecting investment options for participant-directed individual account plans.

The final regulation is set to go into effect on January 12, 2021. The final regulation will apply not only to final investments, strategies and investment options as of that date, but also decisions to retain existing investments, strategies and options, thus requiring a review of existing portfolios, strategies and options for potential inconsistencies with the final regulation. The sole exception to the effective date is for QDIAs that do not meet the terms of the final regulation – those must be replaced by April 30, 2022.

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^[1] The final regulation does not apply to most individual retirement accounts, as they are not subject to ERISA.
^[2] See our release on the original proposal here. The final regulation was published in the Federal Register on November 13, 2020, 85 Fed. Reg. 72846. 
^[3] According to the preamble, the final regulation sets forth only “minimum requirements” with respect to the duty of loyalty, indicating that the final rule does not operate as a “safe harbor” with respect to the application of the duty of loyalty (as opposed to the duty of prudence) to investment decisions.
^[4] In contrast to the original proposal, the operative language of the final rule makes no reference to ESG or similar considerations. So, the critical test under the final regulation is whether any factor is “pecuniary”, not whether it is an ESG factor.
^[5] This standard differs from the duty of loyalty under the statute, which generally permits ancillary benefits to other interests as long as the interests of participants and beneficiaries are not subordinated.