DOL Delivers Lump of Coal to ESG Funds

Proposed DOL regulations would add new restrictions to the use of ESG funds.

The Department of Labor has issued new proposed regulations intended to guide plan fiduciaries seeking to invest in funds that utilize environmental, social and governance (“ESG”) considerations.

In some ways, the proposed regulation rehashes some fundamental fiduciary principles: that in selecting investment options, fiduciaries must act for the “exclusive purpose” of providing benefits to participants. However, the proposed regulations targets ESG investments and adds several new hurdles for fiduciaries using ESG investments.

The Proposed Regulation

Under the proposed regulation a fiduciary meets its ERISA obligations if, in selecting investments, the fiduciary evaluates investment options “based solely on pecuniary factors that have a material effect on the return and risk” of the investment and has not “subordinated the interests of the participants … to unrelated objectives, or sacrificed investment return or taken on additional investment risk to promote goals unrelated to those financial interests of the plan’s participants.” The proposed regulation elaborates by stating that:

“Plan fiduciaries are not permitted to sacrifice investment return or take on additional investment risk to promote non-pecuniary benefits or any other non-pecuniary goals. Environmental, social, corporate governance, or other similarly oriented considerations are pecuniary factors only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories”.

The proposed regulation goes on to state that, in order to add an ESG investment to a participant-directed DC plan the fiduciary must take additional steps. Specifically, an ESG investment can be added only if:

(i) “the fiduciary uses only objective risk-return criteria … in selecting and monitoring all investment alternatives for the plan including any environmental, social, corporate governance, or similarly oriented investment alternatives”
(ii) “the fiduciary documents its selection and monitoring of the investment”
(iii) “the environmental, social, corporate governance, or similarly oriented investment mandate alternative is not added as, or as a component of, a qualified default investment alternative.”

Some Observations

In explaining these additional steps, the proposed regulation sets several traps for ESG investments:

•      The proposed regulation requires the additional review and documentation for all ESG investments and “similarly oriented” investment alternatives. This raises a question as to whether investment advisors need to add this additional review for all investment alternatives that apply any ESG filters–even if such ESG consideration was not a factor in the consideration of the investment.
•      As noted above the proposed regulation specifies that investments selected using ESG criteria cannot be included as part of a qualified default investment alternative (“QDIA”). In light of the fact that an overwhelming majority of plans use target date funds as their QDIA the proposed regulation could prevent use of ESG funds in target date funds.
•      In effect, the proposed regulation specifies that ESG investments can be utilized only if an investment professional can document that the investments present “material” economic opportunities not otherwise available. In effect this is a higher threshold than is required for other investments.

Moreover, by issuing proposed regulations (rather than something less permanent) the DOL seeks to enshrine its position on ESG investments in ways that will be difficult to undo or modify in future guidance.

A Rule Looking for a Problem

The rationale for issuing this proposed regulation is somewhat puzzling:

•      As noted in the preamble to the regulations “Sections 403(c) and 404(a) [of ERISA] … require fiduciaries to act solely in the interest of the plan’s participants and beneficiaries, and for the exclusive purpose of providing benefits to their participants and beneficiaries and defraying reasonable expenses of administering the plan.” However, the DOL has offered no studies or other evidence that these existing rules are somehow inadequate or unclear–or that the proposed regulations will somehow fill in a gap in fiduciaries’ understanding of their obligations under ERISA.

•      The preamble to the proposed regulation also states that “The Department is concerned, however, that the growing emphasis on ESG investing may be prompting ERISA plan fiduciaries to make investment decisions for purposes distinct from providing benefits to participants and beneficiaries and defraying reasonable expenses of administering the plan.” Here too, the DOL offers no evidence that this is actually occurring or that there is any real risk that fiduciaries will be lured by ESG funds to disregard their ERISA fiduciary obligation.

•      Neither the preamble nor the actual proposed regulation makes any reference to the fact that, as noted by the International Monetary Fund, “there is an economic case for sustainable finance”–and that ESG considerations are increasingly recognized as business considerations. In effect, the DOL proposal fails to recognize that ESG criteria are financial considerations.

•      Neither the preamble nor the actual proposed regulation makes any reference to the fact that in recent years ESG funds have outperformed “conventional” funds. This adds further support for the position–disregarded by the DOL– that ESG considerations are business considerations.


Without a hint of irony, the DOL is attempting to slow the grow of ESG funds within just few weeks after issuing an information letter that paves the way for the use of private equity funds within DC plan default investments funds. In that information letter the DOL glossed over questions about the appropriateness of private equity funds as a DC investment–questions relating to high fees, illiquidity and valuation of investments. Instead, the DOL concluded that there may be many reasons why a fiduciary may properly select an asset allocation fund with a private equity component as a designated investment alternative for a participant directed individual account plan. … In making such a selection for an individual account plan, the fiduciary must engage in an objective, thorough, and analytical process that compares the asset allocation fund with appropriate alternative funds …, anticipated opportunities for investment diversification and enhanced investment returns, as well as the complexities associated with the private equity component.

It is unfortunate that the DOL seems unwilling to simply apply this standard to ESG investments.