DOL Eclipses ESG Investing: Fiduciaries Must Use Only Pecuniary Considerations for All Investment Selection
Over the last 30 years, the U.S. Department of Labor (DOL) has taken a variety of positions on whether and how plan fiduciaries should consider environmental, social, and corporate governance (ESG) investments for ERISA-covered retirement plans. ESG investments are designed to advance economic, social, or governance causes. Until now, the DOL’s guidance has been informal and has varied considerably, either embracing ESG investing or not, depending on the political party in the White House.
Acknowledging the inconsistent definitions of ESG investments, last fall the DOL issued a broad final regulation on how all investments must be chosen and monitored. Although ESG investments are not specifically mentioned, they are swept into the broad rule. The final rule is not materially different from the informal guidance issued by prior Republican administrations.
Under the final rule, plan fiduciaries must make investment decisions based on factors that advance participants’ pecuniary—or monetary—interests such as increasing investment returns and lowering risk. They are not permitted to take on additional risk or use nonpecuniary factors in their decision making—with one narrow exception. This embraces ERISA’s duty of loyalty, the so-called exclusive benefit rule, that all fiduciary decisions must be made solely for the purpose of providing retirement benefits to plan participants and beneficiaries and defraying reasonable plan expenses.
The final rule leaves the door ajar for ESG investments, permitting plan fiduciaries to use nonpecuniary factors in “tie-breaking” situations—when two investments are indistinguishable based on pecuniary factors alone. However, the DOL expressed skepticism about this scenario, expecting it to be “rare”. If nonpecuniary factors are considered, the final rule requires the following documentation by plan fiduciaries:
- Why the investment could not be selected based on pecuniary factors,
- How the investment selected compares to reasonably available alternatives, and
- How the nonpecuniary factors considered are consistent with the retirement interests of plan participants and beneficiaries.
The final rule observes that participants’ demands or preferences are potentially a nonpecuniary factor to be considered in a tie-breaker situation.
The final rule cautions plan fiduciaries about using any investment whose prospectus or other documentation suggests that the investment takes nonpecuniary factors into consideration when making investment decisions. It also prohibits the use of any qualified default investment alternative whose investment objectives or strategy include(s) any nonpecuniary factors.
The final rule took effect before January 20, so it cannot be suspended by the new administration. President Biden has instructed the DOL to review the rule for consistency with his environmental and social policy objectives as laid out by executive order.
401(k) Plan Fees and Investments Challenges Continue
The flow continues of new cases, decisions, and settlements in cases alleging fiduciary breaches through the overpayment of fees and the retention of underperforming investments in 401(k) plans. Many copycat lawsuits are being filed, and they are being filed against smaller plans. Good fiduciary processes also continue to prevail.
Hedge Funds in Target Date Funds—As previously reported, Intel’s 401(k) plan used a custom target date fund solution that included a significant amount of hedge fund investments. Plan fiduciaries were challenged for using hedge funds because their performance and high fees were a significant drag on performance as compared to the performance of target date funds that did not use hedge funds. The district court dismissed the claim, making the following key observations:
- Allegations of poor performance, standing alone, are insufficient to support a fiduciary breach claim.
- The ERISA prudence standard focuses on a fiduciary’s conduct in arriving at an investment decision, not on its results, and asks if a fiduciary employed the appropriate methods to investigate and determine the merits of a particular investment.
- On its own, the failure to select the investment with the lowest fees is not sufficient to plausibly state a claim for breach of the duty of prudence.
- It is inappropriate to compare distinct investment vehicles solely based on cost, since their essential features differ so significantly.
Anderson v. Intel Corporation Investment Policy Committee (N.D. CA 2021). (This case went to the Supreme Court as Intel Corporation Investment Policy Committee v. Sulyma v. in 2020 to decide when a plaintiff has actual knowledge of a claim.)
Smaller 401(k) Plan’s One-year Limit for Filing Suit Prevails—Cumulus Media’s 401(k) plan with approximately $200 million in assets was sued, with the plaintiffs alleging that the plan’s fiduciaries improperly used expensive mutual funds and paid excessive compensation to the plan recordkeeper. The plan’s summary plan description provides that any lawsuit must be brought within 12 months of the date of the conduct at issue. This provision significantly shortened the ERISA limitations period of 6 years. The lawsuit was filed on February 24, 2020.
The court concluded that the plan’s shortened limitations period of 12 months was enforceable. Any allegations in the case related to actions that took place before February 24, 2019, were barred. As a result, the case was dismissed. Chiappa v. Cumulus Media, Inc. (N.D. GA 2020).
Smaller 401(k) Plan Fiduciaries Win Fees Case—Fiduciaries of the Vail Corporation 401(k) plan were sued, with the plaintiffs alleging improper use of expensive mutual funds and overpaying for recordkeeping fees, among other things. The plan has approximately $300 million in assets. There were no allegations of imprudence in the fiduciaries’ process. Rather, the claims were based on comparisons of the plan’s investments and fees to others in the marketplace. The case was dismissed with the judge making the following key points (some of which mirror those in Anderson v. Intel above):
- ERISA does not impose on fiduciaries a duty to take any particular course of action if they reasonably decide another approach seems preferable.
- It is not enough to simply allege that an investment did poorly and, therefore, a plaintiff was harmed. Relative underperformance is insufficient.
- The plaintiff must show that no reasonable fiduciary would have retained the challenged investments if they had engaged in proper monitoring.
Kurtz v. The Vail Corporation (D. CO 2021).
Profit-Sharing Plan Asset Allocation Decision Costs Plan Fiduciaries $17.5 Million
Can fiduciaries be too conservative when investing participants’ plan assets? Yes!
DeMoulas Super Markets, Inc., the owner of Market Basket, a grocery chain in the Northeast U.S., sponsors a profit-sharing plan for employees that recently had more than 11,000 participants and $750 million in plan assets. The profit-sharing plan is funded entirely with employer contributions; participants are not permitted to contribute. Plan fiduciaries direct the plan’s asset allocation, which is the same for all participants. The plan’s investment policy statement has an asset allocation of 30 percent equities and 70 percent fixed income.
Plan participants sued, alleging breaches by the plan fiduciaries and that the plan’s one-size-fits-all asset allocation of 30 percent equities and 70 percent fixed income was inappropriate both for participants younger than 50 and also for those nearing retirement. In other words, this allocation was too conservative, costing plan participants millions of dollars. As a point of reference, the target asset allocations in widely used target date funds is approximately 50 percent equities and 50 percent fixed income for those at retirement age and approximately 80 percent equities and 20 percent fixed income for those 10 years from retirement—age 55.
Fiduciaries in the DeMoulas Supermarkets case were also alleged to have imprudently executed the 30 percent equities and 70 percent fixed income target asset allocation. In some periods, the actual allocation was only 16 percent equities and 84 percent fixed income. Compounding the inherently low return of the target asset allocation, at times up to $400 million of plan assets was invested in money market investments and earning only 0.01 percent or 0.05 percent (1 or 5 basis points). It was also alleged that the fixed income investments used were not the least expensive share class.
The plan fiduciaries filed an unsuccessful motion to dismiss. Following that, a settlement was reached under which the plan fiduciaries will pay $17.5 million. Court approval of the settlement is pending. Toomey v. DeMoulas Super Markets, Inc. (D. MA 2020).
DOL Weighs in on Missing Participants
We have previously reported on the Internal Revenue Service’s (IRS) missing participant initiative and its Field Directive on this issue. In plan audits, the IRS has focused on missing plan participants who are required to receive required minimum distributions, which now begin at age 72. The penalty for not taking a timely required minimum distribution is a tax equal to 50 percent of the missed distribution.
The DOL has now issued its own informal guidance on missing participants. That guidance identifies a series of red flags that plan fiduciaries should be aware of and provides a lengthy list of best practices. The red flags include:
- More than a small number of missing or nonresponsive participants;
- More than a small number of terminated vested participants who have reached normal retirement age but have not yet started receiving pension benefits;
- Missing, inaccurate, or incomplete contact information, census data, or both;
- Absence of sound policies and procedures for handling returned mail marked return to sender, wrong address, addressee unknown, or otherwise undeliverable mail; and
- Absence of sound policies and procedures for handling uncashed checks.
Although this guidance does not have the force of law, it would be appropriate for plan fiduciaries to ask plan administrators and recordkeepers about their processes for identifying plans with missing participant issues and the steps they take to assist with locating missing participants.
