The House’s passage of H.R. 2988 highlights policy proposals that may shape future ERISA legislative and regulatory discussions.
On January 15, the House of Representatives passed H.R. 2988, the “Protecting Prudent Investment of Retirement Savings Act” (the “Act”). The act passed along party lines, with only 3 Democrats voting for the bill. This blog will evaluate key implications of the Act—not because we consider passage imminent (or even likely), but because we anticipate that elements of the Act will continue to surface in an array of venues—such as future legislative proposals and future regulatory proposals.
The Act has four components:
- Limiting Use of “Nonpecuniary” Factors
- Restrictions on Provider Selection Criteria
- New Proxy Voting Rules
- Brokerage Window Disclosures and Participant Acknowledgment
This blog will discuss each of these components.
Limiting Use of “Nonpecuniary” Factors
The central element of the Act revises ERISA’s fiduciary standards to specify that investment decisions will meet ERISA’s fiduciary standards “only if the fiduciary’s action with respect to such investment or investment course of action is based solely on pecuniary factors.” The Act defines a pecuniary factor as “a factor that a fiduciary prudently determines is expected to have a material effect on the risk or return of an investment based on appropriate investment horizons consistent with the plan’s investment objectives and …funding policy.” In effect, the Act significantly restricts the use of environmental, social, and governance (“ESG”) criteria in fund selection.
The Act does allow very narrow, limited use of nonpecuniary factors: if a fiduciary is unable to select an investment based only on pecuniary factors, the fiduciary may use non-pecuniary factors as a tie breaker if the fiduciary documents why pecuniary factors were not enough to select an investment, how the selected investment compares to the alternative investment with respect to diversification, liquidity, and the plan’s cash flow needs, and how the selected non-pecuniary factors are “consistent with the interests of participants and beneficiaries in their retirement income or financial benefits under the plan.” This tie-breaker approach cannot be used in any default investment under a plan.
Although the Act does not completely ban the use of ESG factors, it dramatically narrows their use and raises the burden of using such factors—and the litigation risk of allegations that decisions were not based solely on pecuniary factors. And, as was illustrated in the lawsuit against American Airlines, even a whiff of ESG factors influencing investment—or provider—selection opens up new avenues for fiduciary litigation.
Restrictions on Provider Selection Criteria
The Act would also amend ERISA to require that fiduciaries select, monitor, and retain service providers without regard to race, color, religion, sex, or national origin. This means fiduciaries are open to challenge if DEI considerations are incorporated into RFPs or scoring models. In effect, any explicit or implicit preference based on protected characteristics may be challenged, “diverse manager” mandates may require restructuring or elimination, and documentation must show decisions were based solely on competence, cost, and performance.
Importantly, this applies not only to asset managers but to all service providers, such as recordkeepers and TPAs.
New Proxy Voting Rules
The Act adds new requirements for voting proxies of securities held by a plan. Under the Act, when exercising the right to vote, proxies must:
- Act solely in the economic interests of participants
- Consider the costs of proxy voting
- Evaluate material facts supporting each vote
- Maintain records of proxy activity
- Avoid promoting non-pecuniary objectives.
The Act also specifies that in retaining an outside entity to advise or support proxy voting, plan fiduciaries must monitor the proxy voting activities of the outside entity to ensure that the outside entity follows these same standards.
Here too, the Act (effectively) targets the use of ESG factors in proxy voting—while creating another route for fiduciary litigation.
Brokerage Window Disclosures and Participant Acknowledgment
Under the Act, participants using brokerage windows must receive—and affirmatively acknowledge—a detailed notice each time they direct an investment outside designated investment alternatives. These disclosure requirements include a statement that brokerage window investments are not fiduciary-selected or monitored, a warning of potentially higher fees, risk, and lower returns, and a hypothetical illustration showing outcomes at 4%, 6%, and 8% returns to age 67.
Failure to meet these requirements means participants are not deemed to have exercised control over the investments in the brokerage window, potentially exposing fiduciaries to liability for participants’ investment decisions.
This provision of the Act will add to the administrative burden of offering self-directed brokerage windows, and the friction introduced by repeated disclosures and acknowledgments may reduce participant usage. As a result, plan sponsors may reconsider whether brokerage windows remain worth the fiduciary complexity.
Overall Implications of the Act
If passed, the Act could materially alter established fiduciary practices and increase compliance and litigation risk.
- It undermines one of the key operating tenets of ERISA—that fiduciaries are responsible for adopting sound processes—by micromanaging and proscribing specific outcomes.
- The rigid definition of (permitted) pecuniary factors overlooks the fact that theories of valuing stock have shifted over the years, and the effect of ESG factors on corporate performance is still an open topic. See, for example, this meta-study on ESG and Corporate Performance.
- It would expose plan fiduciaries to a whole new category of fiduciary litigation if any investments include factors that the plaintiffs’ attorneys deem sufficiently non-pecuniary.
- It raises the regulatory burden—and cost—for employers using self-directed brokerage accounts. This is particularly troublesome because these self-directed accounts may represent the most likely approach for employers looking to offer alternative investments pursuant to the President’s executive order on these alternatives.
As noted earlier, it is currently unlikely that the Act will be passed by the Senate. What is likely, however, is that the pressures reflected in the Act are not going away anytime soon.
