If the final rules are adopted substantially as proposed, it would signal a significant moment for the US, but would also draw interest from those working with sustainability rules in other investment markets. The direction in the US appears more clear. The approach taken prior to the previous administration—and unwound by the previous administration—is coming back: We have gone back to the future.

Back to the Future?

The focus of the proposed rule is on two separate rules adopted by the previous administration: financial factors in selecting plan investments and fiduciary duties regarding proxy voting and shareholder rights.

These rules required plan fiduciaries to make decisions for ERISA plans—the majority of defined contribution plans covered by the Employee Retirement Income Security Act (ERISA)—based solely on consideration of “pecuniary factors.” The preamble left open a lot of questions and the potential for litigation.

The new administration issued a non-enforcement letter in March, but again, this left the industry with many questions: How would the rules be amended? Would the DOL roll back the regulations to the approach taken by the Obama administration? Or would it forge a new path?

When the DOL released its proposed amendments to the investment duties regulation on October 14, it made it clear: Fiduciaries may consider ESG factors when assessing investment opportunities and making proxy-voting decisions.

The DOL echoes the previous administration in being explicit that ERISA fiduciaries must focus on financial materiality (as the proposed rules describe “with undivided loyalty”), but, in a departure from the existing rules, the proposed rule explicitly notes that ESG factors likely may impact the long-term risk-reward profile of an investment opportunity. If adopted, the proposed rule not only opens the door for more ESG investment options for ERISA investors, it would also remove the special rules that served to hamper the ability of QDIA–default investments made for savers who give no direction—to consider ESG-focused products or strategies as the default option.

“Roads? Where We’re Going, We Don’t Need Roads.”

The proposed rulemaking covers four key pillars, all with the aim of providing clear guidance to the market. It makes clear that the use of ESG factors and strategies in retirement plans is appropriate when material to the risk-return analysis. These four pillars are:

1. Clarification around the permissibility of the consideration of ESG factors

The proposed regulation is explicit that as long as it does not sacrifice investment returns, “…a fiduciary’s duty of prudence may often require an evaluation of the economic effects of climate change and other ESG factors on the particular investment or investment course of action.”

Although climate change was mentioned throughout the preamble as a major potential risk impacting long-term returns, the DOL was clear that material ESG factors were much broader than that and included three sets of examples that a fiduciary may consider in the evaluation of an investment or investment course-of-action if material.

2. The path for ESG to be used in Qualified Default Investment Alternative (QDIA)

The proposed rules would enable plan fiduciaries to apply the same considerations and analysis to a QDIA as they do to other investments. In other words, when assessing the merits of the QDIA option:

“a plan fiduciary must, among other things, focus on material 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.”

This clarity creates greater opportunity for plan fiduciaries to consider ESG factors when determining the QDIA for a plan’s participants.

3. Changes to improve and clarify the tie-breaker test

In the current rules, collateral factors could be considered only as a “tie-breaker” where two competing investments were economically indistinguishable. Moreover, those rules imposed significant documentation requirements to demonstrate that the tie-breaker was used only in that limited context. The proposed rule would espouse a more general principle that where a fiduciary concludes that two competing investment approaches “equally serve the financial interest of the plan,” the fiduciary could base its investment decision on "economic or non-economic benefits other than investment returns." The proposed change would also remove the aforementioned heightened documentation requirements that in the DOL’s view create an impression that fiduciaries “should be wary of considering ESG factors, even when those factors are financially material to the investment decision.”

4. Changes to provisions on shareholder rights/proxy voting

The DOL took a three-pronged approach to the proposed changes regarding proxy voting:
- Eliminate the statement in the current regulation 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.”
- Remove the two “safe harbor” examples for proxy voting policies. “One of these safe harbors permits a policy to limit voting resources to particular types of proposals. [Namely, those] 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 value of the investment. The other safe harbor permits a policy of refraining from voting on proposals or particular 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.”
- “Eliminate the requirement of the current regulation that, when deciding whether to exercise shareholder rights and when exercising shareholder rights, plan fiduciaries must maintain records on proxy voting activities and other exercises of shareholder rights.”

Given the magnitude of the US retirement market, this ruling could potentially result in pools of capital transitioning from traditional investments into ESG-focused strategies. 

“1.21 Gigawatts!?!”

Given the magnitude of the US retirement market, in both $34.9 trillion assets under management as well as the number of participants, opening it up to ESG investing introduces a significant new investor base. This ruling has the potential to result in pools of capital transitioning from traditional investments into ESG-focused strategies.

How Did We Get Here?
In January 2021, immediately after assuming office, President Joe Biden issued an executive order directing federal agencies to review Trump-era regulations that conflicted with the new administration’s climate agenda.² Based on that order, the DOL declared in March 2021 that it would enforce neither the ESG nor Proxy Rules.³ Thus, while both rules remain on the books, the DOL effectively ended them.

However, the DOL did not immediately issue a new ESG standard. This is because, under the direction of DOL Secretary Marty Walsh, the DOL decided it was prudent to solicit feedback from a number of market participants prior to issuing an updated proposal. In May 2021, President Biden issued the “Executive Order on Climate-Related Financial Risk,” which gave the DOL until September 21, 2021, to “consider publishing … for notice and comment a proposed rule to suspend, revise, or rescind” the ESG and Proxy Rules.⁴

In October 2015, the DOL released an interpretive bulletin stating that ESG issues “are proper components of the fiduciary’s primary analysis… so long as the investment is economically equivalent, with respect to return and risk to beneficiaries of the economic merits of competing investment choices.”⁵ In other words, the DOL permitted fiduciaries to incorporate ESG factors into their investment process when such factors were shown to impact returns.

Traditionally, the fiduciary duties of managing other people’s money did not extend far beyond ensuring that their capital grew without exposure to undue market risk. However, the rise of corporate governance in the wake of the Global Financial Crisis and dozens of high-profile corporate scandals, combined with the recent governmental and investor focus on combatting climate change, have all but forced an examination of the factors that often actually impact the bottom line of companies. That, in turn, has led to a regulatory reevaluation of the appropriateness of considering ESG factors—and to some degree—what it means to be a good fiduciary.