On November 22, 2022, the U.S. Department of Labor (DOL) issued a final rule, “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights,” under the Employee Retirement Income Security Act of 1974 (ERISA) that requires a fiduciary to consider all relevant factors in investment decisions, including selecting qualified default investment alternatives (QDIAs); exercising shareholder rights, such as proxy voting; and the use of written proxy voting policies and guidelines. This reverses portions of two 2020 final rules issued under the Trump administration, which generally required plan fiduciaries to select investments based solely on consideration of pecuniary factors.
The rule will affect ERISA-covered retirement and welfare benefit plans. It does not apply to retail accounts or non-ERISA, state-sponsored retirement plans.
The need for clarification comes from the chilling effect and other potential negative consequences caused by the current regulation with respect to the consideration of climate change and other ESG factors.”
The rule is effective on January 30, 2023.
Background
On November 13, 2020, the DOL published a final rule, “Financial Factors in Selecting Plan Investments,” which adopted amendments to ERISA’s “Investment Duties” regulation. The amendments generally required plan fiduciaries to select investments and investment courses of action based solely on consideration of pecuniary factors. One of the 2020 amendments prohibited adding or retaining any investment fund, product, or model portfolio as a QDIA if the fund, product, or model portfolio includes even one non-pecuniary objective in its principal investment strategies. On December 16, 2020, the DOL published a related final rule, “Fiduciary Duties Regarding Proxy Voting and Shareholder Rights,” which also adopted amendments to the “Investment Duties” regulation. These amendments addressed plan fiduciaries’ ERISA obligations when voting proxies and exercising other shareholder rights in connection with plan investments in shares of stock. These two final rules (the 2020 rules) responded to a perception that investment products could be marketed to ERISA fiduciaries based on goals and purported benefits that are unrelated to financial performance. The 2020 rules became effective in January 2021.
Five days after the effective date of the 2020 rules, President Biden signed an executive order, “Protecting Public Health and the Environment and Restoring Science to Tackle the Climate Crisis.” Agencies were directed to review rules issued under the Trump administration to ensure they complied with the nation’s “abiding commitment to empower our workers and communities; promote and protect our public health and the environment.” The DOL announced that pending review, no enforcement actions would be taken against any plan fiduciary that failed to comply with the 2020 rules. The DOL was concerned that the 2020 rule created a perception that fiduciaries are at risk if they included environmental, social, or governance (ESG) factors in plan investment evaluations, and that they would need to have special justifications for even ordinary exercises of shareholder rights.
Highlights
The November 2022 final rule does not change two long-standing principles:
- The duties of prudence and loyalty require ERISA plan fiduciaries to focus on relevant risk-return factors and not subordinate the interests of participants and beneficiaries (such as by sacrificing investment returns or taking on additional investment risk) to objectives unrelated to the provision of plan benefits.
- The fiduciary duty to manage plan assets that are shares of stock includes the management of shareholder rights, such as the right to vote proxies.
Changes to Clarify Permissibility of Consideration of ESG Factors
The final rule deletes the “pecuniary/non-pecuniary” terminology and adds text clarifying that a fiduciary’s duty of prudence must be based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis and that such factors may include the economic effects of climate change and other ESG considerations on the particular investment or investment course of action.
QDIA Provision Updates
A QDIA is the investment used when an employee contributes to the plan without having specified how the money should be invested. It is a safe harbor that relieves an employer from liability should the QDIA suffer investment losses. There are four types of QDIAs:
- An investment service that allocates contributions among existing plan options to provide an asset mix that considers an individual’s age or retirement date
- A product with a mix of investments that considers the individual’s age or retirement date, i.e., a target-date fund
- A product with a mix of investments that considers the characteristics of the group of employees as a whole, rather than each individual, i.e., a balanced fund
- A capital preservation product, such as a stable value fund, that can only be used for the first 120 days of participation
The final rule removes the special provisions for QDIAs that applied under the 2020 rules. Under the final rule, QDIA standards are no different from those applied to other investments. When selecting a QDIA, a plan fiduciary must, among other things, focus on relevant risk and return factors and not subordinate the interests of participants and beneficiaries (such as by sacrificing investment returns or taking on additional investment risk) to objectives unrelated to the provision of benefits under the plan.
The DOL expects to see an increase in the number of QDIAs that are ESG funds.
Changes to Clarify the Application of the Duty of Loyalty
The Tiebreaker Test
Another important change to the 2020 rules is the update of the tiebreaker standard, which permits fiduciaries to consider collateral benefits as tiebreakers in some circumstances. The 2020 rules required that competing investments be economically indistinguishable before fiduciaries could turn to collateral factors to break a tie and imposed a special documentation requirement on the use of collateral factors, meaning benefits other than investment returns.
The final rule requires the fiduciary to prudently conclude that competing investments or investment courses of action equally serve the financial interests of the plan over the appropriate time horizon. The fiduciary is not prohibited from selecting the investment or investment course of action based on collateral benefits.
The final rule also removes the special documentation requirement that suggested to some fiduciaries that they should be wary of considering ESG factors, even when those factors are financially relevant to the investment decision. ERISA’s generally applicable statutory duty to prudently document plan affairs would continue to apply. As noted above, the final rule maintains the long-standing principle that the fiduciary may not accept reduced returns or greater risks to secure collateral benefits.
Investment Alternatives in Participant-Directed Individual Account Plans
The final rule adds a new provision clarifying that fiduciaries do not violate their duty of loyalty solely because they take participants’ nonfinancial preferences into account when constructing a menu of prudent investment options for participant-directed individual account plans.
Provisions on Shareholder Rights Including Proxy Voting
Like the 2020 rules, the final rule adopts a principles-based approach to governing the exercise of shareholder rights. The final rule retains the core principle that when a plan’s assets include stock shares, the fiduciary duty to manage plan assets includes the management of shareholder rights related to those shares, such as the right to vote proxies. The final rule makes three noteworthy changes to the 2020 rules.
First, the final rule eliminates the statement in the 2020 rules that “the fiduciary duty to manage shareholder rights appurtenant to shares of stock does not require the voting of every proxy or the exercise of every shareholder right.” The statement may be misread to suggest that plan fiduciaries should be indifferent to the exercise of their rights as shareholders, even if the cost is minimal.
Second, the final rule removes the two safe harbor examples for proxy voting policies permissible:
- A policy to limit voting resources to types of proposals that the fiduciary has prudently determined are substantially related to the issuer’s business activities or are expected to have a material effect on the investment’s value
- A policy of refraining from voting on proposals or types of proposals when the plan’s holding in a single issuer relative to the plan’s total investment assets is below a quantitative threshold
The DOL concluded that these safe harbors encouraged abstention as the normal course. Abstention should not be the normal course because of the importance of prudent management of shareholder rights in enhancing the value of plan assets or protecting plan assets from risk.
Third, the final rule eliminates specific requirements in the 2020 rules on maintaining records on proxy voting activities and monitoring obligations when using investment managers or proxy voting firms. Monitoring obligations are covered in another provision of the regulation that more generally covers selection and monitoring obligations.
The 2020 rule requirements created a misperception that proxy voting and other exercises of shareholder rights are disfavored or carry greater fiduciary obligations than other fiduciary activities.
Effective Date
The final rule will be effective 60 days after publication in the Federal Register, which will be January 30, 2023. There is a one-year delay for certain proxy voting provisions to allow fiduciaries and investment managers additional time to review any proxy voting policies and guidelines and make any necessary changes.
Conclusion
With the significant investment you make in your employee benefit plan (EBP), you understand the importance of closely monitoring your plan’s areas of risk, internal controls and financial statement amounts, and disclosures, all while maintaining compliance with regulations. That’s why many plan sponsors are turning to FORVIS for timely insight, innovative services, and depth of plan resources. Contact Us for more information.