ESG Investing After the DOL Rule on “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights”

Summary of the Rule

In late 2022, the Department of Labor under President Biden promulgated a new rule on “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights,” superseding the Department’s 2020 rule promulgated under President Trump. Numerous media reports suggested that the 2022 Biden Rule permits or even encourages ESG investing, in contrast to the 2020 Trump Rule, which was reported to be hostile to ESG investing. These reports are wrong. This summary aims clarify the effect of the Biden Rule and what has changed from the Trump Rule.

In brief, the 2022 Biden Rule largely reaffirms the Department of Labor’s longstanding position, compelled by binding Supreme Court precedent, that an ERISA fiduciary may use ESG investing to improve risk-adjusted returns but not to obtain collateral benefits. Subject to a few nuanced changes of limited practical import, the Biden Rule is largely consistent with the 2020 Trump Rule and earlier regulatory guidance.

Much of the confusion that the 2022 Biden Rule endorses ESG investing, and that the 2020 Trump Rule opposed it, traces to the original proposals for those rules. The Biden Proposal favored ESG factors by deeming them “often” required by fiduciary duty. The Trump Proposal disfavored ESG factors by subjecting them to enhanced fiduciary scrutiny. However, following the notice-and-comment period, the Department significantly revised those proposals before finalization. Neither final rule singled out ESG investing for favored or disfavored treatment. The final Trump Rule did not use the term “ESG.” The regulatory text of the final Biden Rule refers once to ESG investing, but only to state that ESG factors “may” be “relevant to a risk and return analysis,” depending “on the individual facts and circumstances.” This statement is true for all investment factors, ESG or otherwise.

The heart of the 2022 Biden Rule is the requirement that an ERISA fiduciary must make investment decisions “based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis.” The heart of the 2020 Trump Rule was the requirement that an ERISA fiduciary must make investment decisions “based only on pecuniary factors.” But a pecuniary factor was defined by the Trump Rule to mean one “that a fiduciary prudently determines is expected to have a material effect on the risk and/or return of an investment.” The changes in the Biden Rule from the Trump Rule are thus cosmetic: changing the terms “prudently” to “reasonably,” and “material” to “relevant.” In practical terms, the Biden Rule replaced the Trump Rule’s use of the term “pecuniary factors” with its definition provided in the Trump rule. Crucially, both the Biden Rule and the Trump Rule specify that a “fiduciary may not subordinate the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to other objectives, and may not sacrifice investment return or take on additional investment risk to promote [other] benefits or goals.”

Under both the 2022 Biden Rule and the 2020 Trump Rule, therefore, an ERISA fiduciary may consider only financial risk-and-return considerations, and no other considerations, including collateral benefits to third parties. In accordance with prudent investor principles, the fiduciary must assess diversification and liquidity needs, be cost sensitive, and consider a reasonable number of alternative investments. The fiduciary must also document this analysis and update it periodically, making prudent adjustments to the investment program in light of changing circumstances. Given the current state of the theory and evidence on ESG investing, a particular ESG strategy could well satisfy these prudent investor principles. However, whether a given ESG strategy is prudent will depend on the particular facts and circumstances and a reasoned relationship to risk and return, as explicitly acknowledged in the regulatory text of the Biden Rule. The key consideration is whether the investment fits as part of portfolio- or menu-level balance of risk and return reasonably suited to the purpose of the plan.

To be sure, the 2022 Biden Rule does make some nuanced technical changes to the 2020 Trump Rule. Relative to the Trump Rule, the Biden Rule: (i) makes adjustments to the language governing reliance on collateral benefits to break a tie between two investment alternatives that “equally serve the financial interests of the plan”; (ii) identifies the “menu” of available investment funds as the portfolio to which prudent investor principles apply in a self-directed retirement plan (such as a 401(k)); and (iii) removes the categorical prohibition of an investment fund that pursues collateral benefits as a qualified default investment alternative (QDIA). However, none of these changes, which are elaborated in the FAQ that follows, reflects a significant change in policy. And none cuts against our bottom line that the Biden Rule, like the Trump Rule, confirms the permissibility of ESG investing in pursuit of improved risk-adjusted returns in accordance with prudent investor principles without mandating such an investment strategy.

Accordingly, the Biden Rule changes nothing for ERISA fiduciaries who are currently pursing risk-and-return ESG investing in a prudent process, without regard for collateral benefits. ERISA fiduciaries who did not use ESG factors prior to 2022 should feel no greater urgency to begin doing so now. And ERISA fiduciaries who are investing for collateral benefits continue to run the same fiduciary risk as before.

Frequently Asked Questions

1. When the Biden Rule was first proposed, it was widely reported as favoring ESG investing. How is the final rule different?

The regulatory text of the proposed Biden Rule favored ESG factors by deeming them “often” required by fiduciary duty. Singling out ESG investing for favored treatment was widely criticized by many commentators, including us, as inconsistent with long-standing prudent investor principles, which apply neutrally without favoring or disfavoring any particular investment strategy. The Department of Labor, supported by dedicated career staff who have served under presidents of both parties, responded by rewording the final Biden Rule to remain neutral between investment strategies, and removed the word “often.” The preamble to the final Biden Rule, though not operative law, confirms that the Department did not mean to favor or disfavor ESG investing.

2. But the final Biden Rule has been widely reported as reversing the Trump Rule by welcoming ESG investing. Are those reports wrong?

As discussed in the summary above, the heart of the final 2022 Biden Rule is the requirement that an ERISA fiduciary must make investment decisions “based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis.” Except for the cosmetic changes from “prudently” to “reasonably,” and from “material” to “relevant,” this language tracks the definition of “pecuniary factors” in the 2020 Trump Rule. In substance, therefore, the Biden Rule replaced the Trump Rule’s use of the term “pecuniary factors” with its definition.

At the same time, the text of the Biden Rule contains an additional, for-the-avoidance-of-doubt provision confirming that “[r]isk and return factors may include the economic effects of climate change and other environmental, social, or governance factors.” Crucially, however, the text also confirms that “[w]hether any particular consideration is a risk-return factor depends on the individual facts and circumstances,” and that “[t]he weight given to any factor by a fiduciary should appropriately reflect a reasonable assessment of its impact on risk-return.” Moreover, under both the Biden Rule and the Trump rule, a “fiduciary may not subordinate the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to other objectives, and may not sacrifice investment return or take on additional investment risk to promote [other] benefits or goals.”

Accordingly, under both the Biden Rule and the Trump Rule, an ERISA fiduciary may consider only financial risk-and-return considerations, and no other considerations, including collateral benefits to third parties. These principles apply to all investment strategies, whether ESG or otherwise. And ESG factors, like any other factor, may or may not be a relevant risk-return factor depending on the circumstances.

3. Does this mean that an ERISA fiduciary may include a fund that uses ESG factors in a plan menu?

An overlooked but potentially important substantive change made by the 2022 Biden Rule is the addition of the term “or menu” to the rule’s references to “the portfolio.” Consistent with Supreme Court precedent, this change confirms that menu construction is a fiduciary act subject to ERISA’s duties of loyalty and prudence. In consequence, that a particular fund relies on ESG factors for risk-and-return purposes is, by itself, neither qualifying nor disqualifying. Instead, as per the preamble to the regulatory text (relying on our comment letter), two questions pertain to the inclusion of any fund, whether ESG or otherwise, as follows: “First, how does a given fund fit within the menu of funds to enable plan participants to construct an overall portfolio suitable to their circumstances? Second, how does a given fund compare to a reasonable number of alternative funds to fill the given fund’s role in the overall menu?”

All told, therefore, an ERISA fiduciary should not hesitate to include an ESG fund in a menu of investment choices offered to plan participants provided that the fiduciary reasonably concludes that the fund’s use of ESG factors will provide superior risk and return benefits within the context of the full menu relative to reasonably available alternatives.

4. What about collateral benefits? May an ERISA fiduciary include a fund that uses ESG factors to promote collateral benefits in a plan menu?

This is a bit more complicated, and touches on another subtle change. Under both the 2020 Trump Rule and the 2022 Biden Rule, a fund with a collateral benefit goal is not categorically prohibited from inclusion in a plan menu. However, an ERISA fiduciary may choose such a fund based only a risk-and-return analysis, and in no event may the fiduciary subordinate the participant’s financial interests to other objectives. In other words, a fund that pursues collateral benefits may be included in a plan menu in spite of, but not because of, those benefits. The fiduciary must determine, without regard for the fund’s collateral benefits, that the fund is a suitable fit within the menu as a whole and will provide superior risk and return benefits relative to reasonably available alternatives. If including a collateral benefits fund in the menu, the normal fiduciary practice of documenting the fiduciary process will therefore be even more critical than usual, and the fiduciary would be well-advised to document its reasoning with greater care than normal.

The change in the Biden Rule pertains to the use of a collateral benefits fund as a qualified default investment alternative (QDIA). The Trump Rule prohibited the use of a collateral benefit fund as a QDIA. The Biden Rule removed this prohibition. Thus, an ERISA fiduciary may now choose a fund with a collateral benefit goal to be a QDIA. However, this choice is subject to the same principles of loyalty and prudence that apply to the choice of such a fund as an ordinary menu alternative. And as just discussed, doing so will require additional process and may entail additional regulatory scrutiny and litigation risk. Given the importance of the QDIA, which a majority of plan participants commonly retain, we believe that well-counseled plan fiduciaries will not use a collateral benefits fund as their QDIA.

5. Does this mean that an ERISA fiduciary may never actively pursue a collateral benefit? What about the “tiebreaker” rule?

The 2022 Biden Rule carries forward the so-called “tiebreaker” principle set forth in the 2020 Trump Rule and earlier guidance bulletins tracing back to 1994. As revised, if an ERISA fiduciary “prudently concludes” that competing investment alternatives “equally serve the financial interests of the plan,” the fiduciary may break the tie “based on collateral benefits other than investment returns.” Crucially, however, the text confirms that the “fiduciary may not … accept expected reduced returns or greater risks to secure such additional benefits.” Moreover, relative to the Trump Rule, the Biden Rule more clearly judges a tie in relation to the portfolio or menu as a whole instead of in isolation.

Two other changes to the tiebreaker warrant discussion. First, the Biden Rule confirms in the regulatory text that an ERISA fiduciary does not necessarily violate the duty of loyalty by taking into account participants’ preferences in choosing a collateral benefit to break a tie. Second, the Biden Rule did not carry forward the Trump Rule’s inclusion in the regulatory text of a specific documentation requirement for the tiebreaker. However, as confirmed by the preamble to the Biden Rule, “removal of the documentation provision from the regulation does not suggest that ERISA fiduciaries are excused from complying with ERISA’s prudence obligations, or subject to a lower standard of care, with regard to documentation or otherwise.” The well-known and longstanding fiduciary obligation to document important decisions and the reasons for those decisions continues to pertain to an ERISA fiduciary’s invocation of the tiebreaker rule.

All told, little of substance has changed regarding the application of the tie-breaker.

6. What sort of disclosures should an ERISA fiduciary look for in a fund prospectus to determine whether the fund relies on ESG factors for a collateral purpose?

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

1. “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.”
2. “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 nonfinancial reasons.”
3. “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, provided that the fund is prudent on risk and return grounds in light of reasonably available alternatives and in light of the overall menu.

Funds B and C, by contrast, consider environmental impacts without connection to risk and return. As such, Funds B and C could be included in a plan menu, including as a QDIA, but only if the fiduciary could show (i) that the decision to include them was based solely on risk and return factors and not on the Fund’s collateral benefit 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 and in light of the overall menu.

7. 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 exclusively 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 worthwhile relative to its benefits, potentially making it prudent under the circumstances. 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.

8. 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 text of the 2022 Biden Rule is unambiguous in not mandating ESG investing: “Risk and return factors may include the economic effects of climate change and other environmental, social, or governance factors on the particular investment or investment course of action. Whether any particular consideration is a risk-return factor depends on the individual facts and circumstances.”

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 this 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 Biden Rule reflects these basic prudent investor principles.

9. What if plan participants want their retirement savings to be invested in an ESG-themed investment fund that pursues collateral benefits?

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 Department of Labor 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 collateral benefit goals is thus uncertain and entails additional litigation risk.