29 November 2022 Andrew Gaines Employment and Incentives - ESG - Pensions

Department of Labor finalizes rules on ESG investing for employee benefit plans

On November 22, 2022, the Department of Labor (the “DOL”) finalized rules under ERISA that will permit fiduciaries of retirement plans governed by the Employee Retirement Income Security Act of 1974, as amended (“ERISA”) to consider environmental, social and governance factors (“ESG”) in the selection process for investments of such retirement plans.  In addition, the DOL also provided clarification on a fiduciary’s responsibility to vote proxies on behalf of the retirement plans that the fiduciary manages.  The DOL had previously issued proposed rules on October 14, 2021.  Over the past year the DOL has been fielding comments to the proposed rules and evaluated concerns from investment managers, plan sponsors and other fiduciaries that could be affected by the proposed changes.  The new rules are set to take effect early in 2023 and will be a shift in direction from the DOL’s non-regulatory guidance on ESG issued in 2020 at the end of the term of the Trump administration.

The DOL has stressed that these new rules do not change the duties of prudence and loyalty under ERISA which require fiduciaries to focus on relevant risk-return factors and not subordinate the interests of participants and beneficiaries (such as by sacrificing investment returns or taking on additional investment risk) to objectives unrelated to the provision of benefits under the plan.  In addition, fiduciaries that manage plan assets which are shares of stock do have a duty to manage shareholder rights related to such shares, which includes the right to vote proxies.

The final rules amend previous DOL guidance and regulations to:

  • Clarify that a fiduciaries decision related to an investment or investment strategy must be based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis, and such factors may include ESG concerns.
  • Remove the stricter rules that applied to qualified default investment alternatives (“QDIAs”) such that QDIAs be held to the same standards that apply to investments in general.
  • Permit fiduciaries to consider collateral benefits, other than investment returns, in a prudent manner when looking at competing investments or strategies in a change to the so called “tiebreaker test.”
  • Removal of the previous rule’s special regulatory documentation requirements in favor of ERISA’s duty to prudently document plan affairs.
  • Fiduciaries may take participant’s preferences into account when creating a menu of prudent investment options for participant-directed individual account plans without violating their duty of loyalty.
  • Clarify that fiduciary duties with respect to shares of stock that are plan assets includes the right to vote proxies.
  • Removal of two “safe harbor” proxy voting examples from the old regulation based on the determination that the safe harbors do not adequately safeguard the interests of the plan and their participants and beneficiaries.
  • Removal of the requirement to maintain records on proxy voting activities and other exercises of shareholder rights, on the belief that treating such activities differently than other fiduciary activities creates a misperception that proxy voting is disfavored or carries with it a greater obligation than other fiduciary duties.

The DOL’s latest position on ESG investments and proxy voting will most likely have an impact on fiduciaries when evaluating investments for retirement plans because now ESG concerns may be factored into the decision making in certain circumstances.  It also should be noted that it has been reported that the SEC is finalizing a new set of rules that will expand the information available to asst managers regarding ESG which should assist asset manages in weighing ESG factors in its fiduciary deliberations.  Getting concrete information regarding company’s efforts on ESG will be key for fiduciaries carrying out their responsibilities under ERISA.

Notwithstanding the new DOL rule, it has been recently reported that various States have taken different positions in the context of government pension plans that are not subject to ERISA.  It has been reported that investment managers have been terminated for both failing to consider ESG and for considering ESG depending on the view of the State overseeing its government plans.  Will the new DOL rule see the same type of oversight by plan sponsors by contractually requiring an investment manager to consider ESG or to not consider ESG when evaluating investments?  In addition, will plan sponsors now be more involved in providing guidance to investment managers on how they want their proxies voted and will ESG be a factor in such guidance?  One thing is for sure, and that is the ESG debate is far from being settled, but for now, fiduciaries of ERISA plans have a more concrete position from the DOL on how it views ESG and proxy voting with respect to ERISA fiduciary duties.

If you have any questions regarding the above, please liaise with your usual Linklaters contact.