Protecting Retirees While
Encouraging
Economically Targeted
Investments
Jayne Elizabeth Zanglein *
The ongoing debate over
economically targeted
investments is primarily
about power and politics and
only secondarily about
•
pensIons.
Introduction
The ongoing debate over economically targeted investments
is primarily about power and politics and only secondarily about
pensions. Although the issue is complicated by political and
moral perceptions, it is the law which governs the investment of
pension plan assets in the fmal analysis. Therefore, the question
is not whether it is morally or politically proper to use pension
fund monies to create affordable housing, to finance expansion
of the infrastructure, or to provide seed money to promising
fledgling businesses. Instead, the question is whether these types
of investments are legal under the Employee Retirement Income
Security Act of 1974 (ERISA).I
Critics ofeconomically targeted investments argue that these
investments are illegal under ERISA. But clearly this is not the
case. In its recent interpretive bulletin, the Department of Labor
restated its long-standing position 2 that "all things being equal", 3
pension plan fiduciaries may consider collateral benefits when
deciding between investments with commensurate risk and return
characteristics.
The controversy over economically targeted investments has
been fueled by the sheer size ofpension funds ($4.8 trillion), 4 the
availability of these funds to finance economic development in
a time of reduced government spending, the encouragement of
ETls by the current administration, the public fmancing of a
clearinghouse on ETls, and the few highly-publicized cases in
which public pension funds have lost money in economically
targeted investments. These events have motivated opponents
ofETls to mount a legislative attack against the Department of
Labor.
In March 1995, the General Accounting Office prepared a
report entitled Public Pension Plans: Evaluation of
Economically Targeted Investment Programs s that addressed the
investment of nonfederal public pension plans in economically
targeted investments. The report concluded that because public
pension plans invest a limited amount in ETls, "the risk posed to
public pension plans by ETl investments is relatively small.,6
In May 1995, the Joint Economic Committee on
Economically Targeted Investments of the United States
Congress held a hearing on economically targeted investments7
in response to H.R. 1594, a bill introduced by Representative
Saxton which would "place restrictions on the promotion by the
Department of Labor ... of economically targeted investments
in connection with employee benefit plans.'~ Most of the
witnesses who testified urged the Department to revoke its policy
on ETls. 9 Another hearing was held in June 1995, this time by
the House Subcommittee on Employer-Employee Relations. 10 In
September, the House passed H.R. 1594 and one day later the
Jayne Elizabeth Zanglein is a Professor ofLaw at Texas Tech
University School ofLaw in Lubbock, Texas.
47
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Senate appropnatlOns subcommittee incorporated into its
appropriations report portions of S. 774, a bill designed to ban
the promotion of ETIs by the Department of Labor.ll At the
same time, the Joint Economic Committee issued a report
entitled The Economics ofETls: Sacrificing Returnsfor Political
Goals. 12 The report concluded that on average, ETIs earn two
percentage points less than traditional investments. This
allegedly translates into a lifetime loss of $43,298 per participant.
The Department of Labor has attacked the report because it is
based on the flawed assumption that pension investors are legally
permitted to make below-market investments.
In October 1995, the Heritage Foundation issued a booklet
called "How to Close Down the Department of Labor.,,13 In its
report, the Foundation suggested that Congress transfer the
Pension and Welfare Benefit Administration to Social Security. 14
The Foundation also suggested that Congress abolish the
Economically Targeted Investment Clearinghouse as it is
"misguided and jeopardizes the safety of pension plan assets.,,15
Against this backdrop of controversy surrounding the
Department of Labor's interpretive bulletin on economically
targeted investments, it is important to analyze the legality of
ETIs within the larger political context. This article analyzes
economically targeted investments in a historical, legal, and
political context.
The Law: Nothing New
ERISA section 404(a)( 1)(A) establishes the exclusive benefit
rule. 16 The exclusive benefit rule requires fiduciaries to act solely
in the interests of plan participants and beneficiaries and for the
exclusive purpose of providing plan benefits and defraying
reasonable expenses of plan administration. 17 Opponents of
economically targeted investments cite this statutory language as
evidence that economically targeted investments are inherently
unlawful.
The exclusive benefit rule establishes a duty of undivided
loyalty - an extremely high standard of care. IS The exclusive
benefit rule is duplicated in the Internal Revenue Code l9 and the
Taft-Hartley Act.20 Yet neither the Department of Labor nor the
Internal Revenue Service has ever interpreted the exclusive
benefit rule as prohibiting "incidental" or "collateral" benefits.
The Internal Revenue Code's version ofthe exclusive benefit
rule is found in I.R.C. section 40 1(a)(2). 21 Under this rule it must
be impossible for any part of the plan assets to be ''used for, or
diverted to, purposes other than ... the exclusive benefit of ...
[the] employees or their beneficiaries."22 Violation of this rule
may result in disqualification of the plan.23
Initially, the Internal Revenue Service interpreted the
exclusive benefit rule to prohibit all "objects or aims not solely
designed for the proper satisfaction of all liabilities to employees
or their beneficiaries."24 Later, when the IRS realized that this
48
rule was unworkable, it modified the rule to express a more
realistic interpretation of the exclusive benefit rule: the primary
purpose test. If the primary purpose of the investment is to
benefit plan participants fmancially, the exclusive benefit rule
does not preclude others from deriving a benefit from the
transaction. 25 Investments must meet four conditions: "(1) the
cost must not exceed fair market value at the time ofpurchase; (2)
a fair return commensurate with the prevailing rate must be
provided; (3) sufficient liquidity must be maintained to permit
distributions in accordance with the terms of the plan; and (4) the
safeguards and diversity that a prudent investor would adhere to
must be present.,,26 If these conditions are met, the fiduciary's
motivation for selecting the investment becomes irrelevant.
In Revenue Ruling 71-391,27 the IRS noted that although
plans must adhere to the exclusive benefit rule, "[t]his
requirement, however, does not prevent others from also deriving
some benefit.,,28 Courts have agreed with the IRS that the
exclusive benefit rule is not meant to be interpreted literally.29
One district court explained that "by adopting the 'exclusive
purpose' standard, Congress did not intend to make illegal the
fact of life that most often a transaction benefits both parties
involved."30
The Department's Long-Standing Position
Congress tailored ERISA's exclusive benefit rule after the
IRC's exclusive benefit rule. 31 The Department of Labor has
consistently interpreted ERISA's exclusive benefit rule as
prohibiting fiduciaries from subordinating retirement assets to
''unrelated activities.,,32 But the Department has never stated that
all incidental or collateral benefits are prohibited.
The
Department has specifically stated that:
There is nothing in ERISA, however, requiring that an
investment decision be wholly uninfluenced by the
desire to achieve social or incidental objectives if the
investment, when judged solely on the basis of
economic value to the plan, is equal or superior to
alternative investments otherwise available.33
This basic statement of philosophy has remained virtually
unchanged over the last twenty years. It has remained intact
throughout the Carter, Reagan, Bush, and Clinton administrations
in spite of the different political philosophies on ETIs expressed
by these administrations.
The rule was announced by Ian Lanoff, the first
administrator of the Pension and Welfare Benefits Program.
Lanoff, a Carter appointee, said that although the exclusive
benefit rule "does not exclude the provision ofincidental benefits
to others, the protection of retirement income is, and should
continue to be, the overriding social objective governing the
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Economically Targeted Investments
investment of plan assets.,,34 However,
Lanoffwas cautious in providing guidance to
trustees who wished to pursue social
objectives with pension fund assets
(primarily, at that time, union construction).
Under Lanotrs guidance, the Department
aggressively commenced litigation against
trustees of funds who implemented
innovative investments and advocated "social
investing."35
Lanoff tempered the
Department's position on social investment
by warning trustees that "[t]o introduce other
social objectives may be to dilute this
primary objective [of protecting retirement
income]."36
The Department of Labor's position
under the direction of Lanoffbecame known
as the "all things being equal" test. Under this
test, "a fiduciary might choose on the basis of non-economic
considerations between two alternatives which in his judgement
were economically equally advantageous.,,37 A plan fiduciary is
not permitted to consider non-economic factors if"the investment
or investment course of action provide[s] the plan with less
return, in comparison to risk involved, than comparable
investments or investment courses of action available to the plan;
or alternatively, involve[s] greater risk to the security of plan
assets than such other investment or investment courses of action
offering similar return.,,38
Each of Lanotrs successors has taken a similar position.
Robert Monks, a Reagan appointee, was supportive of collateral
benefits during his short tenure at the Department of Labor. He
noted that "Congress, speaking through ERISA, stated that
investment objectives that provide the greatest return to the plan
consistent with acceptable risk must be paramount. However,
that does not mean that plans must ignore deeply felt social views
when faced with investment of equal investment merit.,,39
Jeffrey Clayton, a Reagan appointee, said that "[w]hile [the
exclusive benefit rule] does not exclude the provision of
incidental benefits to others, the protection of retirement is, and
must continue to be, the overriding social objective governing the
investment ofplan assets.... [I]nvestment performance may not
properly be sacrificed in order to advance the social welfare of a
group or region; however, an investment is not impermissible
under ERISA solely because it has social utility.'>4O
In 1986, Clayton's successor, Dennis Kass, another Reagan
appointee said:
The controversy
over economically
targeted
investments has
been fueled by the
sheer size of
pension funds ($4.8
trillion).
The view that non-economic benefits may be achieved
incidental to the proper investment of pension funds is
one of long standing under both the Internal Revenue
Code prior to the passage of
ERISA and under ERISA.
Clearly, to prohibit such benefits
where the provisions of the law
have been scrupulously ~dhered to
would unnecessarily constrain
fiduciaries in the exercise of their
Such a
investment duties.
prohibition could result in specific
investment opportunities being
avoided by fiduciaries simply in
order to avoid the possibility of an
incidental benefit arising from
them. 41
David Walker, a Reagan appointee,
stated "that under ERISA, pension plan
investments must be made based upon what
is in the economic interest of the plan as a
separate and distinct legal entity established for the purpose of
providing retirement income, that other considerations can be
considered provided that they are incidental and do not
compromise the required investment decision.,>42
David George Ball, a Bush appointee, was conservative in
his approach to economically targeted investments. Nevertheless,
during his tenure he wrote: "Since the enactment of ERISA in
1974, the Department has consistently stated its position that
ERISA's rules are flexible enough to permit plans to invest in
areas of the economy that are most appropriate for each
individual plan's circumstances. In fact, our regulations ...
adopted a broad interpretation of ... [prudence] precisely for the
purpose of encouraging plan fiduciaries to look beyond the
traditional types of trust investments."43 Ball cautioned that "[i]t
is axiomatic, however, that plan fiduciaries, in order to be
prudent, must achieve a rate of return that is appropriate for the
degree of risk involved. To do otherwise would, in effect,
subsidize certain investments at the expense of market place
discipline.'>44
Olena Berg, a Clinton appointee, is the most vocal of the
departmental spokespersons on economically targeted
investments. Under her guidance in June 1994, the Department
of Labor issued Interpretive Bulletin 94_1 45 in an effort to clarify
the Department's long-standing policy that all things being equal,
a pension plan may make an investment which contains a
collateral or social benefit. The interpretive bulletin does not set
any new conditions or special requirements for economically
targeted investments. The Department specifically stated in the
bulletin that "[t]he fiduciary standards applicable to ETIs are no
different than the standards applicable to plan investments
generally.'>46 The Department restated its position that a
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fiduciary may invest plan assets in an ETI "if the ETI has an
expected rate of return that is commensurate to rates of return of
alternative investments with similar risk characteristics that are
available to the plan, and ifthe ETI is otherwise an appropriate
investment for the plan in tenns ofsuch factors as diversification
and the investment policy of the plan.'>!?
Why the Fuss?
If Interpretive Bulletin 94-1 does nothing more than clarify
the Department's long-standing position on economically
targeted investments, then why all ofthe fuss? Numerous events
have impelled the subject ofETIs to a political forefront.
First, the size of pension fund assets has made the issue
increasingly more important. In the late 1970s, when the issue
was first addressed by the Department of Labor, pension plan
assets totaled $500 billion.48 Since then, plan assets have
increased nearly ten-fold. Although only a very small
percentage of plan assets is invested in ETIs, this small
percentage is expressed as billions of dollars. Certainly,
billions excite politicians, the public, and reporters more than
millions.
Second, the failure of some public pension fund ETI
programs has been highly publicized. Politicians have seized
on these failures to justify changes to ERISA, a law which does
not even govern public plans. 49
Third, times have changed. Over the last twenty years, the
public has seen the effects of underfunded pension plans,
savings and loan scandals, corporate takeovers and downsizing,
insurance annuities invested in junk bonds, fund investments in
derivatives, and state treasurers who adjust actuarial rates of
return in order to reduce pension plan contributions. Most of
these concerns have been addressed through legislative efforts,
but the cumulative effects are great. With the help of the media,
retirees are worried about their retirement security.
Fourth, Republicans are suspicious that Robert Reich and
Olena Berg, both appointed under Clinton, are encouraging
pension funds to invest in ETIs to fill the gap created by
reduced government spending. President Clinton, in his book,
Putting People First,50 called for increased investment by
pension funds and other institutional investors in infrastructure.
Although the Department's issuance ofInterpretive Bulletin 94I simply restated the Department's long-standing position on
the pennissiblity of considering collateral benefits, it was
inevitable that a Republican-controlled Congress would move
swiftly to quash the Department's efforts.
The Saxton bill, H.R. 1594, initially languished despite
Saxton's outraged cries, until the Republican leadership latched
onto it apparently in an effort to divert attention from their
proposals to cut Medicare spending. Suddenly, the Republican
leadership started to take the Saxton bill seriously, leading some
cynics to believe that it was used as a smokescreen to shield the
50
huge Medicare and Medicaid cuts proposed by the
Republicans. 51
ETIs Defined
Interpretive Bulletin 94-1 defines "economically targeted
investments" as "investments selected for the economic benefits
they create apart from their investment return to the employee
benefit plan."52 Common examples of collateral benefits
derived from ETIs include "expanded employment
opportunities, increased housing availability, improved social
service facilities, and strengthened infrastructure.',53
In a recent article published in the Berkeley Journal of
Employment and Labor Law, Professor Edward Zelinsky
criticized the Department's interpretive bulletin. Professor
Zelinsky contended that "if the concept of collateral benefit is
broad enough to encompass all of the externalities conceivably
generated by traditional investments, then the ETI category
loses meaning because it includes the entire universe of
traditional investments."S4 This argument misses the critical
point of the interpretive bulletin. Interpretive Bulletin 94-1
clearly states that economically targeted investments (i.e. those
that create a collateral economic benefit other than the
investment return to the plan) are pennissible investments "ifthe
ETI has an expected rate of return that is commensurate to rates
of return of alternative investments with similar risk
characteristics that are available to the plan, and if the ETI is
otherwise an appropriate investment for the plan in tenns ofsuch
factors as diversification and the investment policy of the
plan."55 This is an updated version of the all things being equal
test: all things being equal, a plan may choose an economically
targeted investment over a traditional investment.
The interpretive bulletin makes clear that "[t]he fiduciary
standards applicable to ETIs are no different than the standards
applicable to plan investments generally.'156 Thus, the general
fiduciary standards of ERISA section 404(a)(1)5? apply equally
to ETIs. It is true that most investments can be categorized as
economically targeted investments in a very general sense.
However, the Department of Labor, in its interpretive bulletin,
does not categorize ETIs as a particular class of investments.
Instead, the Department defines ETIs through the investment
selection process. An investment is deemed an economically
targeted investment only if the investment was "selected for the
economic benefits [it] create[s] apart from [its] investment return
to the employee benefit plan.'158
Under the "all things being equal test," a fiduciary can
choose an investment that offers a collateral benefit if the
fiduciary has acted prudently and has received a competitive rate
ofreturn. The test makes irrelevant the fiduciary's motivation for
selecting the investment if otherwise "all things are equal".
Instead, the focus is on the decision-making process under the
prudence rule.
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Economically Targeted Investments
For example, plan trustees might decide
to invest in XYZ Corporation, a minorityowned business, simply because it has an
expected investment return which is superior
to all other available investment opportunities
with similar risk characteristics. The trustees
might not know or even care that it is a
minority-owned business. In that case, the
investment is not an ETI, even though it may
indirectly create expanded employment
opportunities for minorities.
However, if the plan trustees choose to
invest in XYZ Corporation because it is a
minority-owned business which has an
expected investment return which is equal or
superior to all other investment opportunities with similar risk
characteristics, then the investment is an ETI. The genesis for the
interpretive bulletin is not the premise that investments which
create collateral benefits should be classified differently than
other investments. Rather, investments which create collateral
benefits are regarded as ETls only if they are selected in part
because they provide incidental or collateral benefits. If the
investment is expected to earn a risk adjusted market rate of
return, then the trustee's motivation is irrelevant. However, the
prudence rule is always relevant; all investments, whether ETls
or not, must meet ERISA's prudence rule.
In his article critical ofETls, Professor Zelinsky concluded
that the Department has ''wholehearted[ly] embracerd) incidental
economic benefits as legitimate criteria upon which pension
trustees can base their investment choices."59 This is simply not
what the interpretive bulletin says. Instead, Interpretive Bulletin
94-1 states that investments that create incidental benefits are
permissible only if the expected return is commensurate with
alternative investments with similar risk characteristics. It is not
necessary to quantify the economic value of the collateral benefit
because the investment return must equal or exceed alternative
investments with commensurate risk characteristics without
regard to the economic value of the collateral benefit.
not grant relief from the exclusive benefit
rule.
Prohibited transaction exemptions are
not designed or authorized to exempt
fiduciaries from compliance with the
exclusive benefit rule. ERISA section
408(a) provides that the Department may
provide relief only from the restrictions of
ERISA sections 406 and 407(a), not the
exclusive benefit rule. 63 Exemptions may
not be granted with respect to the exclusive
benefit rule, therefore, it is impossible for
the Department to cite any exemptions that
directly support its position that collateral
benefits per se do not violate the exclusive
benefit rule. Even though the Department cannot grant
exemptions from the exclusive benefit rule, it would be unwilling
to grant a prohibited transaction exemption if the proposed
transaction would possibly violate the exclusive benefit rule.64
The Department cited exemptions that involved transactions that
were designed to create collateral benefits. In each of the cited
exemptions except the first one, the Department restated its
position on the exclusive benefit rule: an incidental benefit
cannot be considered unless the investment would be equal or
superior, in economic value to the plan (apart from collateral
benefit), to alternative investments with the same degree of risk
available to the plan. The flip side ofthis rule is that an incidental
benefit can be considered if the investment meets the "all things
being equal test". The prohibited transaction exemptions thus
clearly support the Department's statement that its position on
incidental benefits has remained unchanged. 65
Likewise, the argument that the advisory opinions cited in
the interpretive bulletin "provide, at most, limited support for IB
94-1"66 is unpersuasive. The advisory opinions were not cited to
provide independent authority, but as examples of the
Department's long-standing attitude on incidental benefits.67
Professor Zelinsky further maintains that the Department has
unjustifiably diluted the exclusive benefit rule by "declaring that
pension trustees must 'ordinarily' concern themselves with the
retirement income interests of participants and beneficiaries.'>68
I suggest, however, that Professor Zelinsky has quoted this
language out of context. The full text reads:
The exclusive
benefit rule
establishes a duty of
undivided loyalty an extremely high
standard ofcare.
Evidence of the Department's Long-Standing Position
Critics of economically targeted investments such as
Professor Zelinsky also maintain that the administrative rulings
cited by the Department of Labor in Interpretive Bulletin 94-1
"belies any contention that IB 94-1 is the codification of wellestablished or convincing administrative precedent.'>60 For
example, Professor Zelinsky believes that the seven prohibited
transaction exemptions cited in the preamble to Interpretive
Bulletin 94_1 61 as support for the Department's long-standing
position on collateral benefits are, "at best, unpersuasive and, at
worst, disingenuous"62 because these particular exemptions did
We have construed the requirements that a fiduciary act
solely in the interest of, and for the exclusive purpose of
providing benefits to, participants and beneficiaries as
prohibiting a fiduciary from subordinating the interests
of participants and beneficiaries in their retirement
income to unrelated objectives. Thus, in deciding
whether and to what extent to invest in a particular
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investment, a fiduciary must ordinarily consider only
factors relating to the interests of plan participants and
beneficiaries in their retirement income. A decision to
make an investment may not be influenced by [a desire
to stimulate the construction industry and generate
employment] unless the investment, whenjudged solely
on the basis of its economic value to the plan, would be
equal or superior to alternative investments available to
the p1an. 69
Read in this context, the Department makes clear that plan
trustees will ordinarily have no reason to consider collateral
benefits. Trustees may consider collateral benefits only if the
investment is economically equal or superior to alternative
investments with risk-adjusted market rates of return. The
"ordinarily" language does not dilute the statutory language; it is
consistent with the Department's position on incidental benefits.
Are Things Ever Really Equal?
If the Department's position on economically targeted
investments is susceptible to criticism, it is most susceptible on
the "all things being equal" test. The question is: are things ever
really equal? Economists tell us that risk and return can be
quantified and compared, but are any two economically targeted
investments ever really equal? Presumably, an investment in a
six month certificate of deposit at 5.5% is equal to another
certificate issued by the same bank at the same rate and with the
same maturity date. But is it possible to say with certainty that
an investment in affordable housing has the same risk and return
characteristics as an investment in a private placement?
Certainly economists can make such evaluations controlling for
variables and assuming away real world choices. They are
obligated to compare apples to oranges everyday. But the test
defies logic and experience for most pension fiduciaries.
Let us take an easy example. A pension fund is considering
six possible real estate investments. Five of the six investments
will use non-union labor; the sixth will use union construction.
All six investments might be considered ETls in a very broad
sense; however, only the sixth investment is likely to be regarded
as an ETl by the Department of Labor. Suppose the fund hires
an investment advisor who rejects potential investments two
through five and concludes that the first and sixth potential
investments have a commensurate risk-adjusted market rate of
return. The trustees decide to invest in number 6 because not
only is it economically equal to investment number 1, but it
provides a collateral benefit of jobs for union members.
Investment number 1 is not an ETl; investment number 6 is an
ETI. Prospectively, the two are economically equivalent. Under
the "all things being equal" test, the trustees can remain true to
their first and foremost duty - the protection of retire-
52
ment income - while benefiting society through the positive
externalities generated by the investment, the creation ofjobs, in
this example.
Suppose we followed these two investments, and it turned
out that investment number 1 earned an annualized rate of return
of 8.2% while investment number 6 earned an annualized rate of
return of 9.1 %. This does not mean that the first investment
would not have been prudent. Prudence is not measured by
hindsight. 70 Of course, the mere fact that the investment number
6 earned 9.1 % does not mean it was more prudent. Prudence is
measured in terms of procedural prudence. In other words, did
the trustees adequately investigate the investment before
making their decision to invest?71 Both investments were
prudent. Investment number 6 was a better performer in dollars
and cents and, incidentally, it provided a collateral benefit of
union jobs.
In hindsight, it might turn out that investment number 1 was
more risky because it was picketed by union members. Again,
while economists may be able to predict that two investments are
equal in terms of risk and return, this is only a prediction. It may
be possible to manipulate numbers to arrive at equal numbers.
And what happens ifthe investments are substantially equivalent:
investment number 1 is projected to return 9.058% and number
6 is projected to return 9.041 %? Is it permissible to choose
investment number 6 anyway since the numbers are only a
projection?72 These real concerns remain unaddressed.
Filling Capital Gaps
Opponents of ETls argue that if economically targeted
investments are truly good investments then "market forces will
clear such investments without consideration of their collateral
benefits."73 This echoes the often-heard argument that "[I]fETls
were solid, sound and prudent, they would attract investors on
their own.,,74 This argument conveniently ignores market
inefficiencies and informational asymmetries that render
investors' decisionmaking more of an art than a science. It also
refuses to recognize well-documented capital gaps.75
The ERISA Advisory Council has described the problem of
capital gaps:
ETI programs are structured with an awareness that
underflnanced sectors of the economy do exist for
reasons independent of whether profit opportunities
exist.
Traditional investors may avoid capital
investments in certain sectors for various reasons,
ranging from human nature reflected in express
discrimination or lack of empathy, to dynamic shifts in
savings patterns over the course of years and a transfer
of capital assets from local banks to pension funds
managed by national investment managers. ETls are
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Economically Targeted Investments
investment opportunities that attempt
creatively to address these capital gaps, while
through financial engineering attempting to
ensure that the pension fund is not absorbing
unjustified risk or a compromised rate of
return. 76
One commentator explains the problems
created by an inefficient market:
common, though erroneous, belief that ETIs
are unlawful and fiduciaries fear personal
liability; and (4) the widespread publicity
that occurs when an investment goes bad. 82
The Department of Labor has attempted to
alleviate some of these problems through
the issuance of the interpretive bulletin and
the creation of the ETI Clearinghouse. 83
However, problems still persist due to the
nature and structure ofETIs. 84
A 1993 study by the Institute for
Fiduciary Education concluded that
economically targeted investing is growing
only modestly and the subject still elicits
strong opinions, both positive and negative,
from the pension fund community.85 In the
preamble to Interpretive Bulletin 94-1, the
Department recognized that "a perception
exists within the investment community that investments in ETIs
are incompatible with ERISA's fiduciary obligations."86 The
Department issued the interpretive bulletin "[i]n order to eliminate
this misconception"87 and encourage investments in ETIs.
In the survey on ETIs, the Institute for Fiduciary Education
asked 119 public pension funds to list reasons why they have not
made economically targeted investments. 88
Thirty-seven
percents9 of the funds stated that the principal reason they did not
invest in ETIs is because of perceived conflicts with fiduciary
duties. 90 Eleven percent said that ETIs take too much staff time;
11 % said ETIs are not statutorily authorized; 8% said that they
did not invest in ETIs because "no one asked us to invest in an
ETI;" 4% said that their legal counsel had advised against ETIs;
and 4% said they perceived no need for ETIs. 91 Thirty-eight
percent of the funds surveyed invested in ETIs;92 50 ETI programs
totaled $19.8 bi1lion. 93
The survey also found that liquidity of ETI investments and
the procurement of a competent asset manager tied as the most
difficult aspects ofETIs. 94 Over 14% of the funds experienced
great difficulty in each of these two areas. Other difficulties
included
risk/return
requirements,95
internal
staff
considerations,96 and political concerns. 97 Economist Teresa
Ghilarducci notes, "The main problem economically targeted
investors face is not the inherent riskiness or unprofitability of
economically targeted investments, but the excessive information
and transactions costs associated with an immature market."98
Lee Smith, Executive Director of Excelsior Capital
Corporation, a New York not-for-profit corporation established
by former Governor Mario Cuomo to encourage pension funds
to make economically targeted investments, also describes the
difficulties faced by pension funds who wish to invest in ETIs:
[W]hile typically
there is no capital
gap in financing
housing, there is a
consistent capital
gap with respect to
financing
affordable housing.
Implicit in the concept of an ETI is
the assumption that the market for
ETIs is imperfect.... In a perfect
market, the sponsors of a
worthwhile project will be able to
find qualified investors without
inordinate investment opportunities
that attempt creatively to address
these capital gaps, while through financial engineering
attempting to ensure that the pension fund is not
absorbing unjustified risk or a compromised rate of
return. 77
Numerous congressional hearings have been held on capital
gaps and economic development. 78 A recent study on Venture
Capital and Technological Innovation in Southern California
found "a significant'capital gap' in venture funding available for
companies based on Southern California."79 "[T]he study found
that fewer companies in the region received venture backing than
at any time in the past decade.,,80 New York also has taken steps
to alleviate its capital gap by raising a $20 million venture capital
fund. 81
Capital gaps sometimes exist only in certain segments of the
market. For example, while typically there is no capital gap in
financing housing, there is a consistent capital gap with respect
to financing affordable housing. The capital gap exists because
it is so difficult and time-consuming to put together an affordable
housing deal. Although government subsidies and foundation
investments make affordable housing possible, additional
fmancing is usually needed. Pension funds can provide
conventional market-rate fmancing to fill this gap, but it is not
easy. They need a clearinghouse that can gather and disseminate
general information about ETI consultants who specialize in
putting these types of deals together.
The opponents' argwnent also seems to ignore the historical
reluctance of pension plans to invest in ETIs. Plans have been
reluctant to invest in ETIs because: (l) they are typically time
consuming and complex investments; (2) there is a lack of
professional support to advise fiduciaries on ETIs; (3) there is a
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ETIs have existed over a decade and their creation and
implementation has often been a slow and arduous task.
This type of capital market innovation is not a well
developed practice nor is it well understood. . . .
Especially when first created, the design and
implementation ofETIs is labor intensive and a costly
process. Often times ETIs require ... the coordination
of several different parties that have previously not
worked together. Coordinating these various groups is
difficult work. And because of this necessary labor
intensity and the scale, the net fees from these
investments often cannot compete with those other
more established investment products....
While it is widely believed that this barrier will be
substantially reduced as vehicles become standardized,
it is unlikely that this will occur in the near future....
While it is not necessary to "start from scratch with
each investment," it is also incorrect to assume that all
ETIs are easily transportable.
A second impediment to full acceptance of the
legitimacy of ETIs is the lingering presence of mixed
signals from the DOL under previous administrations.
Many pension fund managers remain skeptical about
the legality ofETIs under ERISA. For fund managers
the possible negative consequences of an ERISA
violation far outweighed the potential benefits of
making an ETI. 99
ETIs are less common than they otherwise would be as a
result of the lack of a professional database or information
exchange on these types of investments. The 1992 Work Group
on Pension Investments to the ERISA Advisory Committee on
Pension and Welfare Benefit Plans "recognized that since ETIs
target investment opportunities reflecting inefficient markets,
these investments by nature do not start out as generically
standardized investments."IOO
The Work Group further
concluded that "[t]here is a lack of historical data on ETIs and
relatively weak incentives for private markets to create this
information. This gap hampers informed decision making and
impedes efforts to make those markets more efficient.,,101 The
Work Group recommended that "[t]he Department of Labor ..
. take the initiative in gathering information about the investment
performance and attributes to the pension community to aid its
investment decisions."102
The Department of Labor has responded to these concerns
by establishing the ETI Clearinghouse.103 The purpose of the
Clearinghouse is to serve as a resource for funds who wish to
develop an ETI program. The Clearinghouse plans to showcase
successful ETI programs developed by public and private
pension funds and prepare case studies of ETIs in the United
54
States, "cross-referenced by investment category and collateral
benefIt."I04 The Clearinghouse will serve a valuable function as
an information gathering center. This will help improve the
market for ETIs. Greater information, of course, makes any
market more efficient. Yet, through H.R. 1594 and the current
appropriations bill, legislators are attempting to dismantle the
Clearinghouse. If this happens, ETIs will remain an inefficient
market.
Prudence: The Bottom Line
The bottom line is that all pension fund investments must be
prudent. lOS Below-market returns are never acceptable and the
Department recently reaffirmed that it will aggressively sue any
plan fiduciaries that engage in below-market or otherwise
imprudent investments. 106 This is another long-standing tradition
of the Department of Labor.
The prudence rule protects retirees by requiring that all plan
investments be made ''with the care, skill, prudence, and diligence
under the circumstances then prevailing that a prudent man acting
in a like capacity and familiar with such matters would use in the
conduct of an enterprise of a like character and with like aims." 107
According to regulations adopted by the Department, a fiduciary
must act only after giving appropriate consideration to:
facts and circumstances that, given the scope of such
fiduciary's investment duties, the fiduciary knows or
should know are relevant to the particular investment or
investment course of action involved, including the role
the investment or investment course of action plays in
the portion of the plan's investment portfolio with
respect to which the fiduciary has investment duties. los
When considering an investment, the fiduciary must
determine whether the investment reasonably furthers the
purposes ofthe plan, taking into consideration the risk ofloss and
the opportunity for gain. 109 The fiduciary must consider the
following factors in relation to the entire portfolio:
(1) the composition ofthe portfolio with regard to
diversification;
(2) the liquidity and current return of the portfolio
relative to the anticipated cash flow requirements of the
plan; and,
(3) the projected return of the portfolio relative to
the funding objective of the plan. I10
The Department of Labor has added a fourth factor:
"consideration of the expected return on alternative investments
with similar risks available to the plan."1l1 The Department
clarified this factor in Interpretive Bulletin 94-1:
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[B]ecause every investment necessarily causes a plan to
forgo other investment opportunities, an investment will
not be prudent if it would be expected to provide a plan
with a lower rate of return than available alternative
investments with commensurate degrees of risk or is
riskier than alternative investments with commensurate
rates of return. 112
The prudence rule sufficiently protects retirees from
inappropriate, below-market investments.
Withdrawal of
Interpretive Bulletin 94-1 will not give retirees any additional
protections.
Conclusion
Because Interpretive Bulletin 94-1 simply restates the
Department's long-standing policy on collateral benefits, it
should not be repealed by Congress. The repeal of the
interpretive bulletin would only confuse the issue. The enactment
ofH.R. 1594 or S. 774 would be unworkable and would threaten
many transactions entered into over the last twenty years based
on statutory, individual, and class exemptions. The ramifications
of such legislation would be far-reaching and undesirable. 1I3 A
reversal of Interpretive Bulletin 94-1 is neither desirable nor
necessary. ERISA makes clear that all pension investments must
be prudent. The Department has made clear that the "protection
of retirement income ... [must] ... be the overriding social
objective governing the investment of plan assets" and the
Department has aggressively sued trustees who violate ERISA's
fiduciary rules. No further protections are necessary.
Notes
* The author would like to thank Professor Thomas E. Baker
who provided incisive comments on this article.
1.
29 U.S.C. § 1102.
2.
The Department of Labor's position dates back to at least
1980, when Ian Lanoff, then Pension Administrator for the
Department of Labor stated that while ERISA "does not exclude
the provision of incidental benefits to others, the protection of
retirement income is, and should continue to be, the overriding
social objective governing the investment of plan assets." Ian D.
Lanoff, The Social Investment ofPrivate Pension Plan Assets:
May It Be Done Lawfully Under ERISA?, 31 LAB. L.J. 387, 389
(1980).
3. See PWBA Advisory Letter from Department of Labor to
Gregory Ridella (Dec. 19, 1988) (A.a. 88-16A) (stating that in
making investment decisions, plan fiduciaries may be influenced
by factors unrelated to the plan's expected investment return only
if such investments "would be equal or superior to alternative
available investments").
4. Economically Targeted Investments: Hearings on HR. 1594
Before the Joint Economic Comm., 104th Congress, 1st Sess.
(May 18, 1995) [hereinafter ETI Hearings] (statement of Olena
Berg, Asst. Sec. of Labor, Pension and Welfare Benefits
Administration).
5.
GAO, PUBLIC PENSION PLANS: EVALUATION OF
ECONOMICALLY TARGETED INVESTMENT PROGRAMS (1995).
6.
/d. at 28.
7. See Federal Document Clearing House Congressional
Testimony (May 18,1995).
8.
H.R. 1594, 104th Congress, 1st Sess. (1995).
9.
Republicans. Democrats Clash over ETIs at Hearing of
Joint Economic Committee, PENS. REp. (BNA), Vol. 22, No. 21,
at 1240 (May 22, 1995).
10. Economically Targeted Investments: Hearings on HR. 1594
Before the Subcomm. on Employer-Employee Relations of the
House Comm. on Economic and Educational Opportunities,
104th Congress, 1st Sess. (1995).
11. S. 774, 104th Congress, 1st Sess. (1995).
12. See Administration Attacks JEC Report That Calls ETIs
'Risky Investments', PENS. REP. (BNA), Vol. 22, No. 37, at 2046
(Sept. 18, 1995).
13. THE BACKGROUNDER, No. 1058, (The Heritage Found.) Oct.
19,1995.
14. Id. at 3.
15. Id. at 20.
16. 29 U.S.C. § 1104(a)(1)(A)(1995).
17. Id.
18. Fiduciaries must act "with an eye single to the interests of
participants and beneficiaries." Donovan v. Bierwirth, 680 F.2d
263, 271 (2d Cir. 1982), cert. denied, 459 U.S. 1969 (1982).
They may not place themselves in a position in which they are
required to compromise their duty of undivided loyalty to plan
participants. Id.
19. I.R.C. § 401(a) (1995).
20. Labor Management Relations (Taft-Hartley) Act
§ 302(c)(5); 29 U.S.c. § 186(c)(5) (1995).
21. I.R.C. § 401 (a)(2) (1995).
22. Id.
23. Winger's Dep't Store, Inc. v. Commissioner, 82 T.C. 869
(1984).
24. 26 C.F.R. § 1.401-2(a)(3) (1995).
25. Rev. Rul. 69-494, 1969-2 C.B. 88.
26. Id.
27. Rev. Rul. 71-391, 1971-2 C.B. 186.
28. Id.
29. Central Motor Co. v. United States, 583 F.2d 470,490 (10th
Cir. 1978); see also Bing Management Co. v. Commmisioner, 36
T.C.M. (CCH) 1633, 1636 (1977).
30. Donovan v. Walton, 609 F.Supp. 1221, 1245 (S.D. Fla.
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1985), ajJ'd sub nom. Brock v. Walton, 794 F.2d 586 (11th Cir.
1986).
31. CONF. REp. No. 1280, 93d Cong., 2d Sess. 302 (1974),
reprinted in 1974 U.S.C.C.A.N. 5038, 5083. A fiduciary who
meets ERISA's exclusive benefit rule will be deemed to have met
the IRC's parallel provision. Id.
32. Letter from Department of Labor to Helmuth Fandl,
Chairman of the Retirement Board of Avon Products, Inc., at n.
4 (Feb. 23, 1988), reprinted in PENS. REP. (BNA) Vol. 15, No.9,
at 391 (Feb. 29, 1988).
33. Dennis Kass, Assistant Secretary of Labor, Pension and
Welfare Benefits Administration, Current Developments at the
Department of Labor, Address at the Annual Conference in Las
Vegas, Nev., sponsored by the Int'l Found. ofEmployee Benefits
Plans (Nov. 1986), reprinted in INT'L FOUND. OF EMPLOYEE
BENEFITS PLANS, EMPLOYEE BENEFITS ANNuAL, 235, 236 (1987).
34. Lanoff, supra note 2, at 389.
35. See. e.g., Donovan v. Walton, 609 F. Supp. 1221 (S.D. Fla.
1985).
36. Lanoff, supra note 2, at 389.
37. Letter from Ian D. Lanoffto George Cox (Jan. 16, 1981).
38. Advisory Opinion 81-12.
39. Letter from Robert A.G. Monks to Olena Berg (May 8,
1995)
(quoting a speech given before the Florida
Labor/Management Council on December 7, 1984). See Loans
Must Be Appropriate For Plans Before Looking to Social Goals.
Monks Says, DAILY REpORT FOR EXECUTIVES (BNA), No. 240,
at A-I (Dec. 13, 1984).
40. Letter from Jeffrey N. Clayton to Daniel E. O'Sullivan
(Aug. 2, 1982).
41. See ETI Hearings (Prepared statement of Olena Berg.
Assistant Secretary ofLabor (quoting Dennis Kass )), supra note
4, at 6.
42. Pension Investments: Public Hearing Before the New York
State Pension Investment Task Force, 190-91 (Mar. 3, 1989)
(testimony of David Walker, Assistant Secretary for Pension and
Welfare Benefits, U.S. Department of Labor).
43. Letter from David George Ball to Preston Robert Tisch,
Chairman of New York City Partnership, Inc. (Jan. 30, 1991).
44. Id.
45. Department of Labor Interpretive Bulletin 94-1 on
Economically Targeted Investments, 59 Fed. Reg. 32,606 (June
23, 1994) (to be codified at 29 C.F.R. § 2509.94-1) [hereinafter
Interpretive Bulletin 94-1].
.
46. Id.
47. Id.
48. Jack Eagan, Pension Fund Managers Maintain Cautious
Attitude on Stock Market, WASH. POST, Nov. 12, 1978, at L4.
49. Public pension funds are not governed by ERISA. They are
governed by state law but are subject to the Internal Revenue
Code's exclusive benefit rule.
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50.
See BILL CLINTON, PUTIING PEOPLE FIRST (1992).
Anti-ETI Bill Picks Up Steam in the Senate Appropriations
Process, PENS. REp. (BNA), Vol. 22, No. 37, Sept. 18, 1995, at
2044,2046.
52. Interpretive Bulletin 94-1, supra note 45.
53. Hearing on Pension Investments and Economic Growth
Before the Joint Economic Committee on Economically Targeted
Investments, 103 Cong., 2d Sess. (1994) (testimony of Olena
Berg, Assistant Secretary of Labor), reprinted in Federal
Document Clearing House Congressional Testimony (June 22,
1994).
54. Edward A. Zelinsky, ETL Phone the Department ofLabor.
Economically Targeted Investments. IB 94-1 and the
Reincarnation ofIndustrial Policy, 16 BERKLEY J. EMP. & LAB.
L. 333, 341 (1995).
55. Interpretive Bulletin 94-1, supra note 45.
56. Id.
57. 29 U.S.C. § 1104(a)(1) (1995).
58. Interpretive Bulletin 94-1, supra note 45.
59. Zelinsky, supra note 54, at 343.
60. Id. at 344.
61. Interpretive Bulletin 94-1, supra note 45, at n. 3.
62. Zelinsky, supra note 54, at 345.
63. 29 U.S.C. § 1108(a) (1995).
64. ERISA § 408(a) requires the Department to make a fmding
that the exemption is in the interests of the participants and
beneficiaries and adequately protects their rights. In recent
congressional testimony, Assistant Secretary ofLabor Olena Berg
said, "If ERISA were interpreted to state that the exclusive
purpose requirements of ERISA were per se violated by a plan
entering into a transaction that requires a section 408 exemption
because it provides an incidental benefit to a party in interest, the
exemption would be ineffectual and a trap for the unwary." ETI
Hearings (prepared statement ofOlena Berg. Assistant Secretary
ofLabor), supra note 4, at 13.
65. The Department's position has remained unchanged;
however, the Department's encouragement ofETI investments
has clearly changed.
66. Zelinsky, supra note 54, at 345.
67. Professor Zelinsky argues that Advisory Opinion 80-33A is
not supportive because it did not give an opinion on the legality
of the agreement between Chrysler and the United Auto Workers
to establish a committee to recommend certain investments to the
Chrysler pension plans. Id. The Department responded that the
agreement itself would not violate ERISA's fiduciary provisions.
However, the Department refused to opine on any particular
transaction. The Department's statement that the agreement
between Chrysler and the UAW did not violate ERISA's
fiduciary provisions implies that the individual transactions could
not be a per se violation of the exclusive benefit rule. Advisory
Opinion 88-16A (Dept. of Labor, 1980).
51.
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68. Zelinsky, supra note 54, at 345-346.
69. Advisory Opinion 88-16A (Dept. of Labor). This language
is virtually identical to the preambles for the prohibited
transaction exemptions cited in the interpretive bulletin.
70. See DeBruyne v. Equitable Life Assurance Society, 720 F.
Supp. 1342 (N.D. Ill. 1989), affd. 920 F.2d 457 (1990); GIW
Industries, Inc. v. Trevor, Stewart, Burton & Jacobsen, Inc., 10
Employee Benefits Cas. (BNA) 2290 (S.D. Ga. 1989), affd, 895
F.2d 729 (11th Cir. 1990).
71. See Marshall v. Glass/Metal Assoc. & Glaziers & Glass
Workers Pension Plan, 507 F.Supp. 378 (D. Haw. 1980);
Donovan v. Mazzola, 2 Employee Benefits Cas. (BNA) 2115
(N.D. Cal. 1981), ajJ'd, 716 F.2d 1226 (9th Cir. 1983), cert.
denied, 464 U.S. 1040 (l984); Donovan v. Walton, 609 F. Supp.
1221 (S.D. Fla. 1985), ajJ'd sub nom., Brock v. Walton, 794 F.2d
586 (11th Cir. 1986); Whitfield v. Tomasso, 682 F.Supp. 1287
(E.D.N.Y. 1988); Andrade v. Parsons Corp., 12 Employee
Benefits Cas. (BNA) 1954 (C.D. Cal. 1990), ajJ'd, 1992 U.S.
App. LEXIS 18220 (9th Cir. July 31, 1992).
72. The economic benefit received as a result of the externality
cannot be factored into the rate of return.
73. Zelinsky, supra note 54, at 348.
74. Penelope Lemov, Paving the Way With Pension Funds,
ROCKY MOUNTAIN NEWS, Mar. 28, 1994, at 39A. See also
Teresa Ghilarducci, US. Pension Investment Policy and Perfect
Capital Market Theory, CHALLENGE, July 1994, at 4.
75. The Advisory Council Work Group on ETIs states that one
of ETI's three identifying characteristics is that they target a
capital gap. U.S. DEP'T OF LABOR ADVISORY COUNCIL ON
EMPLOYEE WELFARE AND PENSION BENEFIT PLANs, A
CLEARINGHOUSE ON NETWORK FOR ECONOMICALLY TARGETED
INVESTMENTS 7 (Nov. 1993) [hereinafter ADVISORY COUNCIL
ETI REpORT].
76. Id. at 8.
77. Id. at 8.
78. See Legislative Proposals to Provide Financing Assistance
for Projects Fostering Economic Development and Job Creation.
Hearing Before the Subcomm. on Economic Growth and Credit
Formation, 103d Congo 2d Sess. (June 22,1994); Pension Fund
Investments for Economic Growth. Hearing of the Comm. on
Labor and Human Resources, 102d Cong., 2d Sess. (Sept. 29,
1992).
79. New Study Finds 'Capital Gap' in Venture Funding for
Southern California, PRNEWSWIRE, Dec. 13, 1994.
80. Id.
81. Abby Livingston, Venture Fund Debuts to Aid Tech StartUps: Capital Goals May Face Capital Roadblock, CRAIN'S N.Y.
BUS., Feb. 27, 1995, at 14.
82. CENTER FOR POLICY ALTERNATIVES, ECONOMICALLY
TARGETED INVESTING BY STATE-WIDE PUBLIC PENSION FUNDS,
19-20,22-23, 28 (1993).
83. ETI Hearings (prepared statment ofOlena Berg. Assistant
Secretary ofLabor), supra note 5; see also ADVISORY COUNCIL
ETI REpORT, supra note 75.
84. For a more detailed examination of these problems see
Jayne Elizabeth Zanglein, High Performance Investing.
Harnessing the Power ofPension Funds to Promote Economic
Growth and Workplace Integrity, 11 LAB. LAW. 59, 62-68
(1995).
85. INSTITUTE FOR FIDUCIARY EDUCATION, ECONOMICALLY
TARGETED INVESTMENTS, A REFERENCE FOR PUBLIC PENSION
FUNDS (1992).
86. Interpretive Bulletin 94-1, supra note 45.
87. Id.
88. INSTITUTE FOR FIDUCIARY EDUCATION, supra note 85, at
Executive Summary.
89. Id. at B-2 (Table B-8).
90. The survey asked the respondents to list and rank reasons;
therefore, some funds reported more than one reason. Id.
91. Id.
92. Id. at B-1 (Table B-4).
93. Id. at B-2 (Table B-6).
94. Id. at 18 (Table 16).
95. Id. (10.2% reported great difficulty).
96. Id. (6.1 % reported great difficulty).
97. Id. (6.0% reported great difficulty).
98. Teresa Ghilarducci, u.s. Pension Investment Policy and
Perfect Capital Market Theory, CHALLENGE, July 1994 at 4.
99. Hearing on Pension Investments and Economic Growth
Before the Joint Economic Committee on Economically Targeted
Investments, 103d Cong., 2d Sess. (1994) (testimony of Lee
Smith, Executive Director of Excelsior Capital Corporation),
reprinted in Federal Document Clearing House Congressional
Testimony (June 22, 1994).
100. ADVISORY COUNCIL ETI REpORT, supra note 75, at 2.
101. Id. at 5.
102. Id.
103. Hearing on Pension Investments and Economic Growth,
supra note 100 (testimony of Robert B. Reich, Secretary of
Labor). See also ADVISORY COUNCIL ETI REpORT, supra note
75, at 10-25.
104. Id.; see also Hamilton Securities Gets DOL Contract to
Establish First Clearinghouse on ETIs, 21 PENS. & BENEFITS
REp. (BNA) 1925 (Oct 10, 1994).
105. ERISA § 404(a)(I)(B); 29 U.S.C. § 1104(a)(I)(B) (1995).
106. Assistant Secretary OJena Berg recently stated:
There should be no doubt in the minds of
fiduciaries as to their absolute obligation to satisfy all
of ERISA's fiduciary requirements on every
investment made with pension funds including
investments in ETIs. The law requires it; the
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Administration is sworn to uphold it; and we at the
Labor Department are committed to bringing the full
force of law against pension plan fiduciaries who
compromise that obligation.
ETI Hearings (Prepared statement of Olena Berg, Assistant
Secretary of Labor), supra note 4, at 4.
107. ERISA § 404(a)(I)(B); 29 U.S.C. §1104(a)(1)(B) (1995).
108. Preamble to Rules and Regulations for Fiduciary
Responsibility; Investment of Plan Assets under the "Prudence"
Rule, 44 Fed. Reg. 37,221 (June 26, 1979).
109.Id.
110.Id.
111. Interpretive Bulletin 94-1, supra note 45.
112. Id.
113. For example, a transaction involving employer-owned stock
would become impermissible because it involves a collateral
benefit.
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