The use of financially material environmental, social, and governance (“ESG”) information by pension fiduciaries in investment analysis continues to be a hot topic. On October 14, 2021, the US Department of Labor (“DOL”) issued a proposed rule entitled “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights.” As the title suggests, the proposal addresses the fiduciary duties of prudence and loyalty, but it ignores an important additional fiduciary duty—the duty of impartiality. It also misses the opportunity to explain how the dynamic nature of the duty of prudence provides historical context supporting the proposal.
Duty of Prudence
Application of the fiduciary duty to act as a prudent investor evolves over time in response to changing knowledge and circumstances. For example, in the first half of the twentieth century, trust fiduciaries were constrained by legal lists of allowed investments that largely precluded them from investing in corporate equities. That slowly changed as modern portfolio theory was applied and performance benefits of equity investments were recognized. Investment practices correspondingly evolved during the last half of the century. A provision was added to the Restatement (Third) of Trusts, §227 Introduction in 1992 which recognized that prudent investment practices were subject to evolution:
“Trust investment law should reflect and accommodate current knowledge and concepts. It should avoid repeating the mistake of freezing its rules against future learning and developments.”
Language of the Employees Retirement Income Security Act (“ERISA”) applies this principle. Section 404(a)(1)(B) of ERISA, instructs the fiduciary to act “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims….” Use of the phrase “under the circumstances then prevailing” contemplates paying attention to investment industry changes, like growth in understanding of the role that material ESG factors can play in financial analysis.
ERISA does not mandate use of particular investment strategies. However, the above language does require that pension fiduciaries look at industry norms and learn from improvements in peer practices. With investment analysts increasing their use of ESG information in making investment decisions, understanding of how pension investment risk-adjusted performance can benefit from consideration of ESG factors has increased.
In the News Release describing the proposed rule, Acting Assistant Secretary for the Employee Benefits Security Administration Ali Khawar explained, “[a] principal idea underlying the proposal is that climate change and other ESG factors can be financially material and when they are, considering them will inevitably lead to better long-term risk-adjusted returns, protecting the retirement savings of America’s workers.” The preamble to the final rulemaking order should emphasize that dynamic change in prudent investment practices is a fundamental principle in both common law fiduciary duty and ERISA.
Comments Opposing the Proposed Rule
The comment period for the proposed rule ended on December 13, 2021. By then the DOL had received 894 comments. Unfortunately, many of the comment letters opposing the rule reflect misunderstandings of how financial analysts use ESG information and what the proposal provides. Letters in opposition from individuals say things like, “stop taking hard working American’s money” and “Government should not promote funding for climate change. Let the market do what the market do.”[i]
The State of Utah submitted a letter signed by Attorneys General and other state officials from 23 states,[ii] complaining that the proposed rule:
“Encourages, and may in fact require, a plan fiduciary to consider and prioritize non-pecuniary ESG factors when making investment decisions for retirement savings accounts. In other words, the [p]roposed [r]ule would allow employers and investment managers to invest employee retirement savings in a way that benefits social causes and corporate goals even if it adversely affects the return to the employee.”
Contrary to the position of the Utah letter, the proposed rule directly adopts the traditional duty of loyalty approach. The proposal clearly states that fiduciaries “may not sacrifice investment return or take on additional investment risk to promote goals unrelated to the plan and its participants and beneficiaries.” The Utah letter also cites a provision in the proposed rule that a fiduciary may select investments “in part for benefits apart from the investment return” but fails to connect that statement to the proposed rule’s emphasis on the financial interests of the plan participants. Indeed, the proposed rule requires that “[a] fiduciary’s evaluation of an investment or investment course of action must be based on risk and return factors that the fiduciary prudently determines are material to investment value . . .”
Comments Supporting the Proposed Rules
Supportive comment letters point out that the proposal better aligns regulatory guidance with fundamental fiduciary duties. Many of those letters note that the proposal moves the Department’s guidance “closer to a principles-based approach that does not uniquely target or single out (positively or negatively) ESG as compared to any other investment strategies, asset classes, or investment styles.”[iii] These letters note the proposal focuses on a fiduciary’s duty to consider financially material information in compliance with the duties of loyalty and prudence.[iv]
Some of the letters recommend removing examples that are ESG specific because the inclusion of ESG examples “differentiates ESG considerations from broad investment considerations. The neutral application of fiduciary principles and risks should not create a distinction between ESG considerations and other investment and financial considerations as drawing a distinction here may create undue confusion and potentially invite litigation.”[v] Other letters also recommend deleting the tiebreaker rule as “obsolete,”[vi] expressing the concern that the record-keeping required by the tiebreaker adds costs to the plans and therefore to their participants.[vii]
Comments Highlighting the Duty of Impartiality
The proposed rule does not mention the duty of impartiality, but at least one comment letter, which two authors of this article helped write, explains the need to address this duty explicitly. The Intentional Endowments Network filed comments addressing the importance of the duty of impartiality for pension fiduciaries and recommending presumptive inclusion of longer investment time horizons for long-term liabilities.
“The final rule should explicitly recognize a presumption that a long-term investment horizon will nearly always be an appropriate primary time horizon (although perhaps not the exclusive time horizon) for an ERISA fiduciary’s strategic investment decision-making processes.”
The Teamsters’ comment letter also noted, “[t]here are sound reasons for allowing fiduciaries to consider ESG factors, which can have a direct effect on the long-term health of a plan’s assets.”
The duty of impartiality highlighted in the Intentional Endowments Network letter is the duty to consider the different needs and different time horizons of all participants in a pension plan. It addresses the fact that a pension plan serves both participants who are currently taking distributions and those who will retire in the future, perhaps decades into the future. Thus, a pension fiduciary must invest pension assets with an eye to long-term risk and return to ensure the viability of the fund for future retirees, as well as generate current earnings.
In Varity v. Howe, the United States Supreme Court recognized that ERISA fiduciary duties include a duty of impartiality. The Court explained, “[t]he common law of trusts recognizes the need to preserve assets to satisfy future, as well as present, claims and requires a trustee to take impartial account of the interests of all beneficiaries. See Restatement (Second) of Trusts § 183 (discussing duty of impartiality); id., § 232.” [now Restatement (Third) of Trusts § 79] Varity v. Howe, 516 U.S. 489, at 514 (1996)
Varity recognizes that pension plan fiduciaries manage pension funds for multiple generations of participants. These different generations will become entitled to distributions at different times, so they are likely to have different risk tolerance levels and investment time horizons. Inter-generational obligations also raise the potential for uncompensated transfer of risks and returns across fund participant generations. The duty of impartiality mandates careful consideration and good faith efforts to reasonably balance these conflicts.
Investors that focus exclusively on generation of short-term returns or evaluate investments against only a market-relative performance benchmark may not be fully aware of systematic risks, costs, and opportunities associated with investments. Yet, systematic risks and costs, including those from unbalanced short-termism, can spread across portfolio companies and compound over time, increasing risk exposures and degrading future returns to fund participants.[viii]
For a broadly diversified investor, systematic risks embedded in market (beta) exposure can be a primary driver of long-term investment performance.[ix] For example, a major financial problem for today’s younger fund participants can be failure of their pension fiduciary to consider climate change, which presents both company specific and systematic risks and opportunities that impact portfolio risks and returns over the long term.
And climate change is not the only systematic financial issue with duty of impartiality implications. Many other financially material ESG factors (e.g., economic effects of pollution, growing income inequality, and food chain antibiotic resistance) may also have inter-generational risk and return effects.
Pension fiduciaries have an obligation to comply with the duty of impartiality, but the proposed rule fails to include any explicit direction regarding application of this duty. The absence of discussion about impartiality does not obviate the need for ERISA fiduciaries to consider the needs and interests of all plan participants. The duty clearly applies, and plan fiduciaries would be better served by direct regulatory guidance on it.
In addition, compliance with the duty of impartiality would benefit from creation of a rebuttable presumption that a long-term time horizon is usually the most appropriate primary investment horizon for a pension fund. An evaluation of long-term risks, costs, and opportunities is an essential consideration for striking the balance required by the duty of impartiality referenced by the Supreme Court as part of ERISA in Varity v. Howe. An emphasis on including analysis of longer time horizons would also be in keeping with the duty of prudence, given increasing concerns about the problems of short-termism associated with investment decision-making and durable company value creation.
Conclusion
Fiduciaries should be encouraged to use investment strategies that include consideration of financially material ESG information. The proposed rule acknowledges that the ERISA prudence standard evolves as knowledge and circumstances change, and the final version should explicitly recognize that this dynamic provides historical context for the rule.
In addition, adoption of a regulatory presumption on use of longer-term investment time horizons would better equip fiduciaries to impartially balance financially material short- and long-term factors, as required by the duty of impartiality. The final DOL rule should explicitly address the duty of impartiality and its mandate that fiduciaries balance investment and risk effects over fund participants’ different time horizons.
Susan Gary is a Professor Emerita at the University of Oregon School of Law and served as Reporter for the Uniform Prudent Management of Institutional Funds Act.
Keith Johnson is CEO of Global Investor Collaboration Services, LLC, and former Co-Chair of the Institutional Investor Services Group at Reinhart Boerner Van Deuren s.c. He was previously Chief Legal Counsel for the ninth largest pension fund in the US (the State of Wisconsin Investment Board).
Tiffany Reeves is Head of Investor Fiduciary and Governance Services at Reinhart Boerner Van Deuren s.c. and was previously Deputy Executive Director and Chief Legal Counsel at the Chicago Teachers’ Pension Fund.
This post is adapted from their paper, “Proposed US Department of Labor Rules on ESG Ignore Duty of Impartiality” available on SSRN.
The views expressed in this post are those of the authors and do not represent the views of their employers, the Global Financial Markets Center or Duke Law.
[i] Chuck Zupan, Comment re RIN 1210-AC03 (Dec. 7, 2021); Jamal Kahn, Comment re RIN 1210-AC03 (Nov 10, 2021; other letters said things like, “Leave our retirement alone.” Greg McNeil, Comment re RIN 1210-AC03 (Dec. 7, 2021).
[ii] Sean D. Reyes & 36 co-signers, Comments of State of Utah re RIN 1210-AC03; Officials from the following states signed the letter: Alabama, Alaska, Arizona, Arkansas, Florida, Georgia, Idaho, Indiana, Kansas, Kentucky, Louisiana, Mississippi, Missouri, Montana, Nebraska, North Dakota, Ohio, Oklahoma, South Carolina, Tennessee, Texas, Utah, and West Virginia.
[iii] Lew Minsky, Comments of Defined Contribution Institutional Investment Association (DCIIA) re RIN 1210-AC03 (Dec. 9, 2021), the “DCHA Letter.” See also Julie Moret & Shundrawn Thomas, Comments of Northern Trust re RIN 1210-AC03 (Dec. 13, 2021), the Northern Trust Letter (stating “plan fiduciary should have the ability to consider material ESG risks and opportunities…in a manner that is consistent with their duties of loyalty and prudence….Investors can integrate ESG data to create a more holistic view of risks and opportunities, resulting in more informed investment decisions and resilient portfolios.”).
[iv] See e.g., the DCIIA Letter (agreeing with DOL’s attempt, through the 2021 Proposed Rule “to remove barriers that may prevent the prudent integration of ESG factors into ERISA fiduciary decision-making.”).
[v] See e.g., the Northern Trust Letter. See also Chantel Sheaks, Comments of U.S. Chamber of Commerce re RIN 1210-AC03 (recommending removal of examples both because there are numerous other factors fiduciaries should consider and because the list might suggest that the DOL expects fiduciaries to consider these factors, even when not prudent or possible).
[vi] See e.g., the Northern Trust Letter (“Provided that a fiduciary is guided by their duty of prudence, a criterion for defining a ‘tie breaker’ should be obsolete.”)
[vii] See e.g., the Northern Trust Letter and DCIIA Letter.
[viii] See Short–termism Revisited, CFA Institute Position Paper (September 2020) and a similar study published in the Harvard Business Review by McKinsey Global Institute in cooperation with FCLT Global.
[ix] See James P. Hawley and Jon Lukomnik, Moving Beyond Modern Portfolio Theory: Investing that Matters (Routledge, 2021) and a related CFA Institute blog article (May 2021).
