ERISA and the challenges of using ESG in pension investment

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September 20, 2021 – For pension plans, including private company pension plans regulated by the Employees Retirement Income Security Act 1974 (ERISA), employers often ask if they can take into account the “environmental, social or governance” (ESG) factors when selecting investment options. In part, this interest may be driven by the company’s ESG objectives or by the interest of employees (or other stakeholders), or a combination of the two.

The answer to the question of whether ERISA allows ESG to be taken into account is yes, but only if the request complies with ERISA fiduciary standards. These fiduciary standards require that ESG investments by pension plans be made through a prudent process and in accordance with employees’ pension investment interests. This means that employers cannot blindly use ESG. Instead, the fiduciary standards of ERISA must be taken into account.

To add to the challenge of this issue, over the past 25 years, the primary regulator of these standards, the U.S. Department of Labor (DOL), has provided conflicting guidance on how to apply the fiduciary standards of the ERISA at ESG. This regulatory back-and-forth has been particularly hot over the past two years as the Trump and Biden administrations have taken different positions through DOL action.

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For these reasons, it may be useful for employers and pension plan trustees to understand the ERISA issues created by the use of ESG criteria in the selection and management of pension plan investments, including why this remains an issue. area where legal standards are changing, especially in recent years.

Generally speaking, in the context of pension plans, ESG investing refers to taking into account factors related to the environment (such as a company’s track record in terms of pollution and sustainability), social objectives (such as supporting unions or withdrawing from certain industries) or corporate governance (such as diversity of the company and the board of directors). Employers and plan trustees can assess ESG factors in a number of ways. For example, pension plans may invest (or offer an investment in, in the case of a 401 (k) plan) “ESG specific” funds.

Regimes may also apply ESG selection criteria to avoid investments that do not meet certain ESG standards. Pension plans can also apply ESGs indirectly. For example, plan trustees may apply ESG considerations as one type of financial assessment criterion among many (such as risk, cost and expected performance). Additionally, even if employers do not take ESG factors directly into account, the underlying managers of the investment funds and plan options may use ESG factors, even if the investment is not a themed fund. ESG.

ERISA is the main law that defines the legal obligations that apply when a private employer selects investment options for a pension plan that covers its employees. ERISA does not apply to government plans, but national and local laws often incorporate ERISA standards.

Under ERISA, parties who are trustees of a pension plan (such as the employer or third party managers) are required to make investment decisions prudently and with loyalty to the interests of the plan. and its participants. These two duties are broadly called the fiduciary duties of ERISA, and more precisely the duty of prudence and the duty of loyalty. The second duty (the duty of loyalty) requires particular concern for the interests of the pension plan and the employees who participate in it.

The main regulator of these two fiduciary obligations (the DOL) has always taken the position that these obligations require that ESG criteria can only be applied to investment in pension plans if the criteria otherwise meet these fiduciary obligations. prudence and loyalty, that is, as part of a prudent process and to support the retirement income interests of plan members. In this context, an ERISA Trustee could risk violating ERISA if they used ESG criteria only to achieve a political or social outcome without demonstrating that the criteria were part of an appropriate investment process and based on best interests. plan employees.

When applying ESG factors, the second duty (the duty of loyalty) can raise particularly difficult questions as employers may find it difficult to distinguish ESG factors that support retirement savings from those that are incidental and ineffective. outside the “best” interests of the employees.

A classic example is where a trustee of a union pension plan orders the plan to invest in assets that support the union. For example, there have been a number of cases involving union plans investing in union-owned real estate, investing in a construction project involving union labor, or purchasing investments from a bank owned by the union. the syndicate. In these cases, the courts and the DOL frequently, but not always, view this “social” investment as contrary to ERISA’s duty of loyalty, because although the investment may benefit the union and / or its members, the benefit is not directly related to retirement savings. .

Another example is the application of an environmental criterion, such as not investing a pension plan in shares of companies with poor environmental performance. The use of these types of investment “screens” could violate ERISA’s duty of loyalty if the screen is based solely on a pro-environmental objective. Likewise, applying diversity criteria (such as not investing in companies that do not meet diversity standards or have a known history of discrimination or harassment) could be contrary to ERISA’s standard of loyalty if the investment choice is made only to support diversity or not to allow discrimination / harassment.

At the same time, these same ESG factors may, depending on the facts and circumstances, be applied in a manner that supports the retirement income interests of participants. There is a body of academic and investment literature that accepts the use of ESG factors as important investment criteria. In this context, the ESG factor can have a significant impact on the risk, return or any other important financial consideration of an investment. For example, from this perspective, a company’s poor environmental record could be economically relevant if it is a sign of future responsibility. Likewise, poor corporate governance could have a significant impact on the future performance of stocks.

Thus, as these examples demonstrate, ESG factors may be both consistent and inconsistent with ERISA’s fiduciary obligations, depending in part on the surrounding facts and circumstances.

The challenge is compounded by the fact that over the past 25 years DOL has taken different positions on how to interpret this framework and, in particular, on how to distinguish ESG use that is important to the organization. retirement investment versus ancillary use. During Democratic administrations, the DOL generally considers that ESG is not inconsistent with ERISA’s fiduciary obligations and that it can be applied in a manner consistent with the interests of the ERISA plan. Conversely, DOL under Republican administrations has been shown to be more resistant to ESG as a suitable investment factor and, above all, more cautious that such factors can be used without violating the duties of ERISA. , in particular the duty of loyalty.

Under the Trump administration, the Trump DOL issued a regulation that imposed new standards for ESG use by ERISA plans. Many ERISA professionals saw the rule as creating challenges for the use of ESG criteria. In 2020, the DOL conducted reviews of the application of ERISA plans on their use of ESG criteria, thus increasing the risks of using ESG criteria in plans regulated by ERISA.

Under the Biden administration, the DOL is re-proposing the Trump-era ESG rule. While the Biden Rule is meant to be more pro-ESG, the fundamental framework of ERISA’s functions will and likely continue to warrant special attention in applying ESG to pension investment.

Employers looking to consider ESG factors when investing in a pension plan may continue to face compliance issues. Although ERISA does not exclude the application of ESG criteria, employers who wish to apply ESG criteria will need to ensure that this application complies with ERISA fiduciary obligations. This is true even when there is a strong corporate or employee interest in ESG issues. Although companies and employees seem to be increasingly focusing on ESG objectives, ESG investments, or a combination of both, employers cannot satisfy this interest by blindly applying ESG considerations to pension plans. Instead, the fiduciary standards of ERISA should be taken into account.

In particular, employers should confirm that ESG criteria are applied through an appropriate investment process and guided by the best interests of employees in retirement. Finally, this area will likely continue to be subject to DOL guidelines, including efforts by the current Biden administration to reinterpret regulations applicable to ESG through DOL.

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