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Socially responsible investing and the plan fiduciary

In the wake of mass shootings, environmental disasters, industrial accidents, drug and tobacco use pandemics, and other tragedies, retirement plan investors are paying more attention to selecting or rejecting investments based on perceived public policy benefits or detriment.  For example, investors are more focused than ever on the larger implications of a mutual fund’s holdings in arms manufacturers and diamond mine operators. Retirement plan fiduciaries increasingly find themselves in the difficult position of having to respond to these concerns when they are raised by plan participants and beneficiaries while fulfilling their fiduciary duties under ERISA. In fact, ERISA plan fiduciaries and the Department of Labor have been wrestling with the concept of socially responsible investing for many years.

The DOL’s most recent guidance on the subject was released on April 23, 2018 (Field Assistance Bulletin 2018-01). This FAB is the latest in a series of pronouncements that includes opinion letters and prohibited transaction exemptions in the 1980s, and ERISA Interpretive Bulletins in 1994, 2008 and 2015. Consistent with the purpose of a Field Assistance Bulletin, FAB 2018-01 purports to interpret rather than replace prior guidance. Nonetheless, it may have a chilling effect on plan fiduciaries who have relied on the 2015 guidance to consider one or more socially responsible investments for retirement plans.

Socially responsible investing generally means the act of choosing investment vehicles with an eye to their collateral benefits as well as their expected risks and returns. Socially responsible investments go by several names. “ETI” (economically-targeted investment) and “ESG” (environmental, social and governance” are acronyms commonly applied to this type of investing.

ERISA requires plan fiduciaries to manage plan investments for the exclusive benefit of participants and beneficiaries, and with the care, skill, prudence and diligence of a prudent expert. And the DOL has consistently said that ERISA fiduciaries may not use plan assets to promote public policy causes at the expense of participants’ and beneficiaries’ financial interests or retirement security.  The unsettled issue always has been whether and how fiduciaries may satisfy ERISA if they take account of ESG factors in their investment decisions.

The first general statement of the DOL’s views on socially responsible funds was issued in 1994 (Interpretive Bulletin 94-1). IB 94-1 suggested that socially responsible investments are not inherently incompatible with ERISA’s fiduciary obligations, provided an ETI meets two criteria: (1) the ETI fund’s expected rate of return is consistent with rates of return earned by non-ETI funds with similar risk profiles, and (2) the ETI fund is an appropriate investment for the plan in terms of its internal diversification and the plan’s overall investment policy.

The DOL refined its position fourteen years later, replacing IB 94-1 with Interpretive Bulletin 2008-1. Where IB 94-1 suggested that ESG factors might be considered as a possible tie breaker between investments with similar expected returns and risks, IB 2008-1 stated that “fiduciary consideration of collateral, non-economic factors in selecting plan investments should be rare,” and that additional analysis and documentation might be required when ESG factors were considered. This language ended any consideration of potentially socially responsible investments by many interested investment fiduciaries.

Just three years ago, the DOL again reformulated its position and replaced IB 2008-1 with Interpretive Bulletin 2015-01. The Department found the 2008 guidance had “unduly discouraged” consideration of ESG factors by ERISA plan fiduciaries, even though such factors may have a direct relationship to the economic value of a plan investment. IB 2015-01 does not depart from the view that attention to the plan’s financial returns and risk to participants must be paramount in fiduciary investment decisions. But, under IB-2015-01, ESG factors may be included in the primary analysis of an investment option, if the fiduciary believes ESG factors affect the option’s expected returns and risks compared to available alternatives, or ESG factors also may be weighed as a secondary “tiebreaker” when available alternatives are indistinguishable in terms of expected risks and returns. The guidance also makes clear that ERISA would not prohibit a fiduciary from specifically addressing the selection of ETIs in investment policy statements or integrating analytical tools and metrics that could help a fiduciary evaluate ETI investments. Finally, IB 2015-01 explains that no special documentation is required to support a plan’s investment in an ETI.

The principal messages of IB 2015-01 are significantly narrowed by FAB 2018-01. The new FAB acknowledges that ESG factors can involve business risks or opportunities that “qualified investment professionals would treat as economic considerations under generally accepted investment theories.” However, it cautions that fiduciaries must not “too readily” treat ESG factors as economically relevant to a prudent choice for retirement plan investors. It emphasizes that a fiduciary’s evaluation of investment alternatives should focus on financial factors that materially affect an investment’s risk-return profile, based on “appropriate investment horizons,” consistent with the plan’s stated funding and investment objectives. While recognizing that investment policy statements may include references or measures related to ESG factors, the FAB stresses that the inclusion of such references does not mean fiduciaries “must always adhere to them” – in fact a fiduciary may be obligated to disregard them when it would be imprudent to follow them. This statement is not inconsistent with an ERISA fiduciary’s duties, but is notable in light of the message that ESG factors may only occasionally be economically relevant. Finally, FAB 2018-01 expressly rejects any implication under IB 2015-01 that an “ESG-themed” investment alternative might be a suitable default investment (QDIA) in a participant-directed individual account plan.

What conclusions may be drawn from the DOL’s latest pronouncement on ESG investing for retirement plans?   First, the DOL’s evolving position on ESG investing remains opaque.  The agency has felt compelled to refine or reformulate its views over the years as ESG mutual funds have continued to gain popularity, apparently seeking a Goldilocks position – sufficiently cautionary but not too discouraging.  Second, ESG mutual funds should not be selected as QDIAs, because ESG funds are not likely to be sufficiently diversified and inexpensive to support their use as a default investment.  Third, while an investment fiduciary must not use plan assets to promote social policies, it certainly can allow plan assets to be invested in ESG mutual funds (through direct investment or by including such funds in a retirement plan investment menu) as long as the fiduciary selects the fund through the same prudent process it would apply to the selection of any plan investment.  It appears to be acceptable for a fiduciary to use ESG factors as a tie-breaker when choosing among funds that have similar performance and fee structures.  Fourth, we think it still makes sense to include a specific reference to ESG funds in an Investment Policy Statement if the employer and investment fiduciaries wish to make such mutual funds available under a plan.  Finally, we recommend that investment fiduciaries go the extra mile in documenting the basis for selection of an ESG mutual fund by referencing the benchmarking tools, noting the reasons for adding the fund, explaining where the fund fits into the larger investment menu or strategy, and so on.

This article was originally posted by Verrill Dana LLP.

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