esg/sri/eti investments & the dol

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ESG/SRI/ETI Investments & the DOL

The Department of Labor offers proposed

rules concerning ESG


Background

Interpretative Bulletins (IB) 94-1

• ETI (economically targeted investments) are not inherently incompatible with ERISA’s fiduciary actions

IB 2008-1

• IB08 was sometimes misinterpreted as stating that ETIs were never allowed in ERISA plans.

• Cautioned fiduciaries that ERISA is violated if accept reduced expected returns or greater risk to secure social, environmental, or other policy goals.

IB 2015-01

• According to Labor Secretary Thomas Perez, IB15 supersedes IB08 and “reinstates the language” of IB94, and in so doing “return[s] us to a common sense approach.” The DOL desired IB15 to “correct a popular misperception . . . that investments in ETIs are incompatible with ERISA’s fiduciary obligations.”

• “[P]lan fiduciaries are not permitted to sacrifice investment return or take on additional investment risk as a means of using investments to promote collateral social policy goals.”

• “All things being equal” - Serve economic interests equally well, collateral considerations can serve as tie-breakers

• “[T]he requirements of sections 403 and 404 of ERISA do not prevent plan fiduciaries from investing plan assets in ETIs if the ETI has an expected rate of return that is commensurate to rates of return of alternative investments with similar risk characteristics that are available to the plan, and if the ETI is otherwise an appropriate investment for the plan in terms of such factors as diversification and the investment policy of the plan.”

• Fiduciaries can use non-pecuniary considerations as deciding factor

• Must always put economic interest of plan first

• Instances where Environmental, Social, and Governance (ESG) issues present material business risk or opportunities = economic factors

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Background

IB 2016-01

• Investment Policy Statement (IPS) may include policies concerning use of ESG factors in evaluation or integrating ESG-related tools/metrics/etc.

IB 2018-01

• Selection of Qualified Default Investment Alternative (QDIA) is not analogous to merely offering participants an additional investment alternative

• Nothing in the QDIA regulations suggests fiduciaries should choose QDIAs based on collateral public policy goals

• “[D]ecision to favor the fiduciary’s own policy preferences in selecting ESG-themed investment option for a 401(k)-type plan without regard to possibly different or competing views of plan participants and beneficiaries would raise questions about the fiduciary’s compliance with ERISA duty of loyalty.”

• Fiduciaries should engage in traditional and customary proxy activities in discharging fiduciary obligations

• Should not involve significant expenditure of funds by plans

• Should only do so if reasonable expectations that doing so results in enhanced economic value to fund

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Background

Field Assistance Bulletin (FAB) 2018-01

• “If a plan fiduciary is considering a routine or substantial expenditure of plan assets to actively engage with management on environmental or social factors, either directly or through the plan’s investment manager, that may well constitute the type of “special circumstances” …Warranting a documented analysis of the cost of the shareholder activity compared to the expected economic benefit (gain) over an appropriate investment horizon.”

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NFP Comment: Consistent positioning has not always been reflected in

consistent outlook, investigation, and potentially enforcement from

administration-to-administration. Fiduciaries need to understand there may

be rollercoaster effect of providing ESG investments in an ERISA plan


New DOL Proposed Rule

Proposed changes to the regulations promulgated under ERISA Section 404(a) – “Investment duties”

Purpose is to provide regulatory structure to “assist ERISA fiduciaries in navigating these ESG investment trends and to separate the legitimate use of risk-return factors from inappropriate investments that sacrifice investment return, increase costs, or assume additional investment risk to promote non-pecuniary benefits or objectives.”

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NFP Comment: This should be viewed as the Administration’s attempt to

create more long-term certainty in the way fiduciaries are governed regarding

ESG-related decisions.



The rule!

• Evaluate investments and investment courses of action based solely on pecuniary factors that have material effect on return/risk based on appropriate investment horizons and plan’s articulated funding and investment objectives

• Do not subordinate interests of participants/beneficiaries in retirement income to unrelated objectives

• Do not sacrifice investment return or take additional risk to promote goals unrelated to financial interests

• Comply with duty of loyalty

• Take into consideration risk of loss and opportunity for gain

• Consider diversification, liquidity and current return relative to cash flow needs, projected return related to funding objectives of plan, how investment compares to available alternative investments

• “A fiduciary’s evaluation of an investment must be focused only on pecuniary factors.”

• ESG considerations are only pecuniary if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally acceptable investment theories

• Weight given to ESG considerations would reflect prudent assessment of their impact on risk and return

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The rule!

• “Economically indistinguishable alternative investments” (the “all things being equal” test)

• If the investment selected is based on non-pecuniary ESG factors, the fiduciary should document

• “Specifically why the investments were determined to be indistinguishable”

• “Why the selected investment was chosen based on the purposes of the plan, diversification of investments, and the interests of plan participants and beneficiaries…”

• If fiduciary adds a prudently selected ESG, it does not violate ERISA if:

• Fiduciary uses only objective risk-return characteristics to select and monitor allinvestment alternatives under the plan

• Benchmarks

• Expense ratios

• Fund size

• Long-term investment returns

• Volatility measures

• Manager investment philosophy and experience

• Mix of asset types

• Fiduciary documents selection/monitoring; and

• ESG not added as, or component of, QDIA

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Preamble

References 2014 Fifth Third Bancorp v. Dudenhoeffer case that “ERISA retirement plans…must be understood to refer to “financial” rather than “non-pecuniary” benefits…”

• SOME 24 SEPARATE REFERENCES THROUGHOUT PREAMBLE RE: THIS CONCEPT

States that it is the DOL’s “longstanding and consistent position” that in making investment decisions they “…must be focused solely on the plan’s financial returns…”

Recognizes

• Increase in array of ESG-focused investments

• Proliferation of metrics, services, and ratings offered by third party service providers

• Increase in asset flows into ESG

• Lack of consensus regarding what constitutes ESG

• “[O]ften come with higher fees…”

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NFP Comment: The preamble for regulatory rulemaking often provides

important insight into the regulatory agencies basis for design of the

proposed rules as well as their intent in implementation and enforcement.


Preamble

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“ESG investing raises heightened concerns under ERISA.”

“Providing a secure retirement for American workers is the paramount, and eminently-worthy, “social” goal of ERISA plans; plan assets may not be enlisted in the pursuit of other social or environmental objectives.”

“ERISA plan fiduciaries may not invest in ESG vehicles when they understand an underlying investment strategy of the vehicle is to subordinate return or increase risk for the purpose of non-pecuniary objectives.”

Proposed rule not revise fiduciary requirements regarding appropriate consideration

• Composition of plan portfolio

• Diversification

• Liquidity and current return of portfolio relative to cash flow needs

• Projected return relative to funding objectives of plan

“Clarifying that an investment . . . must be compared to available alternatives is an important reminder that fiduciaries must not let non-pecuniary considerations draw them away from an alternative option that would provide better financial results.”


Preamble

“The weight given to pecuniary ESG factors should reflect a prudent assessment of their impact on risk and return – that is, they cannot be disproportionately weighted.”

• Fiduciaries should consider ESG as relates to:

• Diversification

• Degree of liquidity

• Potential risk-return profile in comparison with “available alternatives investments that would play a similar role in their plans’ portfolios.”

All things being equal (the “tie”)

• “The Department expects that true ties rarely, if ever, occur.”

• DOL states that it would essentially have to have the same:

• Target risk-return profile/benchmark

• Fee structure

• Performance history

• Investment strategy

• But different underlying asset composition (due to the ESG)

• With the Scorecard SystemTM, that would also require all 10 analytics be exactly the same

• “[F]iduciary must document the basis for concluding that a distinguishing factor could not be found and why the selected investment was chosen based on the purposes of the plan, diversification of investments, and the financial interests of plan participants and beneficiaries in receiving benefits from the plan.”

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Preamble

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“Adding such a fund is permissible only if:

• The fiduciary uses only objective risk-return criteria, such as

• Benchmarks

• Expense ratios

• Fund size

• Long-term investment returns

• Volatility measures

• Investment management tenure, and

• Mix of asset types… In selecting and monitoring all investment alternatives for the plan, including any ESG investment alternatives;

• The fiduciary documents compliance with the above; and

• The environmental, social, corporate governance, or similarly oriented alternative is not added as, or as a component of, a QDIA…

• …as opposed to a fund added to the menu from which [participants] are free to choose.”

• “… [I]nappropriate for participants to be defaulted into a retirement savings fund with other objectives absent their affirmative decision.”


ESG Considerations

• Recent articles also discuss money pouring into ESG strategies and how they have

significantly outperformed the broad market over the past year

• Senator Patty Murray (WA), ranking member of Senate Health, Education, Labor and

Pensions (HELP) Committee argues proposed rule discourages financial advisors from

considering ESG criteria and ignores findings that ESG investments are outperforming

traditional investments

• Many investment firms (for instance, BlackRock and Pioneer) see ESG as an alpha

opportunity rather than a performance detractor, see below:

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The mindset of the DOL seems to be that the majority of ESG factors will serve as a

negative or detractor from performance.


ESG Considerations

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NFP Comment: Fiduciaries face three primary challenges with ESG

decisions: (1) How are they going to define “ESG” (2) Can they

effectively identify ESG elements as being positive pecuniary factors;

and (3) Can they overcome the “all things being equal” standard?

Different investment houses have different perspectives on ESG

• Removal of some industries (firearms, fertilizer, tobacco, etc.)

• Removal of some companies that engage in sales of certain items (Wal-Mart due to firearms)

• Scoring system based on corporate governance measures

• Difficulty in deciding which environmental, social, or corporate governance issues are important to all members of an organization

• Client wanted to add an ESG that excluded firearms – member of the committee wanted a “gun fund”

Funds fall into different asset classes

• U.S. equity

• International equity

• Fixed income

• Balanced funds


ESG Rating Systems

Work is being done in the financial investor community to measure ESG’s impact on risk management and mitigation.

• For example, in 2016, Morningstar released the Morningstar Sustainability Rating to help investors use ESG information to evaluate portfolios. The rating is intended to provide a reliable, objective way to evaluate how portfolios are meeting environmental, social, and corporate governance challenges

• In a footnote, however, the DOL states that, “ [F]iduciaries should also be skeptical of “ESG rating systems” -- or any other rating system that seeks to measure, in whole or in part, the potential of an investment to achieve non-pecuniary goals -- as a tool to select designated investment alternatives, or investments more generally.”

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Adding an ESG Fund to a Plan’s Investment Menu

• Adding an ESG-themed fund as a “designated investment alternative” to participant-

directed individual account plans (e.g., 401(k) plan investment menu)

• What is an ESG-themed fund? Proposed rule defines ESG-themed fund very

broadly:

• The fund’s investment mandate includes one or more environmental, social or

corporate governance-oriented assessments or judgements (referred to as “ESG

mandates”), or

• The fund’s name includes one or more of these parameters

• Thus, fiduciaries considering investment alternatives for individual account plans

(e.g., 401(k) plans) should review prospectus and other investment disclosures for

statements regarding ESG investment policies and investment approaches

• Adding an ESG-themed fund is permissible only if:

• The fiduciary uses only objective risk-return criteria in selecting and monitoring all

investment alternatives for the plan, including any ESG-themed alternatives

• Examples of objective risk-return criteria include:

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• Benchmarks,

• Expense ratios,

• Long-term investment returns,

• Volatility measures,

• Manager tenure


Adding an ESG Fund to a Plan’s Investment Menu

• Documentation requirement:

• The fiduciary documents his/her compliance with requirement to use only objective risk-

return criteria for selection and retention of the plan’s investment alternatives

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NFP Comment: If the proposed rule is adopted, it will be not merely difficult

but arguably not possible to add an ESG-themed fund if there is another

investment alternative in the same asset class (e.g., large cap blend) that

scores higher based on objective risk-return criteria

The DOL reiterates in the proposed rule that a fiduciary may not sacrifice

returns or increase investment risk compared to other similar asset classes or

funds in the same category in order to achieve “non-pecuniary goals”


EBSA ESG Probes

• End of February – early March Advisor

brought EBSA inquiry to ERISA group

• Nine of twelve (9/12) requests referenced “ESG”

• Client’s plan had ZERO ESG funds (both at

present and historically)

• Letter stated, “Department seeks to better

understand the Plan fiduciaries’ selection of

ESG funds for inclusion in the Plan’s

investment options and compliance with their

duty to administer the Plan prudently and

solely for the purpose of providing benefits

to participants and beneficiaries, and

defraying reasonable expenses of

administering the Plan.”

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EBSA ESG Probes

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EBSA ESG Probes

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EBSA ESG Probes

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NFP Comment: Eventually the EBSA investigation evolved into a more typical

full-blown DOL audit somewhat ignoring the ESG-slant of the original request.


Disclosures

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