DOL Guidance on ESG Investments

Nicholas Zaiko, CIMA

Senior Consultant

Bridgebay Financial, Inc.

www.bridgebay.com

Millennial Interest in ESG Investments

A recent survey by Natixis found that 82% of plan participants want their investments to reflect their personal values. Millennials account for 77% of plan participants surveyed that want more socially responsible investments in their retirement plans.   In fact, 71% stated that they would contribute or increase their retirement plan contributions if their investments were socially responsible.  Amid this growing demand from plan participants, the DOL has provided guidance on ESG (environmental, social and governance) investments for retirement plans.

DOL Guidance on ESG Investments

In response to this increased demand for ESG investments, especially, for retirement plans, the Department of Labor (DOL) issued some guidance on April 23, 2018.  The Field Assistance Bulletin No. 2018-01 (FAB) updates previous DOL Interpretive Bulletins (IBs) IB 2015-01 and IB 2016-01 regarding ESG investments.

This FAB is of interest to plan sponsors as they respond to participant requests that their retirement plans include ESG investments. Essentially, the DOL guidance reinforces that plan sponsors should apply the same due diligence process in selecting ESG-type investments for retirement plans.

IB 2015-01, highlighted that in the process of investment selection when competing investments are economically equivalent, then plan fiduciaries can use ESG-related considerations as tie-breakers for an investment choice.

IB 2016-01, plan fiduciaries may engage in shareholder proposal activities if it may improve the corporation’s investment value, after considering the associated costs. It also indicates that Investment Policy Statements can include criteria for ESG factors, screening tools, metrics, or analyses to evaluate an investment.

The DOL’s FAB emphasizes that fiduciaries should prioritize the economic interests of the plan in providing retirement benefits.  It should not dramatically forego investment returns or assume greater investment risks to meet ESG criteria.  It is not mandatory that investment policy statements contain guidelines on ESG investments or integrate ESG-related tools to comply with ERISA.  However, it may still be best practice to document acceptable criteria for ESG investments so that fiduciaries understand the criteria for quality ESG investments.  The DOL cautions fiduciaries against routinely incurring substantial plan costs to actively sponsor proxy fights on environmental or social issues.

Types of ESG Funds

The DOL identified different types of ESG funds such as Socially Responsible Index Fund, Religious Belief Investment Fund, or Environmental and Sustainable Index Fund.  There ae also conventional funds not explicitly identified as ESG funds that consider ESG factors in their selection criteria and portfolio management.

ESG Investments in 401(k) and 403(b) Plans

The DOL confirmed that including ESG funds in retirement plan investment fund menus that reflect the participants’ social value is permissible. Like any other fund selected for a retirement plan, it should be prudently evaluated, professionally managed, and well diversified.  The inclusion of ESG funds should not exclude other non-ESG funds that provide additional diversification.

ESG Investments in QDIA

The FAB addresses the selection of a qualified default investment alternative (QDIA) to which participants may be automatically defaulted.  The selection of a QDIA is not the same as simply adding an ESG fund to the investment line-up where participants can make choices.

The selection of an ESG-themed target-date fund as a QDIA would not be prudent if the fund provided a lower risk/return profile than non-ESG target-date funds.

DOL discourages the use of ESG-only investment options as QDIAs. However, this does not preclude the selection of a QDIA that has an ESG-fund in the mix of other non-ESG funds as part of the underlying funds.

Investment Policy Statements

The FAB indicates that when the retirement plan’s Investment Policy Statement (IPS) includes guidelines for ESG investments, an investment manager is still responsible to determine if the ESG factors in the IPS are consistent with ERISA.  At times, investment managers may not be able to comply with the IPS if it is not consistent with ERISA.  Best practices, however, would be for the investment manager to point out these inconsistencies to the plan fiduciaries rather than blatantly violate the IPS.

Proxy Voting and Shareholder Engagement

The FAB emphasizes that the costs of shareholder engagement and proxy voting is important and it would be inappropriate for ERISA fiduciaries to routinely incur significant plan expenses.  This is consistent with IB 2016-01 that indicates that ERISA plans involved in proxy voting and shareholder engagement may comply with a fiduciary’s obligation under ERISA.  It also cautioned that fiduciaries should not engage in costly fund advocacy or actively sponsor expensive proxy battles on environmental or social issues concerning their specific corporate stock holdings.   

GAO Report in 2018

The Government Accountability Office (GAO) is expected to issue a report in 2018 on how US retirement plans should handle ESG investments and how other countries handle these investments.

Considerations for Plan Sponsors

Like any other investment decision, plan fiduciaries should maintain well-documented records regarding their evaluation, selection and decision to invest in an ESG fund.  They should consider the ESG investment based on its performance, reasonable fees, diversification, quality of the underlying investments, and sound investment principles.  Investments should not be solely focuses on the potential social benefit and impact.  Interestingly, as more investors embrace ESG factors in their investment selection, demand will typically rise for quality ESG companies which in turn may raise the performance of those investments. 

403(b) Fiduciary and Compliance Requirements

Nicholas Zaiko, CIMA®

Investment Consultant

Bridgebay Financial, Inc.

www.bridgebay.com

The Employee Retirement Income Security Act (ERISA) of 1974, enforced by the Department of Labor (DoL),  established fiduciary responsibilities for plan sponsors.   Although some retirement plans may not be subject to ERISA, it is still best practice to follow those high fiduciary standards when managing non-ERISA plans.  All ERISA and non-ERISA plans must also comply with IRS regulations.

IRS regulations, effective 2009, changed 403(b) plans from essentially employee-controlled and directed, tax-sheltered accounts to integrated, full-service retirement plans whereby the plan sponsor now has fiduciary responsibility and liability for the prudent operation of the plan for the benefit of the participants.

Plan Document

Since 2009, both ERISA and the IRS have required a written plan document for the 403(b) plan that includes detailed information on plan eligibility, benefits, contribution limits and distributions.  The plan document should be reviewed and updated periodically and be consistent with the operation of the plan.   The plan document is then communicated to participants through an updated summary plan description (SPD).

The plan's legal counsel should review the documentation and amend the plan document periodically as regulations change.  Plan sponsors can retain plan document services for creating, modifying or updating plan documents and remaining compliant with IRS and Department of Labor regulations.

Universal Availability

Employer-funded 403(b) plans must meet statutory universal availability requirements and pass nondiscrimination tests, including new rules for control groups.  The IRS requirements were established to ensure that all eligible employees have access to the plan and receive an equitable distribution of plan benefits without favoring highly compensated employees versus rank and file participants.

Reporting Requirements

ERISA 403(b) plans became subject to IRS Form 5500 (Annual Return/Report of Employee Benefit Plan) filing requirements.  403(b) plans with over 100 eligible participants at the beginning of the plan year, generally, must have their financial statements audited by an independent auditor.

Monitor Plan Transactions

Plan sponsors with multiple vendors should establish a process to ensure that contributions, distributions and other participant transactions meet their the IRS limits.  They should monitor participant transactions such as loans and hardship withdrawals across vendors to ensure they comply with IRS and DOL regulations.

Information sharing of transactions and participant-directed asset transfers are generally  limited to authorized fund providers that share information with the plan sponsor. Transaction monitoring helps the plan sponsor comply with IRS rules and ensures employee contributions and distributions are correct.

Plan sponsors can retain compliance monitoring services provided by recordkeepers to help minimize risk and ensure plan compliance in such areas as loan and hardship withdrawals, contribution limits, nondiscrimination and universal availability.

Sponsors should implement a process for notifying employees, as required, about plan eligibility, enrollment readiness, contribution limits, QDIAs and other information.

Noncompliance is Serious

Noncompliance can subject the plan sponsor and the participants to a range of adverse outcomes.  Depending on the severity of the violation, failing to comply with regulations may result in significant fines against the plan sponsor or even  disqualification of the entire plan, making all plan assets taxable.   

If the plan sponsor does not monitor or limit plan contributions or distributions, there may be penalties and taxes due for participants that exceed the IRS limits.

Governance

Every plan sponsor should strive to implement best practices in the administration and oversight of the 403(b) plan by establishing a comprehensive set of policies and procedures that are consistently followed.  Adherence to these procedures should support a well-thought out process that reduces fiduciary risk for plan sponsors.

Prudent oversight should encompass plan governance, rational plan design, consistent oversight and compliance.

Plan governance should be documented with policies that specify fiduciary responsibilities, accountability, roles, and procedures. For compliance purposes, specific roles should be clarified, documented and accountability established for varying responsibilities.

All designated fiduciaries should understand their status, duties and potential personal liability for any fiduciary breach.  The plan should have an Investment Committee that oversees the investments. An Administrative Committee would make decisions on plan design, benefits, and employer contributions.

Plan Design

Plan sponsors should review periodically the plan design to incorporate new features as regulations change, plan demographics evolve, and new services become available to the plan.  They should consider the impact of automatic enrollment, automatic deferral, re-enrollment and  automatic deferral increases as provided for under the Pension Protection Act of 2006 (PPA). 

Another design feature is to add a Qualified Default Investment Alternative (QDIA) to ensure that participant balances are properly invested when they do not make an investment selection for their contributions.

Investments

An investment policy statement establishes the guidelines for selecting and monitoring plan investments, 404 (c) compliance, plan fees and monitoring service providers. Fiduciaries should consider using experts such as independent retirement plan investment consultants that serve as fiduciaries to develop investment policy guidelines, assist with investment menu design and conduct annual investment reviews.

The investment options available to participants should ensure broad diversification to help balance risk and return for all investor types.

By following a prudent and consistent process to demonstrate how each investment was selected for the plan to benefit its participants, plan sponsors can meet their fiduciary obligations.  Once selected, investments should be monitored for performance against relevant benchmarks and fees.

A well-diversified fund menu should address the needs of different types of participants.  An investment line-up should include a variety of investment options, each with different objectives, benefits and risk profiles to serve a wide range of participant needs.  A good line-up would include a range of investment vehicles that enable the participant to create a unique asset allocation.  Asset allocation options are well-suited for participants that prefer to have their investment decision managed professionally.  Finally, guaranteed income options that are designed to provide retirement income may be an effective way to provide participants nearing retirement with a steady stream of income.

Education

Plan sponsors can provide education and advice for participants using a full range of educational programs that offer individual objective advice, webinars, publications, online tools and educational resources.  The quality, impartiality, and effectiveness of these programs should be monitored by the plan sponsor.

Annual Review

An annual plan review can identify areas for improvement and ensure that the plan is being operated effectively.  Reviews should cover areas such as plan participation, asset flows, service quality, cost, transaction activity, participant satisfaction, education, fees and investment performance. By consolidating multiple providers to a single provider, plan sponsors gain greater control, flexibility and cost-efficiency.  Plan sponsors’ role in meeting fiduciary and compliance requirements through an efficient and optimal plan design will produce better retirement outcomes for their participants.

Conclusion

The plan sponsor’s role as a fiduciary should focus on strategies that mitigate risks associated with fiduciary responsibilities and compliance issues.  The risk of not operating a 403(b) retirement plans in a compliant manner have increased as regulations continue to change and evolve.

Bridgebay, an independent retirement plan consultant is dedicated to advising plan sponsors and assisting plan sponsors in meeting their fiduciary and compliance obligations, offering plan design solutions with proven results and providing access to objective advice and guidance for employees.  Bridgebay serves as co-fiduciary to its plan sponsor clients.

403(b) Plans Can Follow the 401(k) Plan (ERISA) Model

Nicholas Zaiko

Investment Consultant

Bridgebay Financial, Inc.

www.bridgebay.com

Defined Contribution Plans Converge

In many respects a 403(b) plan is very similar to a 401(k) plan.  They both provide tax advantaged savings vehicles for employees, the major difference being the groups of employees.  403(b) plans are specifically designed for the employees of nonprofit organizations while 401(k) plans apply to employees of for-profit organizations.  Another major difference has been the level of regulation imposed on these two types of plans.  That difference however, is shrinking as recent IRS regulations have been pushing 403(b) sponsors to streamline administrative functions and take a more active fiduciary role in their plan.  A recent survey conducted by the Plan Sponsor Council of America (PSCA) revealed that the number of non-ERISA compliant 403(b) plans is shrinking as plan sponsors adopt ERISA compliance, in light of increased regulation.

Plan Enhancements

403(b) plan sponsors are realizing that a multi-provider, open-ended plan may not be the best type of arrangement for their participants.  While many believed this type of open arrangement absolved the sponsor of fiduciary responsibility, it is now clear that regulators do not believe that participants should be left to fend for themselves.  A 403(b) plan with multiple service providers has no consistency of message, education or investment products.  The IRS and DoL requirements on 403(b) plan sponsors, similar to those that have existed in the 401(k) market for years, provide an integrated retirement plan.   

Fortunately, 403(b) retirement plan sponsors have the ERISA-covered 401(k) plan model to help them comply with ERISA regulations and emulate the best practices and plan features in the 401(k) market.  Some of these enhancements include automatic enrollment, refining the core fund menu, consolidating service providers and improving and unifying the participant education and communication programs.

Fiduciary Responsibility

Evolving 403(b) regulations have required reporting on a plan basis and compelled 403(b) plan sponsors to take on more responsibility as fiduciaries of the plan.  As fiduciaries, employers may retain a retirement plan advisor as co-fiduciary to provide independent advice on the selection of plan providers, operation of the plan, participant education and investments available to participants.   An independent advisor assists the fiduciaries in implementing best practices and developing a prudent due diligence process in overseeing the plan. As in the 401(k) market, the employer negotiates with the plan sponsor on behalf of the participants, minimizing the potential for unsophisticated individuals to be taken advantage of by opaque and costly arrangements.  ERISA compliance also provides that the DoL and IRS with additional authority to oversee 403(b) plans.  The regulators want to see plan sponsors taking a much more active role in monitoring and overseeing the plan.

This additional oversight is similar to the requirements of a 401(k) plan and so an easy way to achieve this level of compliance is simply to establish the same type of due diligence process which is common in the 401(k) plan environment.  The solutions and best practices already exist so 403(b) plan sponsors can source the experience and knowledge of experts in the 401(k) industry and apply best practices to their 403(b) plan. 

Proper Documentation

Many plan sponsors successfully met the December 31, 2009 deadline to draft, approve and adopt a written 403(b) plan document.  This however, is only part of the requirement.  The IRS is also looking to see that the plan is in fact being operated in accordance with the plan document.  As part of their audit, the IRS may seek information from the payroll and human resources department to validate the operation of the plan.  Deviations from the stated plan document could highlight deficiencies with either the plan document or the plan administration.  As part of an annual review, be sure you can produce the 403(b) plan document and that it is consistent with the day-to-day operations of the plan.  Additionally, ensure that the plan document is consistent with the summary plan document (SPD) which is given to the plan participants.  

Focusing on Participants

Many 403(b) plans that have successfully transitioned to ERISA compliance now find themselves in the enviable position of refocusing energy away from compliance and on to participant outcomes.   

Plan sponsors are increasingly adding plan options such as target-date, target-risk and other investment vehicles designed to increase their participants' chances of reaching their retirement goals.  Administrative enhancements achieved by consolidating providers and streamlining operations free up valuable internal resources that can then be redeployed to enhance plan participation and participant education.

Conclusion

Though the challenges of bringing your 403(b) plan up to ERISA standards may seem imposing, take comfort in the knowledge that the solutions already exist and that once the transition has been completed, maintaining a properly documented due diligence process will yield numerous benefits to both the plan sponsor and the participants.  The most obvious benefits include reduced plan costs, enhanced participation, improved participant education and streamlined plan administration.