GOP’s Effort to Undo 401(k) ESG Rule Centers on Investment Ties

An obscure, 30-year-old test retirement plans use to break ties between substantially similar investment options has become the central focus of a Republican-led effort to undo the Biden administration’s ESG-friendly 401(k) rule.

The latest round of briefs in an appeals court battle challenging the US Labor Department’s environmental, social, and corporate governance regulation have zeroed in on revisions to the “tiebreaker standard,” which 26 red-state attorneys general say violates federal benefits law.

It’s the newest development in a political frenzy emerging over the role factors such as climate change or diversity, equity, and inclusion should play when Wall Street money managers make decisions on behalf of workplace pension or 401(k) investors. A decision in the case before the US Court of Appeals for the Fifth Circuit has the potential to set a precedent that could determine which funds are accessible and when participants and beneficiaries can sue their employers.

“How this gets interpreted and how you’re able to make decisions will directly impact how and when investment managers select investments,” said Bradley C. Fay, a Seward & Kissel LLP partner who counsels employee benefit plan clients on investment plan assets.

DOL’s tiebreaker allows retirement plan decisionmakers—called fiduciaries—to choose one investment over others based on “collateral benefits,” rather than simply risk-adjusted financial returns. Instructions on how to break ties have existed in agency guidance since at least 1994, but the Trump administration ramped up rhetoric over tiebreakers when it issued a set of anti-ESG rules in 2020.

The Biden administration has since tried to distance itself from that argument, eliminating the Trump rules shortly after the president took office and replacing them with the latest policy in an effort to eliminate the “chilling” effect DOL officials say it had on plan options.

“Trillions of dollars are on the line, and we’re counting on that money when we retire,” said Natalia Renta, senior policy counsel for corporate governance and power at the Americans for Financial Reform Education Fund.

A Rare Event

Arguments in the Fifth Circuit case have so far rested on how often retirement plan fiduciaries reach the conclusion that two or more investment options are truly identical.

EBSA’s latest reworking of the tiebreaker test expanded the definition of what can be considered a tie and eliminated the Trump administration’s requirements that fiduciaries clearly document how they selected collateral benefits to break a tie. Those actions put participants and beneficiaries at risk of losing their savings, appellants representing the state of Utah and 25 other Republican-leaning state governments said.

“The tiebreaker provision has always been controversial and thus does not reflect any settled understanding of the law,” the plaintiffs wrote in their January opening brief.

But attorneys for the government have an interest in positing a framework before the court that minimizes the frequency that tiebreakers occur, said Jason Levy, of counsel at Covington & Burling LLP.

Republican critics of the policy are relying on that single feature to try to undermine the entire rule, which otherwise allows ESG consideration when it’s financially material, the chief concern outlined under Employee Retirement Income Security Act of 1974 and US Supreme Court precedent, Levy said.

“I think it’s noteworthy that the appellants in their brief no longer seem to challenge that the main body of the investment standard is inconsistent with ERISA,” he said. “With that argument off the table, they’re now focused on an extremely minor real-world application of the rule, which exposes the gap between the requested relief of vacating the entire Biden rule based off a very narrow provision.”

In a surprising move in 2023, the red state attorneys general lost their initial claim in the right-leaning US District Court for the Northern District of Texas. Trump-appointed Judge Matthew Kacsmaryk concluded that ERISA was silent on using collateral benefits as a tiebreaker and deferred to the agency under the Chevron doctrine.

Room to Disagree

There’s still room for arguments against the department’s rule in the appeals battle, however, according to benefits advisers.

The administration hasn’t yet clearly outlined how fiduciaries selecting and monitoring investments on behalf of participants and beneficiaries can square their duty of loyalty with the use of collateral benefits to break a tie, said Michael Barry, a senior consultant at October Three Consulting LLC.

The fabric of fiduciary conduct as outlined under ERISA requires plan decision makers to act prudently, to diversify assets, and to be loyal to the individuals whose assets are under their care.

DOL’s late-March reply brief in the Fifth Circuit case outlines how tiebreakers can arise in the context of alternative investments that are usually only applicable to multiemployer pension plans. The agency offered an example of two otherwise equal construction projects a plan may be considering investing in.

But in the liquid financial markets 401(k)s tend to participate in, the DOL appears to assume that tiebreakers rarely come up, Barry said.

Disagreements between fiduciaries and plan participants do arise in the context of ESG investing, however. A high-profile example occurred in the Northern District of Texas in 2023 when an American Airlines Inc. pilot sued the company for exposing participants to ESG-tainted investment products.

“DOL’s position on this issue remains somewhat obscure,” Barry said.

The department does contemplate the universe of collateral benefits extending beyond ESG considerations to go as far as including measures that would increase participation and participant deferrals into the plan, Seward & Kissel’s Fay said. That’s a clear indication that, where questions regarding a fiduciary’s intentions may arise, loyalty to participants and beneficiaries can be factored, he added.

“The best plan fiduciaries are considering that as an option,” Fay said.

The case is Utah v. Su, 5th Cir., No. 23-11097, apellee’s brief filed 3/21/24.