On November 22, 2022, the U.S. Department of Labor (“DOL”) announced a final rule (the “2022 Final Rule”) that allows plan fiduciaries to consider climate change and other environmental, social, and governance (“ESG”) factors when selecting retirement investments and exercising shareholder rights, such as proxy voting, for ERISA-governed plans.^[1]

The 2022 Final Rule pulls back rules issued in 2020 during the previous presidential administration (the “2020 Rules”), which interpreted the duty of loyalty and the duty of prudence in a manner that constrained a fiduciary’s ability to select ESG alternatives. While the 2020 Rules did not preclude the inclusion of ESG funds, it required plan fiduciaries to select the funds based on pecuniary considerations, and specified that non-financial considerations could only be used as a tie-breaker for ESG funds, so long as the pecuniary factors were satisfied.

The 2022 Final Rule removes the emphasis on the pecuniary factors in selecting ESG investments and is intended to provide clarity on how ERISA’s fiduciary duties of prudence and loyalty apply to selecting investments and investment courses of action and exercising shareholder rights such as proxy voting.

The 2022 Final Rule will be effective January 30, 2023, except for a delayed applicability until January 30, 2024 for certain proxy-voting provisions, to allow fiduciaries and investment managers additional time to prepare. The following is a summary of the key changes in the 2022 Final Rule.

Four Key Changes to the “Investment Duties” Regulation

Although the 2022 Final Rule makes some significant changes to the current regulations, the DOL contends that its core fiduciary principles remain unchanged.  Specifically, the 2022 Final Rule retains the investment duties regulation’s principles that the duties of prudence and loyalty require plan fiduciaries to focus on relevant risk-return factors and not the subordinate interests of participants and beneficiaries to objectives unrelated to the provision of benefits under the plan.  The four key changes to the current regulation are as follows:

• Allowing the Consideration of ESG Factors

The 2022 Final Rule amends the current regulation to delete the “pecuniary/non-pecuniary” language based on concerns that the language causes confusion and has a chilling effect on financially beneficial choices.  By removing this terminology, the DOL sought to help re-establish its position that climate change and other ESG factors that may be relevant in a risk-return analysis of an investment do not need to be treated differently than other relevant investment factors.  In addition, the impact some ESG factors may have on risk and returns is not always clear or easy to determine at the outset.  Because of this amendment, plan fiduciaries will no longer be discouraged from considering climate change and ESG risk factors when assessing investment options.

• Eliminating the Stricter Rules that Currently Apply to QDIAs

The 2020 Rules do not allow a fund to serve as a Qualified Default Investment Alternative (“QDIA”) if it, or any of its component funds in a fund-of-fund structure, has investment objectives, goals, or principal investment strategies that include, consider, or indicate the use of one or more non-pecuniary factors in its investment objectives, even if the fund is objectively prudent from a risk-return perspective or even best in class.  In issuing the 2022 Final Rule, the DOL noted that QDIAs do warrant special treatment because plan participants have not affirmatively directed the investment of their assets into the QDIA; however, it no longer supports the restriction in the current regulation and has removed it.  According to the DOL, the standard that applies to all other investments shall apply to QDIAs. 

• Eliminating the “Tiebreaker Test”

The 2020 Rules contained a “tiebreaker” test, which required that competing investments be indistinguishable based on pecuniary factors alone before fiduciaries can refer to collateral factors to break a tie.  The 2020 Rules also imposed a special documentation requirement on the use of such factors.  The 2022 Final Rule amends the current regulation to replace the “tiebreaker” provisions with a standard that requires the fiduciary to conclude prudently that competing investments or investment course of action being considered (which includes ESG factors) equally serve the financial interests of the plan over the appropriate time horizon when compared to a competing investment or investment course of action. In such cases, the fiduciary is not prohibited from selecting the investment, or investment course of action, based on collateral benefits other than investment returns. The 2022 Final Rule also removes the special regulatory documentation requirements in favor of ERISA’s generally applicable statutory duty to prudently document plan affairs.

• Allowing for the Consideration of Participant Preferences

The 2022 Final Rule adds a new provision to the investment duties regulation that provides that fiduciaries do not violate their duty of loyalty solely because they take participants’ preferences into account when compiling prudent investment options for participant-directed individual account plans.  The DOL reasons that if accommodating participant preferences leads to greater plan participation and higher deferral rates, then it could lead to greater retirement security, thus furthering the purposes of the plan.  The DOL noted, however, that plan fiduciaries may not add imprudent investment options for plan participants simply because participants request or prefer them. 

The 2022 Final Rule and Exercise of Shareholder Rights

In addition to the changes summarized above, the 2022 Final Rule addresses the application of duties of prudence and loyalty to the exercise of shareholder rights, including proxy voting.

First, the 2022 Final Rule amends the 2020 investment duties regulation to eliminate the statement that “the fiduciary duty to manage shareholder rights appurtenant to shares of stock does not require the voting of every proxy or the exercise of every shareholder right.” This provision was removed because the DOL thought that it might be misread as suggesting that plan fiduciaries should be indifferent to the exercise of their rights as shareholders, even if the cost is minimal.

The 2022 Final Rule also removes the two “safe harbor” examples for permissible proxy voting policies. These safe harbors permitted limiting voting resources to types of proposals that the fiduciary has prudently determined are substantially related to the issuer’s business activities or are expected to have a material effect on the value of the investment, and also permitted fiduciaries to refrain from voting on proposals when the plan’s holding in a single issuer relative to the plan’s total investment assets is below a quantitative threshold. The DOL commented that these safe harbors encouraged abstention as a normal practice and do not adequately safeguard the interests of plans, plan participants, and beneficiaries.

Finally, the 2022 Final Rule eliminates the specific monitoring obligations with respect to use of investment managers or proxy voting firms, and also eliminates a specific requirement on maintaining records on proxy voting activities and other exercises of shareholder rights.  With respect to monitoring obligations, the DOL was concerned that the current regulation’s requirements could be interpreted to require special obligations above and beyond the statutory obligations of prudence and loyalty that generally apply to monitoring the work of service providers.  The record maintenance provision was also removed on the basis that it was perceived to treat proxy voting and other exercises of shareholder rights differently from other fiduciary activities, when these activities are in fact deemed to be core fiduciary responsibilities.  

Next Steps The impact of the 2022 Final Rule remains to be seen. Some fiduciaries may be reluctant to consider ESG alternatives altogether, considering the possibility that the rules could change if a new administration assumes office in 2025, while others may welcome the guidance provided under the 2022 Final Rule when selecting ESG investments.  Plan fiduciaries should continue to carefully evaluate, select and monitor all plan investments.  To the extent they want to potentially accommodate ESG investing, plan fiduciaries should carefully review and potentially revise the plan’s investment policy statement with the 2022 Final Rule in mind.  ERISA class actions involving defined contribution plans are on the rise and the 2022 Final Rule does not protect fiduciaries from potential claims if an ESG investment underperforms or is more expensive than other non-ESG investments. 

FOOTNOTES

[1] A copy of the 2022 Final Rule can be found here:  https://www.federalregister.gov/documents/2022/12/01/2022-25783/prudence-and-loyalty-in-selecting-plan-investments-and-exercising-shareholder-rights. 

Jordan Latham also contributed to this article.