Door to Consideration of ESG Factors is Cracked Open
The DOL Final Rule1 (“Final Rule”) cracks open the door to consideration of Environmental, Social, and Governance (ESG) factors in plan fiduciaries’ investment decision-making. However, before a plan fiduciary can push the door wide open to intentionally consider ESG factors when making investment decisions, it will be important to know how to comply with its broadly-described rules. For example, if fiduciaries intend to take ESG factors into consideration, they must determine: 1) when ESG factors are relevant risk-return factors to an investment decision and 2) how to avoid decisions that sacrifice investment returns or take on additional risk for participants and beneficiaries of the plan when compared to other similar alternatives.
The Final Rule is the outcome of decades of changing sub-regulatory guidance about fiduciaries’ consideration of ESG factors in investment decision-making for ERISA plans. The Final Rule includes an effective date of January 30, 2023 for the investment provisions. The Final Rule impacts investment-decision making by plan fiduciaries when selecting investments and investment courses of action including selecting Qualified Default Investment Alternatives (QDIAs). The Final Rule also impacts fiduciaries’ management of shareholder rights and proxy voting for shares of stock held in a plan, and those provisions are effective December 1, 2023.
What you should know about the Final Rule
- It reflects a more neutral and principles-based approach than previous guidance.
- It maintains ERISA’s Duty of Loyalty: in alignment with this duty, fiduciaries may not subordinate the interests of participants and beneficiaries to objectives unrelated to the provision of benefits under the plan. Specifically, the Final Rule says that fiduciaries may not sacrifice investment return or take on additional risk to promote collateral goals unrelated to the economic interests of plan participants in their benefits.
- It maintains ERISA’s Duty of Prudence: in alignment with this duty, fiduciary investment decisions, including those that consider ESG factors, require a prudent process. Specifically, the Final Rule says fiduciaries are to give appropriate consideration to facts and circumstances the fiduciary reasonably determines are relevant to a risk and return analysis using appropriate investment horizons consistent with the plan’s investment objectives. “Appropriate consideration” is described as taking into consideration the risk of loss and the opportunity for gain (or other return) associated with reasonably available alternatives with similar risks.
- It allows, but does not require, consideration of the economic effects of climate change and ESG factors among the many factors that fiduciaries consider when making investment decisions.
- It specifies when collateral benefits of an investment may be used as a tie breaker between two competing investments under consideration that would equally serve the financial interest of the plan over the appropriate time horizon. Fiduciaries may, but are not required to, use collateral benefits as a tie breaker, as long as all other fiduciary duties are met.
- It permits plan fiduciaries to consider participant preferences when constructing a menu of prudent investment options, as long as all other plan fiduciary duties are met.
Considerations for Plan Fiduciaries
- The unknown: How will the current political environment and future government administrations affect the Final Rule?
- The unknown: What will be the outcome of the January 26, 2023 lawsuit filed by attorneys general from 25 states against the DOL which requests postponement of the Final Rule’s effective date, a preliminary injunction, and to declare the Final Rule in violation of ERISA?
- Will you be agnostic to ESG Factors in your investment decision-making?
- Should you decide to intentionally pursue consideration of ESG factors in your investment decision making:
- What is the cost vs. benefit of proceeding now or waiting?
- How will you modify your Investment Policy Statement and document investment decisions that included consideration of ESG factors?
- Will you consider participant preferences?
- Are there appropriate tools available to reliably screen investments for ESG factors?
- Your participants may already have access to ESG-themed mutual funds and/or other investment vehicles that consider ESG factors in the selection of securities. Will you consider whether self-directed brokerage accounts could be a first, or only, step?
What is PNC’s view on the Final Rule’s Investment Provisions?
- PNC is evaluating the Final Rule
What you should know
- Final Rule’s proxy voting and shareholder rights provisions apply only to shares of stock.
- Final Rule reaffirms ERISA’s fiduciary duties of Loyalty and Prudence in the management of shareholder rights, including the right to vote proxies.
- Duty of Loyalty: when fiduciaries determine whether and how to exercise shareholder rights, including voting proxies, they must carry out their duties prudently and solely in the interests of plan participants and beneficiaries for the exclusive purpose of providing benefits and defraying the reasonable expenses of administering the plan.
- Duty of Prudence: fiduciaries should evaluate relevant facts (including relevant ESG factors) when deciding whether and how to vote proxies.
- Final Rule confirms the fiduciary duty to prudently select and monitor any proxy advisory firm serving the plan, and requires that fiduciaries review the proxy advisory firm’s policies and practices to determine if the service meets the Final Rule.