In the last two weeks, two separate bills have been introduced in Congress attempting to micromanage private employer retirement plan investments. Although the major impact would be on 401(k) plans, defined benefit plans and even IRAs could also be affected.
The Two Bills. Rep. Jim Banks introduced the Protecting Americans’ Retirement Savings Act (HR 4008) attempting to amend ERISA to limit plan investment in “foreign adversary” countries (Iran, North Korea, Russia and China). The Ensuring Sound Guidance Act introduced by Rep. Andy Barr is a continuation of the political war against ESG investing. These bills come on the heels of the enactment of multiple state laws that seek to ban ESG investments for state and local government plans. On the opposite side, we see enactment or consideration of laws requiring divestment of specific classes of assets, such as fossil fuels, by these public plans. If enacted, these two recently introduced bills could have different implications for fiduciaries and participants than those envisioned by their sponsors.
What Does ERISA Say About Micromanagement? When ERISA was adopted, the idea of including lists of permissible and impermissible investments was rejected, and it was decided to rely on the compliance of fiduciaries with ERISA’s prudence, loyalty and diversification requirements. ERISA’s provisions contemplate that different fiduciaries can make different investment choices based on their investment analyses and participant population. The drafters understood that there is a range of decisions that can all be prudent and comply with ERISA’s fiduciary standards. The U.S. Supreme Court recognized this in its 2022 Hughes v. Northwestern University decision (142 S. Ct. 737), and this flexibility is important given that even investment professionals don’t agree on the best way to invest. Is exchanging flexibility for micromanagement the right policy decision, and will it hamper the ability of fiduciaries to make the best investments or to respond quickly to economic developments?
More ESG Restrictions? Earlier this year, a bill to restore the Trump administration’s rules, which were interpreted by many as having a chilling effect on ESG investments, was passed by Congress but was vetoed by President Biden. The supporters of the bill were unable to get enough votes to override the veto. The new bill is a resurrected attempt to overrule the Biden Administration’s more neutral rules on ESG investing, which explicitly require that any ESG investments be prudent, and to make selection of any investments with an ESG link extremely difficult to justify. The selected investment would have to be indistinguishable from a comparable non-ESG investment based on pecuniary factors alone, and the fiduciaries would have to document why pecuniary factors alone weren’t sufficient to support the investment decision. Such a requirement does not apply to any other class of investments under ERISA. Like the Trump regulations, the bill would also prohibit making any investment that takes ESG factors into account a plan’s default investment.
The bill would also amend the Investment Advisers Act to provide that a customer’s best interest is determined using only pecuniary factors unless the customer provides informed written consent to consider non-pecuniary factors. The broker, dealer or adviser would also be required to disclose the expected pecuniary effects of consent over a defined period and the actual pecuniary impact at the end of the period. The assumption may be that an ESG fund will underperform non-ESG fund alternatives or have higher fees, so the projection and reports would discourage further consent. The amendment to the Investment Advisers Act could also impact individual retirement accounts not subject to ERISA.
Investment in Foreign Adversaries. This bill would prohibit future direct and indirect transactions by retirement plans involving the foreign adversary countries listed above and sanctioned entities. The prohibitions go beyond investments in companies based in those countries, and extend to transactions with the government and its military, and to loans, provision of services, and even transferring plan data to covered entities. Derivatives investments are also restricted. If fiduciaries choose to retain current investments, they must disclose them and explain why such investments continue to be held.
If these investments raise security or foreign policy issues for the United States, it is difficult to see why the prohibitions should be limited to retirement plans rather than applied to all investors.
How Could Fiduciaries Comply? The majority of plans invest in pooled investments such as mutual funds, collective investment trusts and limited partnerships. Given the number of investments these investment vehicles make, how could any fiduciary police compliance with these restrictions on a real time basis? It isn’t even clear if the restrictions apply only to vehicles treated as holding plan assets under Department of Labor Regulation 2510.3-101, or to all investments in which a plan is an investor. In the case of the foreign adversary restrictions, the prohibited countries may change over time, which also requires monitoring. In the case of the ESG bill, it will be hard to determine whether any selected default investment that isn’t marketed as an ESG fund considers prohibited factors.
What About Participant Choice? In the last session of Congress, Sen. Toomey introduced legislation to make clear that ERISA does not prohibit alternative investments such as private equity and real estate. The rationale was to help diversify portfolios and to make clear that ERISA did not impose special restrictions on those investments, which could be made available to participants who wanted them. Yet his party members are taking an inconsistent position here-that the government needs to control what can and cannot be a permissible plan investment, regardless of what participants want and even in a self-directed account in which participants choose their own investments.
The Drafters of ERISA Got It Right. Micromanaging plan investments assumes that the members of Congress know more about investments than investment professionals and can determine what should and shouldn’t be permissible. However, the drafters of ERISA understood that flexibility is key. The flexibility in ERISA’s prudent investment rule has successfully accommodated the many changes in plan investment offerings over the years, as 401(k) plans took over the defined contribution space and new products such as target date funds were introduced. The original ERISA provisions have stood the test of time because they don’t require updating lists or amending the law as circumstances change and trust to the judgment of plan fiduciaries. These fiduciaries are required under the prudent expert rule to consult professionals when they need to do so. It should not be forgotten that under existing law, ERISA fiduciaries can be personally liable for losses resulting from imprudent investments. There can be serious consequences for breaches of their fiduciary responsibilities.
Will Participants Pay a Price? If this legislation effectively barring classes of investments is enacted, participants may suffer In the long run. One of the by-products of the explosion of ERISA litigation has been to frighten off some qualified individuals who would otherwise be willing to act as fiduciaries. Inflexible micromanagement of plan investments could amplify this problem and deter the best people from serving on plan committees or providing investment services to plans. More importantly, limiting the investment choices for ERISA fiduciaries could reduce plan investment returns and participants’ retirement readiness. Mixing politics and investments is a bad idea, no matter which side of the aisle generates the bills.