The Department of Labor late last year issued the ESG and proxy voting rule, officially called the Final Rule on Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights. (Here’s our blog post on the announcement of the rule.)

This blog post, based on a recent ESG Research Café with Callan’s ESG Practice Leader Tom Shingler and Richard Ashley, partner and co-chair of the US Employee Benefits and Executive Compensation practice at DLA Piper, is one in a series that focuses on the main aspects of the ESG rule and highlights some of the ways in which it is the same and ways in which it differs from the regulatory guidance issued during the Trump administration.

Tom Shingler: The qualified default investment alternative (QDIA) is where participants are invested if they don’t make an election in a defined contribution (DC) plan. What is this rule saying about ESG incorporation in QDIAs?

Richard Ashley: I think the most important part is what it’s not saying. The way the regulation is constructed, the formulation of a QDIA involves the same construct of a risk-return analysis that would be appropriate for any other kind of investment. And instead of singling out the QDIA to say that it cannot use a nonpecuniary factor, what the rule is saying is that when a fiduciary conducts a risk-return analysis, whatever is appropriate in making that risk-return analysis, which can include ESG as an economic factor, can be used in setting the QDIA for a particular plan.

In that regard, it’s very different from the original regulation during the Trump administration, which in essence prohibited the consideration of any nonpecuniary factor in putting a QDIA in place.

Tom: Another new addition in the specific language of this rule is regarding participant preferences in constructing a DC plan lineup. What is it saying a fiduciary can do in terms of considering participant preferences, and in what context?

Richard: The way this comes into the regulation is this idea of the rules regarding the investment duties of loyalty. And we start with the main premise that a fiduciary cannot subordinate the interests of the participants and beneficiaries in their retirement income or financial benefits to other objectives. And when a fiduciary is making decisions, it cannot sacrifice return or take additional risk for the purpose of promoting other goals.

So that sort of forms the baseline for this discussion. But when you look at what is happening with respect to a particular DC plan, the regulation is clear that a fiduciary of a participant-directed individual account plan will not violate its duty of loyalty when putting together an investment menu if it is taking into account the participant’s preferences consistent with the ordinary fiduciary process that is laid out for the investment fiduciary to go through in selecting an investment.

So to the extent that an ESG investment is something that participants would like to see and it might increase participation, the fiduciary can take that into account in selecting a menu of investment options as part of an investment platform. But at the same time, that preference does not substitute for the ordinary prudence obligation of a fiduciary. The decision still has to be the selection of a prudent investment alternative that makes sense given relative risk and return.

Tom: So a fiduciary cannot put in an ESG fund that does not meet the other criteria simply because of participant preference. That would not be prudent.

Richard: Exactly. To the extent that an ESG fund takes on massively more risk for the same return or had substantially underperformed what would be a non-ESG fund at the same risk level, that has to be a part of the analysis as a fiduciary is putting together an investment menu. The fiduciary always has to go through the prudence process.