In late April, the Department of Labor (“DOL”) released FAB 2018-01 addressing and clarifying previous guidance concerning economically targeted investments (“ETIs”), shareholder engagement and proxy voting.1
The general tenor of the 2018 guidance, perhaps reflecting a change in the Administration, is more skeptical of a retirement plan’s pursuit of ETIs and other social goals, while not changing the otherwise applicable law that ETI investments are permissible provided they are otherwise financially reasonable and economically prudent.
This issue of ETIs (such as a “carbon free” Section 401(k) plan or other type of retirement plan) has increasingly become a topic of discussion due to a growing focus on this issue by pension plan participants and certain retirement plans (including governmental plans). The DOL first offered guidance in Interpretive Bulletin 94-1 ETIs, and that guidance was confirmed and updated by the DOL in 2015 in Interpretive Bulletin 2015-01.
The issues regarding ETIs (e.g. investing in low-income housing), including social responsibility investing (e.g. avoidance of fossil fuel investing), are related in that the plan fiduciaries while investing for the exclusive benefit of plan participants are also trying to achieve a collateral goal (lessen the carbon imprint or help the economy of a particular region) and thus have environmental, social or corporate governance (“ESG”) factors in play.
DOL prior guidance on ETIs
In 2015, the DOL, in its most immediate guidance prior to FAB 2018-01, gave the following advice to fiduciaries considering a “socially responsible fund” as a plan investment or as an investment alternative in a defined contribution plan:
- “fiduciaries may not accept lower expected returns or take on greater risks in order to secure collateral benefits, but may take such benefits into account as “tie-breakers” when investments are otherwise equal with respect to their economic and financial characteristics;” and
- “environmental, social, and governance factors may have a direct relationship to the economic and financial value of an investment [and,] [w]hen they do, these factors are more than just tie-breakers, but rather are proper components of the fiduciary’s analysis of the economic and financial merits of competing investment choices.” (U.S. Dep’t of Labor EBSA New Release 10/22/2015; see also U.S. Dep’t of Labor Interpretive Bulletin 2015-01, 29 C.F.R. § 2509.2015-01).
Under the 2015 guidance, the DOL stated that “the fiduciary standards applicable to ETIs are no different than the standards applicable to plan investments generally” (29 C.F.R. § 2509.2015-01). Therefore, just as with any decision to invest plan assets, plan fiduciaries have the burden of showing, in the case of a divestment, that the money diverted from the given investment (e.g. an oil or gas investment fund) will be earmarked for a different investment (e.g. a carbon free investment fund) with the same or superior characteristics of return and risk/ reward that the divested investment offered. The new investments must also satisfy the general ERISA fiduciary requirements related to diversification and liquidity.
2018 DOL guidance on ETIs
The newest FAB chose to emphasise that the Department had previously stated:
“its longstanding view that, because every investment necessarily causes a plan to forego other investment opportunities, plan fiduciaries are not permitted to sacrifice investment return or take on additional investment risk as a means of using plan investments to promote collateral social policy goals. [The 2015 guidance] also reiterated the view that when competing investments serve the plan’s economic interests equally well, plan fiduciaries can use such collateral considerations (i.e. carbon free investing) as tie-breakers for an investment choice. The preamble of [the 2015 guidance] added: ‘if a fiduciary prudently determines that an investment is appropriate based solely on economic considerations, including those that may derive from environmental, social and governance (ESG) factors, the fiduciary may take the investment without regard to any collateral benefits the investment may also promote.’” (emphasis added)
However, the DOL has now dialed back its “observation” in that 2015 preamble as “merely recognising” that there could be some instances where collateral ESG factors could involve business risks or opportunities that are properly treated as economic considerations themselves in evaluating alternative investments, with the weight given to those factors being appropriate to the relative level of risk and return involved compared to other relevant economic factors, and in those limited instances the ESG considerations are more than “mere tie-breakers.”
Clearly, a fair reading of the above and the following passage from the 2018 FAB results in a less than full throated endorsement of ESG type investments. As the Department notes:
“Fiduciaries must not too readily treat ESG factors as economically relevant to the particular investment choices at issue when making a decision. It does not ineluctably follow from the fact that an investment promotes ESG factors, or that it arguably promotes positive general market trends or industry growth, that the investment is a prudent choice for retirement or other investors. Rather, ERISA fiduciaries must always put first the economic interests of the plan in providing retirement benefits. A fiduciary’s evaluation of the economics of an investment should be focused on financial factors that have a material effect on the return and risk of an investment based on appropriate investment horizons consistent with the plan’s articulated funding and investment objectives.” (emphasis supplied)
Participant directed investment fund
With respect to participant directed investment funds in a defined contribution plan setting where there are many investment choices offered, the Department seems more open to have at least some of those investment funds to incorporate ESG goals. As the Department notes in the 2018 FAB:
“In the case of an investment platform that allows participants and beneficiaries an opportunity to choose from a broad range of investment alternatives, adding one or more funds to a platform in response to participant requests for an investment alternative that reflects their personal values does not necessarily result in the plan forgoing the placement of one or more other non-ESG themed investment alternatives on the platform.”
Qualified default investment funds-proceed with caution
However, with respect to a qualified default investment fund (QDIF) where a participant who makes no investment choice is defaulted into by the terms of the plan, the Department appears less sanguine in promoting a use of an ESG type fund as a QDIF (the DOL gives examples of ESG funds, including a Socially Responsible Index Fund, a Religious Belief Investment fund, or an Environmental Investment Fund). The Department’s cautionary words are as follows:
“In the case of a qualified default investment alternative (QDIA),2 however, selection of an investment fund is not analogous to merely offering participants an additional investment alternative as part of a prudently constructed lineup of investment alternatives from which participants may choose. Nothing in the QDIA regulation suggests that fiduciaries should choose QDIAs based on collateral public policy goals. In the QDIA context, the decision to favor the fiduciary’s own policy preferences in selecting an ESG-themed investment option for a 401(k)-type plan without regard to possibly different or competing views of plan participants and beneficiaries would raise questions about the fiduciary’s compliance with ERISA’s duty of loyalty.” (emphasis added)
Shareholder engagement issues
Though the 2018 FAB concentrated on ETI type issues, it also touched on proxy voting and shareholder engagement by retirement plans. In both areas the same cautionary voices (as in the ETI and ESG area) are sounded. The Department noted that its prior guidance was “not intended to signal that it is appropriate for an individual plan investor to routinely incur significant expenses to engage in direct negotiations with the board or management of publicly held companies with respect to which the plan is just one of many investors.”
The Department notes that normally engaging in shareholder activities (including proxy voting) is consistent with fiduciary obligation under ERISA (as such activities may be likely to enhance the economic value of the plan’s investment in the company at issue). However, from a reading of the 2018 guidance one should not expect to receive a total carte blanche from the Department with respect to such activities. The DOL chose to reiterate its guidance from a 2016 Interpretive Bulletin (U.S. Dep’t of Labor Interpretive Bulletin 2016-01, 29 C.F.R. § 2509.2016-01):
“[t]he Department has rejected a construction of ERISA that would render ERISA’s tight limits on the use of plan assets illusory and that would permit plan fiduciaries to expend trust assets to promote myriad public policy preferences. Rather, plan fiduciaries may not increase expenses, sacrifice investment returns, or reduce the security of plan benefits in order to promote collateral goals.”
The Department FAB concludes on a rather chilling (intentionally?) note that:
“If a plan fiduciary is considering a routine or substantial expenditure of plan assets to actively engage with management on environmental or social factors, either directly or through the plan’s investment manager, that may well constitute the type of “special circumstances” that the IB 2016- 01 preamble described as warranting a documented analysis of the cost of the shareholder activity compared to the expected economic benefit (gain) over an appropriate investment horizon.”
Obviously, if the above analysis is to be applied, a plan fiduciary will need greater documentation (which may generate greater expenses) to justify the ESG investment potentially making those investments less likely.
Conclusion and take away points
In summary, plan fiduciaries should be aware of the DOL’s position that a decision to designate an investment alternative may not be influenced by non-economic factors unless the investment ultimately chosen for the plan, when judged solely on the basis of its economic value, would be equal to or superior to alternative available investments. Similarly, proxy voting and shareholder governance initiative activities (and the plan expenses related thereto) should also be viewed in the context of the overall best economic interests of plan participants. Finally, with the issuance of FAB 2018-01, we would anticipate plan ETI and ESG investments will receive closer scrutiny by the Department.
This alert is for general informational purposes only and should not be construed as specific legal advice.
Bernard O’Hare is a partner at Patterson Belknap Webb & Tyler LLP, where he concentrates in the fields of employee benefits and executive compensation. Mr. O’Hare is a member of the American Bar Association, Section of Taxation, Committee on Employee Benefits, where he is a past-chair of the Section 401(k) Subcommittee. Mr. O’Hare has particular experience representing large pension funds in regulatory and fiduciary matters before the Internal Revenue Service and the United States Department of Labor. He is also experienced in addressing compensation matters at both for-profit and tax-exempt entities and has provided extensive advice on plan investment vehicles, including commingled funds and venture capital.
David Glaser is a partner at Patterson Belknap Webb & Tyler LLP, where he co-chairs the Firm’s Employee Benefits and Executive Compensation practice group. Mr. Glaser is a nationally recognized authority on the design and operation of qualified pension plans (including defined benefit, cash balance, 401(k) and other defined contribution plans), non-qualified deferred compensation programs and welfare plan arrangements. He advises clients on legal issues regarding the investments of pension plan assets, on choices of investments offered under participant directed plans, and on related administrative and fee concerns.
Douglas L. Tang is a counsel at Patterson Belknap Webb & Tyler LLP in the employee benefits and executive compensation department. He advises clients on a wide variety of employment, employee benefits, and executive compensation matters, both in the course of clients’ day-to-day business dealings and in connection with corporate transactions.
Jessica Carter is an associate at Patterson Belknap Webb & Tyler LLP in the employee benefits and executive compensation department. Ms. Carter advises employers with respect to pension and welfare plan issues, executive compensation, human resources planning and fiduciary responsibility and liability.
For more information, please visit www.pbwt.com.
2 The Department's QDIA regulation at 29 CFR § 2550.404c-5 establishes conditions under which a participant or beneficiary in a participant-directed individual account plan will be deemed to have exercised control over assets in his or her account when, in the absence of investment directions from the participant or beneficiary, the plan invests all or part of a participant's or beneficiary's account in a QDIA. When a plan complies with the regulation, plan fiduciaries are not liable under Part 4 of ERISA for any loss or by reason of any breach which results from such participant's or beneficiary's exercise of control, but the plan fiduciaries remain responsible for the prudent selection and monitoring of the QDIA.