ESG Investing After the DOL Rule on "Financial Factors in Selecting Plan Investments" By: Calvert Institute

In the fall of 2020, the Department of Labor passed a rule that put ESG funds back into the spotlight when used in an ERISA-governed retirement plan. Given the importance of the issue and the desire for clarity on behalf of ERISA practitioners, Federated Hermes Responsible Investing Office and Calvert Institute for Responsible Investing collaborated with two leading academic experts in fiduciary law to provide an unbiased interpretation of the rule. Max M. Schanzenbach, Seigle Family Professor of Law, Northwestern University LawSchool, and Robert H. Sitkoff, JohnL. Gray, Professor of Law, HarvardLaw School, have provided an overview of the rule and its interpretation relative to the current interest in offering various forms of ESG funds in ERISA plans.


Summary of the Rule

In the wake of the Department of Labor’s new rule on “Financial Factors in Selecting Plan Investments,” some ERISA fiduciaries and their advisors have expressed concern about the permissibility of ESG investing. This summary of the rule aims to dispel that concern. In brief, the final rule confirms the permissibility of ESG investing by an ERISA fiduciary to improve risk-adjusted returns. Fiduciaries that use ESG factors to improve risk-adjusted returns have nothing to fear from the rule, and indeed should be reassured by it.

Much of the concern traces to the original proposal for the rule, which singled out ESG investing for heightened scrutiny. The final rule, by contrast, does not single out ESG investing. Instead, it applies neutrally to all investment decisions by an ERISA fiduciary, whether based on ESG factors or otherwise. The operative text of the final rule does not even use the term “ESG.

The heart of the rule is the requirement that an ERISA fiduciary must make investment decisions “based only on pecuniary factors,” that is, factors that are reasonably “expected to have a material effect on the risk and/or return of an investment.” An ERISA fiduciary may not make an investment decision to “promote non-pecuniary benefits or goals.” Nor may an ERISA fiduciary “subordinate … retirement income or financial benefits under the plan to other objectives.” Under the rule, therefore, an ERISA fiduciary may consider only financial risk-and-return considerations, and no other considerations, including benefits to third parties. These principles apply to all investment strategies, whether ESG or otherwise.

The rule thus confirms the permissibility of ESG investing in pursuit of better risk-adjusted returns in accordance with prudent investor principles. Those principles require a diversified, portfolio-level balance of risk and return reasonably suited to the purpose of the plan. To that end, the fiduciary should assess diversification and liquidity needs, be cost sensitive, and consider a reasonable number of alternative investments. The fiduciary should also document this analysis and update it periodically, making prudent adjustments to the investment program under the circumstances.

Given the current state of the theory and evidence on ESG investing, a particular ESG strategy could well satisfy prudent investor principles. However, whether a given ESG strategy is prudent will depend on the particular facts and circumstances, just as the prudence of any type or kind of investment strategy will depend on the facts and circumstances. The key consideration is whether the investment fits as part of portfolio-level balance of risk and return reasonably suited to the purpose of the plan or other fiduciary account. Finally, the rule has specific provisions for breaking a tie between two investment alternatives that are economically indistinguishable, for investment in funds that support non-pecuniary goals, and for qualified default investment alternatives. These specifics, which are elaborated in the FAQ below, clarify earlier guidance bulletins from the Department of Labor. None cuts against our bottom line that the rule confirms the permissibility of ESG investing in pursuit of improved risk-adjusted returns in accordance with prudent investor principles. 

Frequently Asked Questions

1. When the rule was first proposed, it was widely reported as being anti-ESG. How is the final rule different?

The original proposal for the rule subjected ESG investing to enhanced scrutiny relative to other investment strategies. Singling out ESG investing was widely and rightly criticized, including by us, as inconsistent with long-standing prudent investor principles, which apply neutrally without favoring or disfavoring any particular investment strategy. The leadership at the Department of Labor, supported by dedicated career staff who have served under presidents of both parties, heard the criticisms of the rule as originally proposed and responded accordingly in the final rule. The final rule is neutral as between investment strategies and drops any mentions of ESG.

2. May an ERISA fiduciary include a fund that uses ESG factors in a plan menu?

An ERISA fiduciary should not hesitate to include an ESG fund in a menu of investment choices offered to plan participants if the fiduciary reasonably concludes that the fund’s use of ESG factors will provide superior risk and return benefits relative to reasonably available alternatives (i.e., “pecuniary factors”). That a particular fund relies on ESG factors for pecuniary purposes is, by itself, neither qualifying nor disqualifying. Instead, the question for the inclusion of any fund, whether ESG or otherwise, is whether the fund provides superior risk and return benefits appropriate to the plan menu relative to reasonably available alternatives.

3. What about non-pecuniary goals? May an ERISA fiduciary include a fund that promotes non-pecuniary ESG goals in a plan menu?

This is a bit more complicated. The rule categorically prohibits use of a fund that promotes non-pecuniary goals as a qualified default investment alternative (QDIA). Outside of a QDIA, the rule expressly states that a fund with non-pecuniary goals is not categorically prohibited from inclusion in a plan menu. However, an ERISA fiduciary may choose such a fund only on the basis of pecuniary factors, and in no event may the fiduciary subordinate the participant’s financial interests to other objectives.

In other words, a fund with non-pecuniary goals may be included in a plan menu in spite of, but not because of, those non-pecuniary goals. The fiduciary must determine, without regard for the fund’s non-pecuniary goals, that the fund will provide superior risk and return benefits relative to reasonably available alternatives. The normal fiduciary practice of documenting the fiduciary’s reasoning and analysis will therefore be even more critical than usual in such a case. 

In sum, the inclusion of a fund that uses non-pecuniary factors is potentially permissible but entails additional cost, uncertainty, and litigation risk.

4. Does this mean that an ERISA fiduciary may never consider non-pecuniary factors? What about the so-called “tiebreaker” rule?

The rule clarifies the so-called “tiebreaker” principle set forth in earlier guidance bulletins. Under the rule, a fiduciary may consider non-pecuniary factors as a tiebreaker between economically indistinguishable investments, meaning investment alternatives that cannot be distinguished on pecuniary factors alone. Such a tiebreaker decision is subject to enhanced substantive scrutiny and procedural safeguards. The rule requires the fiduciary to document: (i) why pecuniary factors alone were insufficient to choose among the alternatives, (ii) how the selected alternative compares to the others on normal prudent investor risk and return criteria (i.e., pecuniary factors), and (iii) how the non-pecuniary factor or factors used to break the tie “are consistent with the interests of” the plan participants. The Department of Labor has also cautioned that it expects tiebreaker situations to be “rare.” Accordingly, the use of non-pecuniary factors as a tiebreaker entails additional cost, uncertainty, and litigation risk. 

5. What sort of disclosures should an ERISA fiduciary look for in a fund prospectus to determine whether the fund relies on ESG factors for non-pecuniary purposes?

The key inquiry is how and why the fund uses ESG factors. Does the fund use ESG factors for pecuniary purposes only? Or does the fund use ESG factors to any extent for non-pecuniary reasons? By way of illustration, suppose the following three funds:

a. “Our investment objective is to seek the highest total return. We employ a responsible and sustainable investing philosophy that aligns with environmental, social, and governance values. We integrate ESG factors into our fundamental analysis to identify investment opportunities, manage risk, and pursue alpha, and we integrate ESG factors into proxy voting guidelines to minimize risk and maximize return.”

b. “Our investment objective is to seek the highest total return consistent with our prescribed environmental criteria. We seek to invest in companies that have positive environmental impacts and avoid companies with negative environmental impacts. These environmental criteria exclude securities of certain issuers for non-financial reasons.”

c. “Our investment objective is to seek the highest level of current income consistent with generating environmental benefits via investment in so called ‘green bonds’ that finance projects that will have positive environmental impacts.”

Fund A integrates ESG factors for the purpose of improving risk-adjusted returns. As such, Fund A is permissible for an ERISA fiduciary, including as a QDIA, provided that the fund is prudent on risk and return grounds in light of reasonably available alternatives.

Funds B and C, by contrast, consider environmental impacts without connection to risk and return. As such, Funds B and C are impermissible as a qualified default investment alternative. They could be included in a plan menu, but only if the fiduciary could show (i) that the decision to include them was based solely on pecuniary factors and not on the Fund’s non-pecuniary goals (a litigation risk that is not present for Fund A), and (ii) that they were prudent on risk and return grounds in light of reasonably available alternatives.

6. How much due diligence must an ERISA fiduciary conduct with respect to a fund’s use of ESG factors? Can the fiduciary rely on the fund’s prospectus?

An ERISA fiduciary must act with the same care, skill, and diligence that a similarly situated prudent person would under like circumstances. Applied to the fiduciary’s due diligence about a fund’s use of ESG factors, the answer will necessarily be context specific. For a smaller plan, it will often be prudent to rely on the plan’s prospectus. A prospectus is subject to securities law regulation and further investigation may be disproportionately costly relative to its benefits. On the other hand, for a larger plan with more market power, the cost of further inquiry, such as meeting with the fund’s adviser or manager, may be less costly relative to its benefits, potentially making it prudent under the circumstances. Crucially, these prudence principles are of general application, and not specific to ESG factors. The same prudence principles, including balancing costs and benefits, apply to an ERISA fiduciary’s due diligence for any investment decision, whether ESG or otherwise.

7. We’ve heard that use of ESG factors is required by fiduciary principles because ESG factors are material to risk and return. Why aren’t fiduciaries required to use ESG factors?

The claim that ESG investing is required by fiduciary principles is not true, at least not under American law. The great innovation of the prudent investor rule was to eschew categorical rules of permissible or impermissible investments. No type or kind of investment strategy is favored or disfavored. The law does not prescribe types or kinds of investments that are per se prudent or imprudent. Instead, any fiduciary investment, whether based on ESG factors or otherwise, is judged in light of its relationship to a diversified, portfolio-level balance of risk and return reasonably suited to the purpose of the plan. To that end, the fiduciary should consider diversification and liquidity needs, be cost sensitive, and consider a reasonable number of alternative investments. In a given case, a prudent investor analysis could point to active use of ESG factors, active use of non-ESG factors, a passive investment strategy, or a blend. The rule reflects these basic prudent investor principles. 

8. What if plan participants want their retirement savings invested in non-pecuniary, ESG-themed investment funds?

The U.S. Supreme Court has said ERISA mandates that plan funds are to be used for the “exclusive purpose” of securing the retirement of plan participants. Once retired, a participant can take a distribution and spend it on whatever he or she pleases. But until then, the quid pro quo for the substantial tax and creditor protection benefits granted to ERISA plans is the requirement of administration by fiduciaries subject to ERISA’s strict fiduciary duties.

A potential gray area is a self-directed brokerage window that supplements the plan’s menu of designated investment options. A brokerage window can offer access to numerous mutual funds, including ESG funds, as well as other types of investments. Through a brokerage window, therefore, a plan participant might be able to pursue an investment program that more closely matches the participant’s preferences. However, the decision to provide a brokerage window, the choice of broker, and setting the broker’s fees and other charges are fiduciary actions subject to ERISA’s strict fiduciary duties. Moreover, the DOL has not addressed under what circumstances ERISA’s strict fiduciary duties might require a plan fiduciary to disregard or overrule a participant’s brokerage window selections. The viability of using a self-directed brokerage window to permit investment funds with non-pecuniary goals is thus uncertain and entails additional litigation risk.

9.What impact do you anticipate the Biden administration to have on the rule?

Among the flurry of Executive Orders signed by President Biden upon taking office was one that directed the Department of Labor to review the rule. Secretary of Labor nominee Marty Walsh has likewise stated that he intends to direct the Department to review the rule. On March 10, 2021, the Department announced that it would not enforce the rule pending further review. However, the Department reserved the possibility of bringing an enforcement action under the ERISA statutory duties of prudence and loyalty. The Department’s non-enforcement policy also does not bind private parties from enforcing the rule.

As for the rule itself, neither the President nor the Secretary of Labor can unilaterally amend or rescind a formally promulgated rule that has taken effect. Because the rule was promulgated in a formal notice-and-comment procedure and has already taken effect, it can be amended or rescinded only by a fresh deliberative notice-and-comment rule making by the Department or by an act of Congress. To forestall a court challenge, the Department would need to provide a cogent explanation for a significant amendment or rescission given the recency of the rule.

In the meantime, while preparing a fresh notice-and-comment rule making, the Department could augment its non-enforcement policy by issuing a bulletin that states clarifying interpretive guidance that softens the rule. As a formal legal matter, an interpretive bulletin cannot amend or rescind a formal notice-and-comment rule, but it may clarify a rule.

Additional Information and Disclosures

Calvert Research and Management is part of Morgan Stanley Investment Management, the asset management division of MorganStanley.

Calvert does not provide legal or tax advice. The views expressed here are those of the authors and are current only through March15, 2021. The discussion is general in nature and provided for informational purposes only.There is no guarantee as to its accuracy or completeness. These views are subject to change at any time, and Calvert disclaims any responsibility to update such views. These views may not be relied upon as investment advice. Past performance is no guarantee of future results. This material is presented for informational and illustrative purposes only. This material should not be construed as investment advice, a recommendation to purchase or sell specific securities, or to adopt any particular investment strategy; it has been prepared on the basis of publicly available information, internally developed data, and other third party sources believed to be reliable. However, no assurances are provided regarding the reliability of such information, and EatonVance has not sought to independently verify information taken from public and third-party sources. Investment views, opinions, and/or analysis expressed constitute judgments as of the date of this material and are subject to change at any time without notice. Different views may be expressed based on different investment styles, objectives, opinions or philosophies. This material may contain statements that are not historical facts, referred to as forward-looking statements.Future results may differ significantly from those stated in forward-looking statements, depending on factors such as changes insecurities or financial markets or general economic conditions.

This material is for Professional Clients/Accredited Investors only.

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