W. Scott Simon
A number of readers of this column have, over the years, asked me how I would describe the ideal investment advisor to fiduciaries of retirement plans. This month’s column is an extended explanation of what I tell them.
Prudence as Process
Prudence as process, as noted many times in this column, is the cornerstone of modern prudent investing for all bodies of fiduciary law including the Employee Retirement Income Security Act of 1974 (ERISA) as well as the Uniform Prudent Investor Act (UPIA) and the Restatement 3rd of Trusts (Prudent Investor Rule).
In the context of ERISA retirement plans, I believe that a prudent process should be one that’s legally sound, academically rigorous, cost efficient and morally right. The ultimate goal of this process must be to provide plan participants with the best chance to efficiently (cost-wise and risk-wise) accumulate the greatest amount of retirement assets possible. Let’s examine in detail what I mean by each aspect of this prudent process.
The Legally Sound Aspect of the Prudent Process
The process described here must (not should) begin with a focus on the law of ERISA. That focus, more specifically, is on ERISA section 404(a)(1) which describes the four primary duties of a plan fiduciary. These include the (1) duty of loyalty (which underlies all fiduciary duties), expressed as the “sole interest” and “exclusive purpose” rules of ERISA section 404(a)(1)(A), (2) the duty of prudence under ERISA section 404(a)(1)(B), (3) the duty of (broad) diversification under ERISA section 404(a)(1)(C) and (4) the duty to follow all plan documents under ERISA section 404(a)(1)(D), but only to the extent that the terms of such documents don’t conflict with ERISA.
These four duties, of course, are not those of the investment advisor to a qualified retirement plan. But the ideal advisor will educate plan fiduciaries about these duties and their critical importance, and remind them that they have personal responsibility (and therefore personal liability) for the prudent management of plan assets.
There are two situations in which plan fiduciaries can shed themselves of responsibility (and liability) in the management of plan assets. In the first situation, plan fiduciaries can avoid responsibility (and liability) for any dumb investment mistakes that they themselves might make. They can achieve this when the ideal plan investment advisor offers to be an ERISA section 3(38)-defined “investment manager” via a written agreement with the fiduciaries. By doing so, the advisor becomes an ERISA section 405(d)(1)-defined “independent fiduciary.” In this situation, plan fiduciaries delegate their personal responsibility for the selection and monitoring of a plan’s menu of investment options to the advisor under section 3(38). (Note that even here, though, plan fiduciaries still retain the responsibility (and liability) for selecting, monitoring and replacing (if necessary) the investment manager periodically to ensure that the manager is handling the plan’s menu of investment options prudently.)
Very few investment advisors assist plan fiduciaries by acknowledging such fiduciary status because they cannot do so legally (i.e., broker/dealers–although the RIA arm of a broker/dealer can do so if it so chooses) or because their business model ordinarily doesn’t allow them to do so (i.e., insurance companies, banks and mutual fund companies). I can’t count the advertisements I’ve seen in which broker/dealers, insurance companies and others offer to help plan fiduciaries be better fiduciaries if they would only buy their patent-pending “tools.” Such offers never include the providers themselves becoming ERISA sections 3(38)/405(d)(1) fiduciaries which would allow them to bring real value to plan fiduciaries by removing from their shoulders “virtually all of the fiduciary responsibility.” (Source: http://www.reish.com/publications/article_detail.cfm?ARTICLEID=544)
Some of these plan providers will, at best, offer to help plan fiduciaries by becoming a co-fiduciary. Be careful, though, this is one of those wolf in sheep’s clothing situations. Although a plan provider offering to be a “co-fiduciary” must comply with the (previously noted) four duties under ERISA section 404(a)(1), such providers refuse to accept real transfer of responsibility (and liability) from plan fiduciaries to themselves because they refuse, by definition, to accept delegation of discretion. In other words, since there’s no discretion, there’s no real transfer of responsibility and therefore no mitigation of any potential liability.
Plan providers such as broker/dealers and insurance companies that peddle this to plan fiduciaries as some sort of “solution” create the illusion that they stand alongside the fiduciaries in equal fiduciary solidarity. The term “co-fiduciary,” of course, does appear in ERISA but only to describe legal duties, not as a marketing gimmick.
Plan fiduciaries, then, have a real choice. They can choose the ideal plan investment advisor to work with that offers to remove from their shoulders “virtually all of the fiduciary responsibility” (and liability) for the selection and monitoring of plan investment options via ERISA sections 3(38)/405(d)(1). This method of delegation, grounded in ERISA, is endorsed by leading legal authorities. Or they can choose another method of delegation: a “co-fiduciary” illusion which is endorsed by leading advertising firms and the marketing departments at many broker/dealers and insurance companies.
There’s a second situation in which plan fiduciaries can shed themselves of responsibility (and therefore liability) in the management of plan assets. In that situation, plan fiduciaries can avoid responsibility (and liability) for the dumb investment mistakes that plan participants might make. Plan fiduciaries are usually told that they can do so by meeting the myriad requirements of ERISA section 404(c). There’s at least one problem with section 404(c), though: plan fiduciaries can never really know whether they have complied fully with its 25-30 requirements. The 404(c) regulations are written such that every one of them seemingly must be implemented to secure the protection of section 404(c); failing to implement even one appears to nullify such protection.
A number of commentators, though, believe that not all the requirements of section 404(c) need be met to secure its protection. At least one court (Langbecker v. Electronic Data Systems, U.S. Court of Appeals for the Fifth Circuit, January 18, 2007) has (sort of) ruled that way but in the absence of any truly definitive judicial decisions, this issue still appears to be up in the air. In any event, the 404(c) regulations comprise a lot of moving parts to add to a retirement plan which thereby increases any potential uncertainty for plan fiduciaries.
Plan fiduciaries choosing not to embrace the section 404(c) regulations for whatever reason are ordinarily tagged with the responsibility (and therefore liability) for any dumb investment mistakes made by plan participants. Not to worry, though: there is a much simpler and less costly solution for such fiduciaries to avoid liability for such mistakes without having to fool with the complicated maze of section 404(c).
That solution is to retain the ideal plan advisor that will step up and assume ERISA sections 3(38)/405(d)(1) responsibilities (and corresponding liabilities) for managing the individual accounts of the participants in a revenue-neutral plan. (This seldom used solution existed even prior to the Pension Protection Act.) In this situation, the advisor eliminates participant investment discretion altogether (i.e., plan participants aren’t able to direct the investment of their retirement accounts) by creating and managing sub-accounts (e.g., model portfolio investment options) that reflect appropriate asset allocations for participants with differing risk tolerances and investment time horizons.
In an article published nearly three years ago, two co-authors and I dubbed this a “non-participant-directed 401(k) plan.” That plan can otherwise be described as a trustee-directed plan in which the selection and monitoring responsibilities (and corresponding liabilities) are delegated to the ideal plan advisor that creates and manages the sub-accounts of plan participants. The advisor provides qualified, reasonably priced professional investment management at both the plan and participant level.
Plan fiduciaries that retain the ideal investment advisor in this situation therefore get the best of both worlds: they have no need to implement the costly and time consuming section 404(c) regulations while getting all the benefits of doing so. Oh yeah, this solution also benefits plan participants (remember them?) since they don’t have to bear the added costs of section 404(c) “relief.” As an article on this Web site made clear, the extra costs involved in invoking section 404(c) to protect plan fiduciaries are not borne by plan fiduciaries; nope, plan participants themselves get to pay for that privilege.
The DALBAR studies over the last 20 years show with disturbing consistency that average investors not only widely underperform (i.e., by 700-900 basis points) the benchmarks of the mutual funds in which they’re invested but also fail to capture, due to stock picking and market timing, the returns of those funds. The ideal investment advisor to fiduciaries of retirement plans can have a significant impact in correcting this disastrous state of affairs by managing, through acceptance of delegation, the investment of plan participants’ sub-accounts it has created. This can help increase the chance of participant investment success and help protect plan fiduciaries from liability under ERISA.
The Academically Rigorous Aspect of the Prudent Process
The crucial insight of Nobel laureate Harry Markowitz, the father of Modern Portfolio Theory (MPT), is that investors must consciously think about risk as well as return. That’s why the “central consideration” of an investment fiduciary under the UPIA is to determine the tradeoff between the risk and return of a portfolio. ERISA has a similar requirement as well as the requirement (as does the UPIA) that the costs of a portfolio must be reasonable (i.e., Section 404(a)(1)(A)). MPT (and its progeny) which comprises the academically rigorous aspect of the prudent process described here, provides the underpinnings not only for ERISA but also the UPIA.
Although portfolio risk can be reduced through prudent management, the other part of the great equation that must be solved by every investment fiduciary–return–is nothing more than a random variable over which no one has any control (despite billions of dollars of advertising expended to convince investors of the contrary). The fact that nearly the entire investment information delivery system is focused on the random variable of return is therefore just plain goofy (there’s just no other word for it except maybe “nutty”).
What is a plan fiduciary to do? Why, focus on those matters over which it does have control: portfolio risk and costs. Retention of the ideal plan advisor will ensure that the menus of investment options it offers to plan fiduciaries will be diversified broadly to reduce risk (which increases return) and be reasonable in cost (which also increases return). Although decidedly not very sexy, the road to enhanced portfolio return meanders through the tried and true formula of broad diversification and low costs.
What’s ironic about the prevalent yet goofy focus on return is that financial markets–increasingly now in more and more parts of the world–provide investors over the long run with healthy market returns that are there for the taking. A wide variety of empirical and academic evidence finds that passive investing is the most effective and efficient way of reaping such returns. The ideal plan advisor, then, offers plan fiduciaries model portfolio investment options comprised of prudent and broadly diversified, low cost, institutional level asset class funds and index funds that capture financial market-level returns at market-level risk. This approach holds true in all financial markets – both efficient and inefficient – since all financial markets are zero sum games. (Passive investing, of course, is not the only way to invest prudently–it’s just the best way.)
Anyone who thinks that passive investing won’t be an issue in the spate of lawsuits bearing down on some companies in the Fortune 500 should read the pleadings in Spano v. Boeing Co. (U.S. District Court for the Southern District of Illinois). This lawsuit alleges that the
Boeing retirement plan imprudently included costly actively managed fund options rather than low cost and better performing passively managed fund options. Future such lawsuits are bound to raise this very germane issue.
The Cost Efficient Aspect of the Prudent Process
The ideal advisor to plan fiduciaries eliminates “visible” costs such as commissions and 12b-1 fees from–and minimizes “invisible” costs such as trading costs, bid-ask spread costs and market impact costs in–the investment options it offers to plans. The best way to achieve this is with a menu of prudent model portfolio investment options comprised of low cost and broadly diversified funds that are passively managed. Such an advisor doesn’t engage in any revenue-sharing which helps avoid even the appearance of a conflict of interest. The advisor’s fully disclosed and transparent fees are paid directly by plan fiduciaries or plan participants (or both), not by hidden and undisclosed third parties.
The fact that Congress, the Department of Labor, the plaintiffs’ bar and the Securities and Exchange Commission are all focused intently on the subject of (high and undisclosed) fees in retirement plans is underscored by allegations in the lawsuits against some Fortune 500 companies. Those lawsuits allege, in general, that the companies breached their fiduciary duties under ERISA by failing to contain plan costs and paying unreasonable fees to plan service providers.
The testimony of noted independent fiduciary Matthew Hutcheson before the U.S House of Representative’s Committee on Education and Labor in March 2007 should be studied closely to understand thoroughly the full economic impact of the visible and (undisclosed) invisible costs inherent in the investment options offered to participants in many, many 401(k) (and other retirement) plans in America today.
The Morally Right Aspect of the Prudent Process
There’s even a moral aspect to the prudent process followed by the ideal investment advisor to fiduciaries of retirement plans. As I wrote nearly four years ago in this column: “Those of us in the investment advisory profession have a special duty to be good stewards of other people’s wealth. In these times when we are asking men and women in uniform all over the globe to lay down their lives to defend America and to help build a better world, is it too much to ask that each of us do our utmost to help create an America imbued with the ideals for which so many of our countrymen shed their blood through the ages?… One way to help build a better America in the world of investing is to adopt a fiduciary business model…the scandals over the past few years that are emblematic of the widespread corruption in many parts of our financial system would never have occurred had the lodestar of a fiduciary standard been set in place and followed scrupulously.”
In Summary
The legally sound, academically rigorous, cost efficient and morally right process that the ideal investment advisor to fiduciaries of retirement plans follows helps achieve two important goals at the same time. First, this process can help maximize wealth more efficiently for plan participants. Second, it can help minimize the personal liability of plan fiduciaries. The prudent process that I’ve described in this month’s column is designed to protect not only plan participants (because they are the center of the ERISA universe) but also plan fiduciaries (because they provide a valuable employee benefit that strengthens the American economy and, indeed, America itself). Getting it right for plan participants through use of this process, then, has the effect of getting it right for plan fiduciaries as well.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. The author’s views expressed in this article do not necessarily reflect the views of Morningstar.