The U.S. Department of Labor (DOL) released a rule on Nov. 22, 2022, that clarifies fiduciary responsibilities under the Employee Retirement Income Security Act (ERISA) for selecting investments and exercising shareholder rights such as proxy voting. The regulation, titled “Final Rule on Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights,” is summarized below. It is commonly known as the ESG rule.

Background About the 2022 ESG Rule

In late 2020, under the prior administration, the DOL published two rules that adopted amendments to ERISA’s “Investment Duties” regulation. The first rule stated that plan fiduciaries must only consider “pecuniary factors” (loosely defined as financial factors) when selecting investments. The second rule addressed fiduciary obligations primarily around proxy voting. These rules caused confusion across a variety of stakeholders, especially around whether environmental, social, and governance (ESG) factors could be considered by plan fiduciaries in their investment decisions and actions. The rules were widely opposed by the investment industry for their “chilling effect” on considering ESG factors in investment decision-making and on the exercise of shareholder rights, including proxy voting.

In January 2021, the Biden administration issued an executive order to review these (and other) regulations, and in March the DOL announced its review and said the 2020 rules would not be enforced. In May, the White House issued a multipart executive order on climate-related financial risk that stated the DOL would consider publishing a proposed rule later in the year to “suspend, revise, or rescind” the then-current ESG and proxy voting rules. A proposed rule was released in October 2021 and comments were accepted for 60 days, during which time the DOL received more than 900 written responses. The effective date for the Final Rule is 60 days from publication in the Federal Register, save for a couple of specific features that have a one-year implementation timeline.

This Final Rule is the most recent in a series of varying DOL positions that have tended to vacillate between Democratic and Republican presidential administrations, dating back decades. This differing guidance has been commonly referred to as “regulatory whiplash” or “regulatory ping pong.” The DOL has attempted to take a relatively neutral “principles-based” approach to ESG factors, with the goal of having the Final Rule endure through future changes in administrations. Time will tell.

Key Highlights of the Final Rule

• Importantly, the Final Rule retains the core principle that 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 benefits under the plan.”
• That said, the Final Rule clarifies that the “economic effects of climate change and other ESG considerations” are potentially relevant risk-return factors. The rule does not require that ESG factors be considered. But it removes the barriers created by the 2020 rule for fiduciaries to do so. The Final Rule differs from the proposed rule in that it deletes the language that the consideration of ESG factors “may often be required” and instead provides that 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,” and that “(w)hether any particular consideration is a risk-return factor depends on the individual facts and circumstances.” The Final Rule does not include examples of E,S, and G factors that were enumerated in the proposed rule. Ultimately, it is up to the plan fiduciary to determine the weight given to any factor (not just ESG) in assessing its impact on the risk and return of a potential investment or investment course of action.
• The Final Rule also clarifies standards for qualified default investment alternatives (QDIAs) and states in the preamble that they are no different from those applied to other investments in that relevant risk-return factors must be the basis for determination. This has important implications in that it opens the door for defined contribution plans to select ESG options for QDIAs as long as it is financially prudent.
• A “tie-breaker test” was also revised to allow fiduciaries to consider “collateral benefits” (those other than risk-return factors) when making a decision between competing investments that “equally serve the financial interests of the plan over the appropriate time horizon,” though not if they reduce returns or increase risk. This is consistent with the proposed rule in that it removes the reference from the 2020 rule to tiebreakers only being used when investments are indistinguishable, which was widely viewed as a very high bar. The Final Rule also eliminates the current rule’s detailed documentation requirements when making tiebreaking decisions.
• The Final Rule permits fiduciaries to consider participant preferences, declaring that such consideration is not in violation of the fiduciary duty of loyalty. The DOL reasoned that a fiduciary may consider participant preferences (including ESG and other preferences) if it could lead to greater participation and higher deferral rates. That said, the inclusion of any such option must be prudent and may not be included simply due to participant preference. While this permits fiduciaries of participant-directed account plans such as 401(k)s to potentially consider participant preferences in determining their lineups, it raises other questions, including how to ascertain participant preferences.
• With regard to proxy voting and the exercise of shareholder rights, the Final Rule states that fiduciaries must exercise their shareholder rights prudently and for the benefit of participants and beneficiaries and not “subordinate” those interests to other objectives.
• The approach in the Final Rule regarding proxy voting is that proxies should be voted as part of the process of managing the plan’s investment in company stock unless a responsible plan fiduciary determines voting proxies may not be in the plan’s best interest (e.g., in cases when voting proxies may involve out-of-the-ordinary costs or unusual requirements.) The DOL’s position is that this approach recognizes the importance that prudent management of shareholder rights can have in enhancing the value of plan assets or protecting plan assets from risk.
• The Final Rule differentiates between when plans vote their own proxies from when that duty is delegated to investment managers. The rule states that investment managers should vote proxies in proportion to each plan’s economic interest in a pooled vehicle, if it cannot reconcile different plans’ proxy voting policies—this may be operationally burdensome. As an alternative, the investment manager may develop an investment policy statement and require participating plans to accept it upon subscribing to the pooled vehicle, thus putting the onus on ERISA fiduciaries to assess the proxy voting policy for ERISA compliance prior to investing.
• The Final Rule provides that a fiduciary may not adopt a practice of following the recommendations of a proxy advisory firm or other service provider without first determining that such firm or service provider’s proxy voting guidelines are consistent with the fiduciary’s obligations.
• The Final Rule requires plans to periodically review their proxy voting policies.

Bottom Line

The Final Rule is considered a “win” for investors that embrace the notion that ESG principles warrant consideration for fiduciaries in assessing the material risk-and-return implications for proposed investments or investment policies. That said, because the rule does not prescribe that ESG factors must be considered, the DOL may also be perceived as having taken a moderate approach. The merits and importance of ESG investing remain hotly debated politically both at the federal level, in Congress, and at the state level. While the Final Rule provides increased regulatory clarity regarding ESG for ERISA fiduciaries, the topic remains politically controversial at the federal and state levels. Callan will continue to follow emerging guidance on this Final Rule and recommends that plan sponsors consult with their legal counsel.

Final Fact Sheet

Final Rule