How Would an ESG-Friendly DOL Final Rule Change the Investment Marketplace for ERISA Plans?

January 18, 2022
24:06 minutes

In the latest installment of our Ropes & Gray podcast series addressing emerging issues for fiduciaries of 401(k) and 403(b) plans to consider as part of their litigation risk management strategy, ERISA and benefits partner Josh Lichtenstein, counsel Sharon Remmer, and associate Jon Reinstein continue the discussion from our prior episode about the Department of Labor’s proposed regulation pertaining to ERISA investment duties and environmental, social, and governance (ESG) considerations, by focusing on (i) how the rule might change the market for retirement plan investing and (ii) what impact it could have on plan investment committees and asset managers who manage plan assets.


Jon Reinstein: Happy New Year, everyone. We hope our listeners had a nice holiday season, and we appreciate you joining us for the newest episode in our Ropes & Gray podcast series addressing emerging issues for 401(k) and 403(b) retirement plan fiduciaries to consider as part of their litigation risk management strategy. I’m Jon Reinstein, an ERISA and benefits associate, based in New York. I’m here today with Josh Lichtenstein, an ERISA and benefits partner, and Sharon Remmer, an ERISA and benefits counsel, who are also both based in New York. Welcome, Josh and Sharon. Over the last year, we have used this series to highlight significant case law and litigation trends, analyze the DOL’s cybersecurity guidance and discuss the rise of pooled employer plans (or PEPs), among other developments.

Before we get into the substance of today’s episode, we want to provide an update about the protracted Intel retirement plan litigation, which we had covered in our prior episode in April 2021, addressing whether the inclusion of private equity and hedge fund investments on a defined contribution plan lineup would be considered imprudent under ERISA. Last January, Judge Lucy Koh of the Northern District of California at that time (she has since been appointed to the Ninth Circuit), had granted the Intel defendants’ motion to dismiss with leave to amend, holding that the participants failed to plausibly allege that the Intel Investment Committee violated ERISA’s duty of prudence by selecting and maintaining the Intel retirement plans’ investments in target date funds that provided exposure to alternative assets. Less than two weeks ago, Judge Koh, who was sitting by designation on the Northern District of California, wrote a new opinion that dismissed all but one of the counts in the plaintiffs’ first amended class action complaint.

Similar to the 2021 opinion, Judge Koh’s new ruling focused heavily on the benchmarks the plaintiffs presented, finding that the plaintiffs again failed to provide factual allegations explaining why their chosen benchmarks were “meaningful” benchmarks that have similar aims, risks, and rewards as the Intel target date funds. According to the court, conclusory allegations that funds have “the same investment style” or “materially similar characteristics” are insufficient to state a claim for relief. Without more factual allegations about how and why the funds the plaintiffs cited were similar to the Intel TDFs at issue in the case, the plaintiffs failed to allege a meaningful benchmark to the Intel target date funds.

Although it does not directly address the merits of whether investing in alternatives like private equity or hedge fund strategies are prudent under ERISA, Judge Koh’s opinion should provide some comfort to plan fiduciaries that, absent specific factual allegations about a defect in process or for that matter, at least being able to offer up better or more targeted benchmarks, a court may be more deferential to the decision-making of the plan fiduciaries in this context. 

Moving on to today’s topic, we are going to continue our discussion from our last episode about the DOL’s proposed regulations concerning ESG investing and proxy voting, for which the comment period ended in mid-December. The rule is expected to be finalized in the first half of 2022. In our previous episode, we summarized the key features of the proposal and identified some considerations for plan fiduciaries to start thinking about as the proposal made its way through the rulemaking process. Today, we are going to focus on how this rule could alter the investment landscape for ERISA plans as well as the impact it could have on investment committees and the asset managers that manage plan assets.

Josh, as we discussed last time, the 2020 rule created by the Trump Administration had a chilling effect on plan fiduciary decision-making, causing them to avoid considering ESG-themed investment options and even funds that discussed how ESG characteristics factor into investing at all, such as managers who had made net zero pledges. Assuming the final rule bears close resemblance to what the Department of Labor has proposed, do you think this is going to open the floodgates for funds and investments that fall across the ESG spectrum in plan lineups?

Josh Lichtenstein: It’s a good question, Jon. I think, for sure, the 2020 rule was forcing many asset managers to contort themselves, in a sense, to avoid talking plainly and directly about ESG commitments they had made, out of fear that an investment that would otherwise be appropriate from a financial perspective would be viewed by plan sponsors as risky just because it mentioned ESG. If the DOL comes out with a final rule that explicitly recognizes the legitimacy of ESG characteristics and the appropriateness of considering those types of factors in evaluating and selecting investments, I think this can be felt in several different ways in the ERISA world. First, a new rule would allow more open discussion of ESG factors between the plan sponsors and the plan’s investment advisors, and there wouldn’t be this pressure on the asset managers to be silent about or avoid really talking in detail about these types of topics when they’re marketing to ERISA plans, so they can speak to the ERISA plans with a more natural level about their overall philosophy as a manager.

Second, this shift could lead to asset managers creating ESG-branded or ESG-themed investment vehicles in response to the competition for the so-called “ESG slot” on a plan’s investment menu—and with more managers marketing impact funds or sustainability-themed investments to plan fiduciaries for inclusion in their plan lineups, we can see just a broader selection of these defined contribution and 401(k)-targeted ESG slot investments.

But from the plan sponsor’s perspective, I think you really need to think in terms of the overall composition of the investment menu for the plan. If an investment committee is going to go down the road of adding an ESG-themed fund to its lineup, it has to really ask itself what purpose or function the fund is going to serve on the lineup. Will it actually fill some need for the plan’s investments and not just overlap with a fund or strategy that is already available to participants? Moreover, a fiduciary will want to make sure that participants aren’t misunderstanding the ESG-themed fund or thinking that it offers something more than or different than what it’s really offering. And I think this is part of the reason why there has been and may continue to be some hesitation from plan sponsors about adding an ESG slot to the plan lineup with a designated ESG fund alongside the other funds. There are these ongoing concerns and there’s confusion still about what a fund being an “ESG-themed fund” really means, or what ESG factors are really encompassing in this context. Hopefully this is something the Department will help with through clarifications and definitions in its final rule, although the proposal was certainly already clearer on this point than the prior final rule.

In addition to thinking about an ESG-themed fund as a category on the plan lineup, we may also see ESG risks and opportunities becoming integrated into the financial analyses of more generalized product offerings, which may lessen the desire to have an ESG-themed fund on the menu in the future. To put it differently, by incorporating ESG factors into their investment strategies, the other funds in the lineup could potentially render the ESG “slot” superfluous—it’s sort of like how very few people use iPods these days because they can just listen to music with their iPhones instead.  

Jon Reinstein: That is very helpful context, Josh. I especially appreciate the iPod-iPhone analogy, which I think describes the dynamic nicely. Today you might have an ESG-themed fund on the plan lineup that is getting good returns, balancing risk appropriately and standing up to the benchmarking for its class when compared to non-ESG-themed investment options. But let’s say over time, you may start seeing these more generalized funds or investments that are incorporating ESG considerations into their investment approach. If those funds end up performing similarly, and they carry potentially lower fees and offer a better risk-return calculus, Sharon, how would you even justify keeping the ESG-themed product on the menu? Is that even possible?

Sharon Remmer: That’s a good question, Jon—and to me, the critical item you just mentioned is benchmarking. I’d like to focus on that for a couple of minutes. Even if ESG factors start becoming more openly discussed and evaluated—either in the context of ESG-branded funds or with respect to the characteristics of generalized funds—it’s important that investment committees and their advisors continue to benchmark these investments under their usual approaches for gauging financial risk and return as well as any watch-list criteria they may have in place. No matter where the DOL’s final rule lands with respect to the status of ESG, engaging in regular and robust benchmarking will remain an essential fiduciary function.

Now, according to the relevant section of the current investment duties regulation—which the proposal will leave in place—in discharging its duties, a plan fiduciary should give “appropriate consideration” to the facts and circumstances that the fiduciary knows or should know are relevant to the particular investment. “Appropriate consideration” shall include a determination by the fiduciary that the particular investment or investment course of action is reasonably designed, as part of the portfolio, to further the purposes of the plan, taking into consideration the risk of loss and the opportunity for gain (or other return) associated with the investment or investment course of action compared to the opportunity for gain (or other return) associated with reasonably available alternatives with similar risks.

So, this comparison could be a challenge for investment committees and their advisors because they are used to analyzing historical performance over varying durations of time—quarterly, yearly, three years, five years, even as much as ten years. But there aren’t many ESG-themed products on the market right now that have been around long enough to have this mature track record for benchmark comparisons. Even products that include ESG features and have long track records may not historically have been branded as ESG-themed funds. Remember, the fiduciary is comparing the investment to “reasonably available alternatives with similar risks.” Right now, you’d be comparing your ESG-branded fund to other non-ESG funds in its class—for example, another standard passive index fund. But over time, with more wide-scale acceptance and adoption of ESG-themed investment options, the world of what is a “reasonably available alternative” might evolve.

All of this is to say that for a plan fiduciary, benchmarking remains an essential aspect of evaluating potential investment options—and when it comes to comparing ESG products in particular, the fiduciaries will need to ensure that their benchmarking methodology is appropriate and well-suited for the specific characteristics of the investment(s) being reviewed. And as always, these benchmarking activities and discussions should be documented in the investment committee’s meeting minutes.     

Jon Reinstein: Sharon, those perspectives are very helpful. I want to shift gears now and talk a little bit about qualified default investment alternatives (or QDIAs). The DOL’s proposal would eliminate the flat prohibition on selecting an investment fund, product or model portfolio that includes the use of one or more non-pecuniary factors as (or as a component of) a QDIA. According to the Department, if a fund that expressly considers climate change or other ESG factors is financially prudent and meets the protective standards of the QDIA regulations, there is no reason to foreclose plan fiduciaries from considering the fund as a QDIA. Josh, we already spoke about how an ESG-friendly rule could expand the marketplace for these types of products more broadly, but with respect to QDIAs in particular, what sort of changes do you anticipate there? 

Josh Lichtenstein: Yes, I definitely think that we’re going to see action in this space. I think we’ll start seeing more announcements from investment managers that are going to be offering ESG-themed products that are intended to serve as a plan menu’s QDIAs—for example, an ESG-specific target date fund. But my sense is that there’s going to be a range here. We’ll certainly continue to see target date funds that are very traditional in their investment strategies and characteristics, and those may not reflect ESG factors at all or may not overtly discuss them. Then there will be more products that will join existing target date funds in the middle of the spectrum that are incorporating ESG in their investment processes and marketing materials, but they are not branded as such—think of these as ESG integration products, instead of ESG-focused or -themed products. And then, finally, there will be default investment funds that are very explicitly ESG-themed products, with varying focuses and calling back to what we were discussing before, and that where you see a plan using one of these explicitly ESG-themed products that won’t be in an ESG slot because since it’s the default investment, it’s going to be occupying a central place in the plan’s investment lineup.  

Now, one thing to keep in mind is that ESG-themed investment products may require additional resources for the asset manager to implement, and fiduciaries are going to need to be attuned to the fees that these products are charging relative to non-ESG funds when they’re conducting their evaluations of what product to offer. Therefore, a plan fiduciary and its investment advisor are going to want to benchmark any ESG-themed target date funds against non-ESG-themed target date funds to make sure that the risks and returns justify the selection of the ESG-themed fund on a comparative basis. So, again, going to what Sharon was just discussing, not just ESG versus ESG, but ESG-targeted funds versus the broader universe of target date funds.

To me, the big takeaway is that while there will be more flexibility to select a broader range of QDIAs under the new rule, plan fiduciaries will want to continue being more careful about the selection of a QDIA versus other funds on the investment menu and they’ll want to be careful in making changes to which investment is the QDIA, because any changes are going to have to be backed up by the economic characteristics of the fund on a fee-adjusted basis. By referencing the QDIA regulations in the preamble to the proposed rule, I think the DOL made it clear that it’s still expecting fiduciaries to continue to be prudent and disciplined in their QDIA evaluation and selection, which is what we would expect, but the Department has made that clear as well.

So, Sharon, I’m curious to hear your perspective—do you think for sponsors that don’t want to have an ESG slot or are hesitant about incorporating ESG factors directly in the fund selections, do you think they’ll try to use brokerage windows as a way to give participants exposure to these types of products?  

Sharon Remmer: Well, first, I’d like to say that I fully agree with you about the importance of continuing to be prudent and diligent with your QDIA selections. As you said, a QDIA plays a different role than a single investment on the plan lineup that a participant may or may not choose. So, to me, plan fiduciaries may want to step back and see how the ESG market develops, and how the benchmarking data develops, before moving to an ESG-themed QDIA. Now, in terms of brokerage windows, you raise another interesting point. Brokerage windows are often used today to give participants access to a broader universe of investment options, and there is nothing in the proposed rule that would require a change in that practice. By offering a brokerage window, a plan fiduciary could help facilitate participant access to ESG-themed funds, and perhaps it would even mitigate the concern we discussed before about the ESG-themed fund being potentially misused or misunderstood by participants. By using a brokerage window, if the participant wants those kinds of investments, he or she would have to consciously make the choice to pick them.

But don’t forget, offering a plan brokerage window itself involves fiduciary functions—such as evaluating the brokerage window provider, their services or fees—and it’s a very fact-specific and heavily vetted decision. Also, brokerage windows are more complex and they may not be appropriate for all plans or all workforces. So, I’m a little skeptical about the notion that plan sponsors are going to start adding brokerage windows willy-nilly once this rule gets finalized, just to give participants the opportunity to make ESG investments.  

Jon Reinstein: A recurring theme of this discussion (and for that matter, many of our discussions in this podcast series) is the importance of having a diligent process in place for analyzing and evaluating options—whether it’s ESG or otherwise—and for deciding which are appropriate and where they should go—whether as a QDIA, in an ESG slot on the lineup, part of the brokerage window, what have you. For many plan fiduciaries that have been relying on pecuniary or financial screens in assembling investment lineups, ESG is the next frontier, and they will need to get up to speed in order to ensure that they are acting prudently and diligently when considering these types of products. I’m going to ask both of you: What role will plan sponsor education play in helping fiduciaries properly execute their duties? 

Josh Lichtenstein: Well, I’m happy to take a first shot at this question, and then, Sharon, please share your thoughts as well. I think that plan sponsor education is crucial now and it’s only going to become more so once this rule is finalized. Asset managers and advisors to plans are going to increasingly want to help investment committees to understand the spectrum of ESG types of products and the considerations that go into them, and managers and plan advisors are going to need to help investment committees to understand exactly how to determine how and if the ESG factors relevant to a product will have a material impact on an investment’s risk-return profile. To that end, I think that the plan’s investment advisors are going to have to play an outsized role in taking on these education responsibilities because the majority of plan investment committees are just not going to have the internal expertise to be able to evaluate these claims without that help. To anticipate this increased demand for ESG expertise, some advisors are ramping up their research capabilities, including by hiring dedicated teams of professionals to engage in ESG portfolio research, similar to what we’ve seen over the last several years within the asset management industry where there’s been more directed ESG hiring in order to build up their ESG investing capabilities.

At the same time, more comprehensive reporting and disclosure by the asset managers on ESG factors and performance will help the advisors and their plan sponsor clients to better understand the ESGness of the different funds available to them so they can assess which ones may be appropriate options for their plans. Another benefit of more comprehensive reporting of this information would mean that sources like Morningstar or their peers would be able to provide better data to plan sponsors that would allow them to more reliably benchmark these ESG products in the future. Finally, the Department has indicated that it intends to engage in extensive plan sponsor outreach once this rule is finalized to help fiduciaries better understand the lay of the land. So, this isn’t just a legal rulemaking process—I think that this is also a process from the Department of Labor trying to make sure that plan sponsors actually understand what the DOL means and intends by this rule.

Sharon Remmer: Yes, I agree with you, Josh—and to build on what you’ve already said, as part of this “education” process, I think plan fiduciaries are also going to have to make sure that their participant base understands what this ESG stuff is all about. That entails being able to clearly define the scope of “ESG,” explain how these ESG factors influence the selection process and describe what impact they have on the risk or return of a given investment. And this will be especially important if an investment committee anticipates using an ESG-themed fund as a QDIA in the future.

Furthermore, investment committees will want to start thinking about including ESG-related questions in their RFPs for investment advisors as well as due diligence questionnaires for fund managers. And in the PEP context, the participating employer’s RFP for the pooled plan provider should also include ESG-related questions as well. Finally, investment committees will want to ensure that they’re having regular and ongoing discussions with their investment advisors in order to understand the movement to ESG and just to become more conversant with ESG issues generally.

Jon Reinstein: I think those practical takeaways are a good note to end on. I would like to thank Josh and Sharon for a very insightful conversation today. For more information, please visit our website at And of course, if we can help you navigate any of these topics, please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to your podcasts, including on Apple and Spotify. Thank you again for listening, and please take care.

Subscribe to RopesTalk Podcast