Recent Developments in ERISA Plan Investment Regulation

July 14, 2020

The US Department of Labor has issued guidance on private equity in 401(k) plan designated investment alternatives and a proposed regulation on environmental, social, and governance investing.

The US Department of Labor (DOL) has recently focused its attention on ERISA’s fiduciary duties and the obligations they impose on plan fiduciaries in the following contexts:

  • Choosing plan investments based on environmental, social, and governance (ESG) factors
  • Using private equity as a component in the asset allocation of a designated investment alternative (DIA) available to participants in ERISA-governed 401(k) plans

The proposed rule, Financial Factors in Selecting Plan Investments (the ESG Proposal),[1] and Information Letter dated June 3, 2020 regarding private equity in DIAs, with a focus on investment types that raise different issues and considerations, both highlight the longstanding view that in meeting the ERISA prudence obligation, process is paramount, and that a prudent process must focus on objective, risk-adjusted pecuniary benefits of the investment when evaluating whether it is appropriate for a plan.

ESG Proposal

Would Require Focus Solely on Pecuniary Benefits to the Plan, and Impose Additional Conditions on Potentially Non-Pecuniary Investments

The DOL’s ESG Proposal, if finalized as proposed, would consolidate a series of Interpretive and Field Assistance Bulletins and other guidance the DOL has issued over the years (going back to 1980) addressing fiduciary considerations in the ESG investment space. While each piece of guidance has examined ESG investing through a lens that reflects the changing proclivities of presidential administrations, they have been consistent in stating that plan fiduciaries must make investment decisions solely in the interest of plan participants and may not accept reduced returns or greater risks to advance collateral goals.

Key pieces of guidance are summarized below:

  • Interpretive Bulletin 94-1 (issued during the Clinton administration) allowed plan fiduciaries to make “economically targeted investments” (ETIs), so long as the investment has an expected rate of return commensurate with the rates of returns of other investments with similar risk characteristics. This is commonly referred to as the “all things being equal” test.
  • Interpretive Bulletin 2008-01 (issued during the Bush administration) focused on the limits of the all things being equal test, stating that “fiduciaries must first have concluded that the alternative options are truly equal, taking into account a quantitative and qualitative analysis of the economic impact on the plan,” and noting that fiduciaries “will rarely be able to demonstrate compliance with ERISA absent a written record demonstrating that a contemporaneous analysis showed that the investment alternatives were of equal value.”
  • Interpretive Bulletin 2015-01 (issued during the Obama administration), the first guidance to consider the concept of ESG factors as such, was viewed as representing a marked shift in the prior guidance in concluding that there could be circumstances in which ESG factors could be more than “tie-breakers” in the all things being equal test, and could instead be material economic factors that themselves impact an investment’s risks and returns.

Most recently, the DOL issued Field Assistance Bulletin 2018-01, recognizing that ESG factors could bear on the economic merits of an investment, but that fiduciaries “must not too readily treat ESG factors” as relevant to evaluating whether an investment is in the interest of plan participants and beneficiaries.

The ESG Proposal, which followed a year after a White House executive order that was viewed as directing the DOL to review its guidance on ESG investing,[2] reflects the current DOL skepticism of ESG investing. It notes in the preamble that ESG investing “has engendered important and substantial questions and inconsistencies, with numerous observers identifying a lack of precision and rigor in the ESG investment marketplace,” and further that “[t]here is no consensus about what constitutes a genuine ESG investment, and ESG rating systems are often vague and inconsistent, despite featuring prominently in marketing efforts,” and “often com[ing] with higher fees.”

The DOL goes on to note particular concerns with ESG investing by ERISA plan fiduciaries who are “statutorily bound” to manage plan assets “with an eye single to maximizing the funds available to pay retirement benefits”—an “eminently worthy, ‘social’ goal of ERISA plans”—and highlights that some ESG investment products are marketed as appropriate for ERISA plan investments, but include risk disclosures indicating that the product “may perform differently or forgo certain opportunities, or accept different investment risks, in order to pursue the ESG objectives.”

According to the DOL, while there may be instances where factors such as environmental considerations will present business risks or opportunities that can appropriately be treated as material economic considerations under “generally accepted investment theories” (a term frequently used in DOL guidance to describe current views on prudent investing), that would be determined on a fact-specific basis. For this reason, the DOL intends its proposal to assist ERISA fiduciaries in navigating ESG investment trends to separate what it called 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.”

The ESG Proposal builds on the DOL’s original 1979 ERISA prudence regulation, which emphasizes the need for fiduciaries making investment decisions to consider risk and return factors and the role an investment plays within the plan’s overall investment portfolio, by adding the following concepts to that regulation (the first three of which would apply to fiduciary investment decisions broadly, with the remainder applying specifically in the context of ESG investing):

  • No Subordination of Interests. A specific statement that fiduciaries must act solely in the interest of the plan and its participants and may not subordinate the interests of the plan participants and beneficiaries to unrelated objectives, or to the interests of the fiduciary or others, concepts inherent in ERISA’s fiduciary duty of loyalty and consistently described in the earlier DOL guidance.
  • Evaluation of Investments Based Solely on Pecuniary Factors. An explicit requirement that fiduciaries evaluate investments and investment courses of action “based solely on pecuniary factors that have a material effect on the return and risk of an investment based on appropriate investment horizons and the plan’s articulated funding and investment objectives,” a concept that is generally consistent with prior guidance and fiduciary concepts that would now be expressly stated in the DOL’s regulations.
  • Comparison to Other Investments. A requirement to compare investments or investment courses of action to “available alternative investments” or investment courses of action, including with regard to level of diversification, degree of liquidity or potential risk and return.
    • Observation: This concept, implicit in prior guidance related to the “all things being equal” test, would apply more broadly than just to ESG investing under the prudence regulation. A similar concept is reflected in the DOL’s recently proposed class exemption, Improving Investment Advice for Workers and Retirees, as well as in the US Securities and Exchange Commission’s (SEC’s) Regulation Best Interest (adopted in June 2019),[3] which generally requires broker-dealers to consider “reasonably available alternatives” in meeting the regulation’s care obligation. We note that, though the SEC has indicated that its requirement does not require comparison to all investments available in the marketplace, there remains significant uncertainty under the securities laws (as well as under ERISA) as to the extent of the comparison required.
  • ESG Factors May Be Considered Only If They Are Pecuniary Factors. A specific statement (subject to the “tie-breaker” concept in the next bullet) that ESG factors and other similar considerations may only be considered if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories, and must be appropriately weighted in the investment decision.
  • Close Scrutiny of Tie-Breakers and Required Documentation. The DOL would retain the all things being equal test, but would require fiduciaries to adequately document such occurrences—specifically, the basis for concluding that no distinguishing factor could be found and why the selected investment was chosen based on pecuniary considerations.
    • Observation: Documenting the basis for investment decisions has historically been viewed as a best practice, and not a required practice, under ERISA’s prudence obligation (and other standards of care).
  • Designating Investment Alternatives for Participant-Directed Plans. The ESG Proposal would permit the addition of a “prudently selected, well managed, and properly diversified fund” that includes ESG investment mandates to the investment lineup of a participant-directed plan (such as a 401(k) plan), but only if based on objective risk-return criteria, and subject to documenting compliance with these standards. Also, consistent with the DOL’s 2018 guidance, the ESG Proposal would not permit ESG-themed investment alternatives to serve as a plan’s qualified default investment alternative.

Proposal Observations

The basic effect of the proposal, if it goes forward in substantially the same form as proposed, may be to establish standards that reflect a level of skepticism toward ESG investing by labeling it as being focused on “non-pecuniary factors” and requiring additional documentation to justify investment decisions made on this basis.

While, like the 2015 guidance, the rule would acknowledge that ESG factors can in specific instances be treated as material economic considerations, it would create a presumption otherwise by requiring a documentation process to justify those instances, including through a comparison to alternative investments that do not consider ESG factors. In effect, making investments that have the ESG label, or that reference ESG considerations as part of their investment process, would trigger additional required steps to demonstrate the prudence of the investment.

Many funds, even those not necessarily ESG focused, currently position themselves as using ESG factors in their investment strategy as part of their marketing efforts. Funds’ imprecise or varying use of the ESG terminology could pose challenges to drawing meaningful distinctions as to which funds or investment strategies actually trigger the presumption requiring additional scrutiny and documentation by the fiduciary. Thus, the proposal could contribute to a dampening effect on the use of ESG terminology, particularly if the ESG imprint could disqualify a manager’s funds from being used as, or as components of, a plan’s QDIA. We would query whether this is fundamentally a marketing and distribution issue, as opposed to an investment strategy issue (notwithstanding any ESG risk disclosures to the contrary).

We further note that, if finalized, this proposal would apply only to fiduciary investment decisions and recommendations by ERISA plan fiduciaries. ESG investment advice to other investors (such as non-ERISA governmental plans, IRA investors, and taxable accounts) would not be directly impacted by this regulation as it would be subject to other statutory and regulatory frameworks, including applicable state, securities, and banking laws. However, note that these regulators are also evolving in their approaches to ESG investing, and, as an example, the SEC currently has initiatives with respect to the adequacy of investor disclosures in this space.[4]

A change in approach that this would represent is to codify the DOL’s guidance in this area in the form of a regulation adopted pursuant to notice-and-comment rulemaking. As such, any changes would also require going through a notice-and-comment rulemaking process, resulting in a set of rules that would be more difficult to modify going forward. That said, several elements of the new rules could still be subject to interpretation as to when and how they apply to specific circumstances.

As a general matter, the ESG Proposal appears to be part of a broader DOL focus on ESG/ETI investing. In the last several months, a number of plans and investment funds have received requests from DOL regional offices asking about their consideration of ESG or similar factors as part of their investment process, and how they disclose and document those investment decisions.

Comments on the proposal are due on July 30—a relatively short comment period for such a complex issue, likely signaling a goal to finalize the regulation by January 20, 2021.

Private Equity

Including a Private Equity Component in a Professionally Managed Asset Allocation Fund Can Be Consistent with ERISA’s Duty of Care

Although private equity has long been part of investment strategies for defined benefit plans and large institutional investors, it was generally not an option for defined contribution plans due to the lack of certainty around fiduciary responsibilities and the inherent risk of private equity investments. The DOL’s new guidance may help allay many plan fiduciaries’ concerns about including diversified investment options with allocations to private equity, such as target date, target risk, and balanced funds.

Moreover, though issued separately, the Information Letter is consistent with the ESG Proposal’s approach in suggesting that ERISA fiduciaries should focus on an investment’s expected risk-adjusted performance.

  • Observation: The DOL’s guidance does not address issues involved in allowing participants to invest directly in private equity, but notes that such investments would raise “distinct legal and operational issues for fiduciaries of ERISA-covered individual account plans.” Plan fiduciaries that desire to include direct private equity options in their lineups may continue to face some uncertainty and will need to carefully consider plan demographics, liquidity needs, nondiscrimination requirements under the Internal Revenue Code, and investor sophistication requirements under the securities laws, among other issues, as well as the factors outlined in the Information Letter discussed below.

Noting the DOL’s view that there are important differences between investing defined benefit plan assets in private equity and including private equity as part of a designated investment alternative available under a participant-directed defined contribution plan, the DOL suggests that plan fiduciaries should consider the following in evaluating such investments consistent with their fiduciary duties:

  • Diversification. Whether adding the asset allocation fund “offer[s] plan participants the opportunity to invest . . . among more diversified investment options within an appropriate range of returns net of fees . . . and diversification of risks over a multi-year period.”
    • Observation: The DOL seems to be focused on whether the addition of private equity to a fund’s asset allocation would increase investment diversification so as to improve participants’ ability to select investments with appropriate risk and return profiles. Note also that the DOL would focus on returns net of fees in evaluating whether a fiduciary has satisfied the prudence obligation.
  • Fiduciary/Professional Oversight. Whether the fund is overseen by plan fiduciaries (using third-party experts as necessary) (i.e., a “plan assets” fund), or managed by qualified investment professionals.
  • Limited Allocation—Liquidity and Valuations. Whether the allocation to private equity is appropriately limited to address “the unique characteristics associated with such an investment, including cost, complexity, disclosures, and liquidity, and has adopted features related to liquidity and valuation designed” to enable participants to take distributions and direct their investments consistent with the plan’s terms.
    • To address liquidity concerns, the DOL suggests, as an example, setting a maximum percentage allocation to private equity.
    • Regarding valuations, the DOL suggests ensuring the private equity investments are “independently valued according to agreed-upon valuation procedures that satisfy the Financial Accounting Standards Board Accounting Standards Codification (ASC) 820, ‘Fair Value Measurements and Disclosures.’”
    • The DOL goes on to note that additional disclosures may be needed to meet ERISA’s obligations to report current value information about plan investments.
  • Alignment with Plan Features and Participant Profile. Whether the asset allocation fund’s characteristics align with the plan’s features and participants’ ages, normal retirement age, employee turnover, and contribution and withdrawal patterns, taking into account the fund’s investment allocation and strategy, fees and expenses, liquidity restrictions, and participants’ ability to access funds and change investment selections.
  • Plan Fiduciary Expertise. Whether the plan fiduciary has the skills, knowledge, and experience to make determinations about the fund, or needs to seek assistance from a qualified investment professional, including for periodically reviewing the fund regarding whether it remains prudent and in the best interest of plan participants.
  • Alternative Funds Without Private Equity. How a fund with an allocation to private equity compares with appropriate alternative funds that do not include a private equity component.
  • Plan Disclosures. Whether plan participants will be furnished with enough information about the character and risks of the fund so that they can make informed investment decisions, particularly where the plan fiduciary seeks protection from participant investment decisions under ERISA Section 404(c), and where the fund would be used as a qualified default investment alternative (QDIA).
    • Observation: While the DOL notes the importance of participant disclosures, it did not provide guidance on what disclosures are necessary beyond those already required under ERISA Section 404 for participant-directed plans (including 404(c) plans and plans with QDIAs). Given the nature of funds with private equity allocations and the issues raised in the Information Letter, key areas to consider would include disclosures related to liquidity/withdrawal restrictions, any special limitations or assumptions related to valuations and performance reporting, and specific risks related to the private equity allocation.

General Observations

Overall, this new guidance is welcome news to many individual account plan sponsors and fiduciaries looking for ways to diversify their plans’ investment lineups and offer participants more ways to meet their retirement needs. Although an information letter is, as the name suggests, informational only and not binding on the DOL, the Information Letter provides comfort that plan fiduciaries may offer private equity as a plan’s investment option without violating the ERISA fiduciary standards.

While the ESG Proposal and the Information Letter may, respectively, discourage and encourage investments in the types of investments they address, and raise a number of issues that will require further consideration for those making these types of investments, we take comfort in the commonality of the view that fiduciaries must focus on the expected pecuniary benefits of an investment to the plan and its participants and beneficiaries.

In that respect, their approach is consistent with historic views on the fiduciary duty of prudence under ERISA, and it may be that the DOL’s differences in approaches here are rooted in concerns that particular investments may raise under ERISA’s duty of loyalty—concerns that may be perceived as elevated in the ESG investment space. As such, plan fiduciaries may wish to consider the ESG Proposal and Information Letter more broadly in evaluating their current investment processes, including with respect to the following:

  • Factors Considered in Evaluating Investments. The ESG Proposal and Information Letter show a focus on objective “pecuniary” factors, including liquidity, diversification, risk/return characteristics, and expected returns net of costs and expenses. Plan fiduciaries may want to consider whether their current processes reflect these factors and how they align with the plan’s funding and objectives, as well as participant profiles and demographics.
  • Comparison to Alternative Investment Options. The ESG Proposal is particularly focused on comparing potential investment options when making an investment selection. This is mentioned as well in the Information Letter, which states that the fiduciary’s process should compare a fund with a private equity component with appropriate alternative funds that do not include private equity. We note that benchmarking and comparative decisionmaking are widespread practices in the ERISA fiduciary space, though a focus may be developing on which alternative investments are appropriate in drawing these comparisons.
  • Documenting the Basis for Recommendations. As with benchmarking, documenting the basis for investment recommendations is a common practice that the DOL would require with respect to certain ESG-related investments. Plan fiduciaries may want to consider practices around documentation, including how and when it is appropriate to do so.
  • Participant Disclosures. Appropriate investor disclosures have been a focus of the SEC in the ESG space, and such disclosures are noted as a consideration for private equity investments in the Information Letter. Plan fiduciaries may want to evaluate participant disclosures, particularly with respect to investment options that may raise unique investment considerations.
  • Independent Expertise. The Information Letter highlights that fiduciaries selecting funds with private equity allocations should consider whether they have the needed expertise or require assistance from a third-party professional, such as an investment consultant. We note that independent investment expertise can be viewed as supporting that a fiduciary met ERISA’s fiduciary obligations.


If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Marla Kreindler
Julie Stapel

New York
Craig Bitman
Melissa Hill

Robert Abramowitz
William Marx

Elizabeth Goldberg

Washington, DC
Lindsay Jackson
Daniel Kleinman
Michael Richman

[1] 85 Fed. Reg. 39,113 (June 30, 2020).

[2] Executive Order on Promoting Energy Infrastructure and Economic Growth (Apr. 10, 2019). This order directed the DOL to study trends in private pension fund investment in energy and to undertake a review of its guidance on fiduciary responsibilities for proxy voting. The DOL has a regulatory project pending on proxy voting.

[3] Regulation Best Interest: The Broker-Dealer Standard of Conduct, Securities Exchange Act Release No. 34-86031 (June 5, 2019).

[4] See, e.g., Office of Compliance Inspections and Examinations, SEC, 2020 Examination Priorities, at 15; Request for Comment on Fund Names, Release No. IC-33809 (Mar. 2, 2020).