The U.S. Department of Labor (DOL) has proposed amendments under ERISA that specify retirement plan fiduciaries must not consider non-financial factors in making recommendations and decisions for ERISA-covered retirement plans (including 401(k) plans). If finalized, the rule would expand on the DOL’s historical stance that investment-related decisions focus solely on economic considerations. This proposal is also in line with the current administration’s recent communications that have discouraged allocating assets to ESG funds and ESG integration by ERISA plans. Practically, the amendments would limit the ability of a plan fiduciary to consider ESG factors. This means asset managers may need to have another look at how they market their ESG-related products.
Pecuniary vs. Non-Pecuniary
The amendments include a new section that provides a framework for considering pecuniary and non-pecuniary factors. A “pecuniary factor” is defined in the proposal as a factor that has 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(a)(1) of ERISA. According to the DOL, plan fiduciaries are not permitted to sacrifice investment return or take on additional investment risk to promote non-pecuniary benefits or any other non-pecuniary goals.
Importantly here, ESG or other non-financial considerations are pecuniary factors only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories. The proposal gets more specific and states that:
- the weight given to those factors should appropriately reflect a prudent assessment of their impact on risk and return; and
- fiduciaries are required to examine the level of diversification, degree of liquidity, and the potential risk-return of an ESG investment in comparison with other available alternative investments that would play a similar role in their plans’ portfolios.
If two investments are determined to be equal economically, after conducting this evaluation, and one of the investments is selected on a non-pecuniary basis, the proposal requires a fiduciary to document why the investments were determined to be indistinguishable. Furthermore, the fiduciary must document why the selected investment was chosen based on the purposes of the plan, the diversification of investments, and the interests of plan participants and beneficiaries in receiving benefits from the plan.
Practical impact on asset managers and plan fiduciaries
The amendments restrict the ability of plan fiduciaries to take into account other considerations in evaluating and selecting investments outside of the tie-breaker scenario. Practically speaking, this will limit the ability of a plan fiduciary to consider ESG factors. Asset managers who offer their funds to plan fiduciaries should re-examine their ESG-related marketing to determine if the content or disclosures make it harder for plans to select their products (i.e. ESG considerations are being made part of the investment process). Managers might ultimately have to revise their marketing materials to more clearly describe the material pecuniary benefits that ESG factors offer to investors in a fund, or more clearly indicate how ESG factors are factored into the fund’s investment decisions. Given the SEC’s increasing focus on this area during examinations of registered investment advisers, a thorough review of ESG marketing materials and disclosures should be undertaken regardless.
Documentation is one of the areas where the proposal will likely cause a significant shift for plan fiduciaries, as the proposal reverses prior guidance suggesting no extra documentation was required for considering ESG investments. Under the proposal, extra documentation is required in the tie-breaker scenario for pension plan fiduciaries that select investments on the basis of a non-pecuniary factors.
It should be noted that the proposal and its amendments would only apply to a subset of the investor community, therefore asset flows to ESG and similar investment strategies are expected to continue to increase, and large asset owners will continue to require managers across strategies to adhere to both affirmative and negative covenants relating to ESG matters.
How Bovill Can Help
- Review of marketing materials/disclosures for ESG content
- Review of policies & procedures for ESG considerations/documentation
- Submission of comment letters on behalf of clients