ESG funds, those that build investment portfolios focused on environmental, social, or governance-related issues, have become a hot topic the past few years. While such funds have been around for many years, they have gained assets, media attention, and credibility more recently. However, ESG investing, also referred to as socially responsible investing (SRI), is still controversial in retirement plans.
ERISA mandates that all investments in qualified plans be evaluated solely on their risk and return characteristics. This has previously precluded plan sponsors from including ESG funds on their plan menus since ESG investment portfolios are inherently built around issues unrelated to risk and return.
To provide clarity on this topic, the Department of Labor recently issued regulatory guidance to assist ERISA fiduciaries on this topic. As there is no precise definition of ESG investing, the final rule mentions only pecuniary and non-pecuniary factors as the basis for determining investment responsibilities and makes no specific reference to ESG investments. The rule states 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 non-pecuniary benefits or goals.”
However, the final rule does not prohibit including an ESG investment on the retirement plan fund menu, provided it has been selected solely on pecuniary factors. The exception to this is that ESG funds may not be the default option (QDIA) for investors who have not made their own investment decisions. Any fund that has one or more non-pecuniary factors is not permitted to be used as a QDIA.
The final rule confirms that plan fiduciaries are required to select investments and investment courses of action based solely on financial considerations. This is to ensure that fiduciaries are protecting the financial interests of participants and beneficiaries.
The final rule requires plan fiduciaries to maintain documentation when choosing between or among investments that the fiduciary prudently determines would serve equivalent roles in the plan’s portfolio based on appropriate consideration of the investment and that the plan fiduciary is unable to distinguish on the basis of pecuniary factors.
The final rule will become effective on January 12, 2020. The current 404a-1 regulation applies until then. However, plans will have until April 30, 2022 to make any changes necessary to comply with the requirements related to the selection of QDIAs. This grace period will allow for time to review and make changes to any QDIA investments with non-pecuniary (such as ESG investments) considerations.