The Latest Word on ESG

Art by Tim Bower

ADVISER QUESTION: I’m a registered investment adviser (RIA) who advises 401(k) plan committees, helping them select the plan investment options and the qualified default investment alternative (QDIA) for participants who fail to make an investment election. Committee members have been inquiring about choosing funds that use environmental, social and governance (ESG) factors. What are my fiduciary obligations with respect to the selection of ESG funds?

ANSWER: As with the selection of any investment fund, you are subject to the Employee Retirement Income Security Act (ERISA) duties of prudence and loyalty. In its recently issued final regulation, the Department of Labor (DOL) explained that, to meet those duties, ESG funds must be evaluated based solely on pecuniary factors—i.e., factors that you expect will have a material effect on risk and/or return. In general, you may not use non-pecuniary factors to select investments except as part of a “tiebreaker” process when two funds in the same asset class are equally qualified based on pecuniary factors. But other conditions must also be met.

In explaining the fiduciary process for selecting ESG funds, the DOL noted that the ERISA duty of loyalty prohibits fiduciaries from subordinating participants’ interests to unrelated objectives. This means that a plan fiduciary may not sacrifice investment returns or take on additional investment risk to promote non-pecuniary factors. Accordingly, the rule requires that a plan fiduciary must base its investment decisions on pecuniary factors only. This includes investment decisions about the options to be offered on the plan lineup as well as investment decisions about the QDIA. Incidentally, this regulatory standard also applies to the selection of investments for a plan such as a pension plan that is not participant-directed.

Under the rule, a pecuniary factor is defined as a “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 …”

Applying that approach, you’ll need to examine information about the ESG fund to determine whether the ESG factors are used for pecuniary purposes—i.e., to improve risk and/or return—or, instead, for non-pecuniary purposes such as to promote social or political outcomes. If the factors produce better returns, less risk, or a combination of the two, it doesn’t matter that they are social, environmental or governance factors.

Reviewing the fund’s prospectus is a good starting place. If the document does not clearly indicate whether the ESG factors are used to improve risk and/or return, then you should further investigate the fund’s investment strategies, primary investment objectives and processes to determine whether there is sufficient information to support its compliance with what the DOL requires.

In conducting this evaluation, you may find there are two funds in a particular category that are equally qualified based on pecuniary factors. What process can you use to select one of those funds?

In that instance, the regulation sets forth a tiebreaker process where non-pecuniary factors may be used as the deciding factor—but only if you document the following:

• why pecuniary factors were insufficient;
• how the selected investment compares with the other, as to the prudence factors listed in the regulation; and
• how the non-pecuniary factors are in the interests of participants in their retirement income/financial benefits.

The regulation prevents a fund from being a QDIA if its investment objectives or principal strategies include, consider or indicate the use of non-pecuniary factors, therefore the tiebreaker rule may not be used for selecting a QDIA.

The analysis needed to satisfy the tiebreaker requirements and the associated documentation will likely be time-consuming and, in some instances, difficult to undertake. Therefore, we expect that many advisers will avoid this process entirely and make their investment decisions based on pecuniary factors only.

The new regulation was effective on January 12; however, the rules for QDIA investments are effective on April 30, 2022. The QDIA requirements permit the use of ESG factors only if the investment manager uses them as pecuniary considerations. Because this rule was based on a Republican approach to ESG factors, it is likely the new Democratic administration will delay the effective date of the QDIA provisions. Also, it would not be surprising if the DOL under the new administration undertakes to propose a new or revised regulation—a process that could take a year or more.

Fred Reish is chairman of the financial services ERISA practice at law firm Faegre Drinker Biddle & Reath LLP. Joan Neri, a nationally recognized expert in employee benefits law, is counsel in the firm’s financial services ERISA practice, where she focuses on all aspects of ERISA compliance affecting registered investment advisers and other plan service providers.