The US Just Got New ESG Rules

Retirement plans should treat sustainability as they would any other relevant factor, based on the fiduciary standards of prudence and loyalty

Jon Hale 2 December, 2022 | 9:41AM
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The US Labor Department finalised a rule last week that will remove barriers, real and perceived, to environmental, social, and governance investing in retirement plans governed under the Employee Retirement Income Security Act of 1974, or Erisa.

Called "Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights," the new rule replaces two hastily drawn rules rushed to the finish line at the end of the Trump administration. Those rules were widely interpreted as discouraging retirement plan fiduciaries from considering ESG factors and from exercising shareholder rights.

Here are four key takeaways about the new rule.

It Includes Climate Change and Other ESG Issues

Under Erisa, a retirement plan fiduciary must base decisions on factors that the fiduciary reasonably determines are financially material to the plan’s investments. That has not changed and is part of the so-called duty of prudence.

What has changed is the new rule makes clear that these factors may include climate change and other ESG issues.

That means plan administrators may consider climate change and other ESG factors when selecting managers for defined-benefit plans or selecting funds for defined contribution (DC) plan lineups. That also means those making direct investment decisions for a plan, like fund managers, may include climate and ESG considerations in their investment process.

The Trump-era rule being replaced was opaque about whether it was prudent for a fiduciary to consider climate change or other ESG issues. It said "nonpecuniary" factors could not be considered by a fiduciary and strongly suggested that ESG issues were hardly ever "pecuniary" in nature. Climate change was never so much as mentioned in the proposed or final rule.

The current Labor Department concluded that the previous rule was deterring retirement-plan fiduciaries from acting prudently on behalf of beneficiaries in taking steps that many other marketplace investors have been taking to enhance the performance of their investments – namely, taking climate change and other ESG factors into consideration.

QDIAs Also Get the Go-Ahead

The Trump-era rule essentially banned the consideration of supposed nonpecuniary issues like climate change and other ESG factors in decisions related to qualified default investment alternatives, or QDIAs, in DC plans. QDIAs are the default investments used when an employee contributes money to the plan but hasn’t selected an investment. Under the new rule, the same standards apply to QDIAs as to investments generally.

This is important because QDIAs attract the lion’s share of DC plan contributions, mainly through the use of target date funds. Plan administrators may now include climate change or other ESG criteria when selecting and designating QDIAs. Target date funds may now also include ESG criteria and may include sustainable funds within their fund-of-funds structures.

Other Collateral Benefits Can Be Tiebreakers

The concept of collateral benefits has been part of the Labor Department’s guidance since the 1990s. The idea is that if an investment offers some sort of benefit above and beyond risk-adjusted returns, such as a positive impact on people and planet, that "collateral benefit" could not be given precedence over investment performance. However, "all things equal" among similarly situated investments, the collateral benefit could be used as a tiebreaker in selecting investments for retirement plans.

The tiebreaker could apply to sustainable funds and investment strategies that exclude investments in certain products or activities that they deem harmful to people or planet, or to those that include criteria focusing on positive impacts. In these cases, the investment’s focus on ESG issues is not always about financial materiality, at least in the narrow sense of having an effect on short-term stock prices.

Even if the ESG issues being addressed by a fund are not immediately or obviously material, their use in a fund can be considered a collateral benefit. So long as the fund offering collateral ESG benefits is a prudent financial choice, then a plan fiduciary can consider the collateral benefits in selection.

The Trump-era rule did not out-and-out ban tiebreakers, but it set an unreasonably high bar. It required that performance of an investment with collateral benefits first had to be demonstrably "indistinguishable" from other similar investments, and it required extra documentation of the decision-making process.

Under the new rule, the fiduciary is simply required to conclude prudently that when competing investments equally serve the financial interests of the plan, the fiduciary may decide based on a collateral benefit. There are no special documentation requirements other than Erisa’s long-standing statutory duty to prudently document plan affairs.

Importantly, the new rule also clarifies that fiduciaries aren’t violating their duty to act solely on behalf of plan participants and beneficiaries when they take participants’ preferences into account in constructing a menu of investment options for defined-contribution plans. This is important because a number of surveys have suggested that plan participants want sustainable funds in their lineup. Accommodating these preferences can lead to greater participation and higher income deferral rates, resulting in enhanced retirement security for participants.

The Prudent Exercise of Shareholder Rights

The new rule also unwinds the Trump-era rule that discouraged plan fiduciaries from exercising their rights as shareholders. That rule permitted plans to limit proxy voting to a predetermined set of issues they deemed to be financially material and to refrain from voting when its holdings in a single issuer were small relative to the plan’s total assets. It also required extensive recordkeeping about proxy voting and any relationship a plan had with proxy advisors.

Taken together, these provisions in the Trump-era rule encouraged abstention as a normal course of action.

The new rule simply states that the fiduciary duty to manage plan assets includes the management of shareholder rights related to those shares, such as the right to vote proxies. Plan fiduciaries must use prudence and loyalty in fulfilling these duties.

It's Out With the Old…

The Trump-era rules being replaced may have been opaque but they sent clear messages to retirement fiduciaries: Incorporate ESG and climate-change considerations at your own risk.

Under the old rules, fiduciaries that included these matters in investment selection or proxy voting activities would need to expend plan resources on excessive documentation of their decisions to mitigate the risk of lawsuits for not meeting vague standards:

  • Don’t overassume that ESG risks are material;
  • Don’t invoke the tiebreaker in favour of funds with collateral benefits unless the choices can be documented as indistinguishable;
  • Don’t vote proxies unless you can demonstrate that benefits to the plan outweigh the costs.

…And in With the New

By contrast, the new rule is a model of clarity. Reflecting what’s happening in the real world, it says climate change and other ESG issues are material and therefore something plan fiduciaries may prudently consider in their decisions.

On the selection of funds that offer so-called collateral benefits, the new rule says these funds can be chosen as long as they serve the financial interests of the plan equally as well as alternatives.

On QDIAs, which are designed to be long-term investments for retirement plan participants, it says funds that incorporate climate change and ESG considerations should not be disadvantaged or disallowed.

On proxy voting and other shareholder activities, it says use these tools in a prudent manner to enhance the long-term value of the plan.

Keep in mind the new rule does not mandate retirement plan fiduciaries to consider climate change or other ESG issues. It simply removes the barriers to doing so and says fiduciaries should treat ESG as they would any other relevant factor, based on the fiduciary standards of prudence and loyalty.

Jon Hale ( has been researching the fund industry since 1995. While Morningstar typically agrees with the views Jon expresses on ESG matters, they represent his own views

This article is reproduced from the US original for UK audiences interested in international developments in ESG, impact, and sustainable investing


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Jon Hale  Jon Hale is a consultant with Morningstar Institutional Investment Consulting.

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