PLANADVISER - January/February 2021 - 38

ERISA vista
Fred Reish and Joan Neri
The Latest Word on ESG
In terms of plan investing, fiduciary duty continues to come first
QUESTION: I'm a registered investment adviser
advises 401(k) plan committees, helping them select
[RIA] who
the
plan investment options and the qualified default investment
alternative [QDIA] for participants who fail to make an investment
election. Committee members have been inquiring
about choosing funds that use environmental, social and
governance [ESG] factors. What are my fiduciary obligations
with respect to the selection of ESG funds?
ANSWER: As with the selection of any investment fund, you
are subject to the Employee Retirement Income Security Act
(ERISA) duties of prudence and loyalty. In its recently issued
final regulation, the Department of Labor (DOL) explained
that, to meet those duties, ESG funds must be evaluated based
solely on pecuniary factors-i.e., factors that you expect will
have a material effect on risk and/or return. In general, you
may not use non-pecuniary factors to select investments
except as part of a " tiebreaker " process when two funds in
the same asset class are equally qualified based on pecuniary
factors. But other conditions must also be met.
In explaining the fiduciary process for selecting ESG
funds, the DOL noted that the ERISA duty of loyalty
prohibits fiduciaries from subordinating participants' interests
to unrelated objectives. This means that a plan fiduciary
may not sacrifice investment returns or take on additional
investment risk to promote non-pecuniary factors.
Accordingly, the rule requires that a plan fiduciary must
base its investment decisions on pecuniary factors only.
This includes investment decisions about the options to be
offered on the plan lineup as well as investment decisions
about the QDIA. Incidentally, this regulatory standard also
applies to the selection of investments for a plan such as a
pension plan that is not participant-directed.
Under the rule, a pecuniary factor is defined as a " factor
that a fiduciary prudently determines is expected to have a
material effect on the risk and/or return of an investment
based on appropriate investment horizons consistent with
the plan's investment objectives ... "
Applying that approach, you'll need to examine information
about the ESG fund to determine whether the ESG
factors are used for pecuniary purposes-i.e., to improve
risk and/or return-or, instead, for non-pecuniary purposes
such as to promote social or political outcomes. If the
factors produce better returns, less risk, or a combination
of the two, it doesn't matter that they are social, environmental
or governance factors.
Reviewing the fund's prospectus is a good starting place.
If the document does not clearly indicate whether the ESG
factors are used to improve risk and/or return, then you
should further investigate the fund's investment strategies,
primary investment objectives and processes to determine
whether there is sufficient information to support its
compliance with what the DOL requires.
In conducting this evaluation, you may find there are
two funds in a particular category that are equally qualified
based on pecuniary factors. What process can you use to
select one of those funds?
In that instance, the regulation sets forth a tiebreaker
process where non-pecuniary factors may be used as the
deciding factor-but only if you document the following:
* why pecuniary factors were insufficient;
* how the selected investment compares with the other,
as to the prudence factors listed in the regulation; and
* how the non-pecuniary factors are in the interests of
participants in their retirement income/financial benefits.
The regulation prevents a fund from being a QDIA if
its investment objectives or principal strategies include,
consider or indicate the use of non-pecuniary factors, therefore
the tiebreaker rule may not be used for selecting a QDIA.
The analysis needed to satisfy the tiebreaker requirelikely
be
ments and the associated documentation will
time-consuming and, in some instances, difficult to undertake.
Therefore, we expect that many advisers will avoid this
process entirely and make their investment decisions based
on pecuniary factors only.
The new regulation was effective on January 12; however,
the rules for QDIA investments are effective on April 30, 2022.
The QDIA requirements permit the use of ESG factors only if
the investment manager uses them as pecuniary considerations.
Because this rule was based on a Republican approach
to ESG factors, it is likely the new Democratic administration
will delay the effective date of the QDIA provisions. Also, it
would not be surprising if the DOL under the new administration
undertakes to propose a new or revised regulation-
a process that could take a year or more.
Fred Reish is chairman of the financial services ERISA practice at
law firm Faegre Drinker Biddle & Reath LLP. Joan Neri, a nationally
recognized expert in employee benefits law, is counsel in the firm's
financial services ERISA practice, where she focuses on all aspects
of ERISA compliance affecting registered investment advisers and
other plan service providers.
38 | planadviser.com January-February 2021 Art by Tim Bower
http://www.planadviser.com
PLANADVISER - January/February 2021

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