Many plan committees will be holding their Q4 meetings soon, and should begin reviewing compliance with recently issued final rules governing investments in plans covered by the Employee Retirement Income Security Act (ERISA). Bottom line: ERISA plan fiduciaries must focus solely on pecuniary factors in choosing plan investments and never sacrifice investment returns, take on additional investment risk, or pay higher fees to promote non-pecuniary goals.
The final rules stem from the U.S. Department of Labor's (DOL) concern that a growing emphasis on environmental, social, and corporate governance (ESG) factors may cause plan fiduciaries to choose investments for the wrong reasons, and digress from ERISA's duties of loyalty and prudence. The final rules substantially revise proposed rules discussed in our previous advisory, most notably by dropping references to ESG investments, but at the same time requiring plan fiduciaries to select investments and investment courses of action based on pecuniary factors only.
Pecuniary factors are defined as factors a fiduciary prudently determines are expected to have a material effect on risk and/or return of an investment based on appropriate investment horizons consistent with the plan's investment objectives and funding policy. At best, non-pecuniary factors come into play only in tie-breaker situations, but must comply with additional requirements.
So, what is a plan fiduciary to do? Follow this checklist:
- Follow the prudence safe harbor in the regulations
Under the prudence safe harbor, fiduciaries must give appropriate consideration to relevant facts and circumstances by choosing investments to further the plan's purpose, and consider (1) portfolio composition with regard to diversification; (2) liquidity and current return relative to anticipated cash flow; and (3) projected portfolio return relative to funding objectives. Fiduciaries are required to compare alternatives that are reasonably available under the circumstances, but are not required to scour the market or to consider every possible alternative.
- Use pecuniary factors only
Fiduciaries must base investment decisions solely on pecuniary factors, except in limited tie-breaker circumstances described below. Fiduciaries also must not subordinate participants' interests to other objectives and must not sacrifice investment return or take on additional investment risk to promote non-pecuniary goals. The weight given to any pecuniary factor by a fiduciary should appropriately reflect a prudent assessment of its impact on risk return. The DOL confirms in the preamble that these are the minimum legal requirements for compliance with ERISA's duty of loyalty, and are not to be construed as a safe harbor.
- Follow tie-breaker rules only if pecuniary factors create deadlock
Non-pecuniary factors can be used to make investment decisions only where a fiduciary cannot distinguish investments based on pecuniary factors alone. The DOL takes the position that deadlock situations will be rare. If non-pecuniary factors are used, fiduciaries must document: (1) why pecuniary factors alone were insufficient; (2) how the selected investment compares to the alternatives with regard to certain factors in the prudence safe harbor; and (3) how the non-pecuniary factors are consistent with participants' interests/financial benefits.
The DOL cautions that when a fiduciary makes an investment decision based on non-pecuniary factors, the fiduciary remains subject to ERISA's general loyalty obligation, which might, for example, be satisfied based on participant demand for a type of investment to increase plan participation or contributions, but would not be satisfied by a decision based solely on a fiduciary's policy preferences.
- No additional rules for choosing investment alternatives in account-based plan
There are no additional rules for selection of designated investment alternatives within participant-directed account-based plans. Therefore, fiduciaries must make their determination of investment line-up based on pecuniary factors, and can use non-pecuniary factors only as a tie-breaker (except for the qualified default investment alternative (QDIA), which must always be chosen by reference to pecuniary factors – see below).
The DOL indicates in the preamble an expectation that fiduciaries review prospectuses or other investment disclosures for statements regarding non-pecuniary investing. Note, a brokerage window is not subject to these rules, and would provide an option for participants to choose their own funds (with the important caveat that permitting a brokerage window carries its own fiduciary concerns that must be addressed and monitored).
- Prohibition on non-pecuniary factors for QDIA
An investment cannot be used as a plan's QDIA if the fund's investment objectives, goals or principal investment strategies include, consider, or indicate the use of one or more non-pecuniary factors.
The final regulations apply to investments made and investment courses of action taken after January 12, 2021. However, plans have until April 30, 2022 to make any necessary QDIA changes.
While the final rules are effective prospectively and fiduciaries are not required to take immediate action with respect to existing investments, fiduciaries' future decisions—including the duty to monitor—must comply with the final rule, and that might require investment line-up changes in the near future. Of course, the Biden Administration may take an entirely different approach and support ESG investing. Contact your DWT attorney for more information.