W. Scott Simon
December 3, 2015
Darlene M. Miller President and CEO Permac Industries, Inc.
14401 Ewing Avenue South Burnsville, MN 55306
Re: Caveat Emptor and the Permac Industries, Inc. 401(k) Profit Sharing Plan and Trust
Dear Ms. Miller:
I read with interest your testimony in July before the Senate Subcommittee on Employment and Workplace Safety of the Senate Committee on Health, Education, Labor and Pensions. You spoke about “Restricting Advice and Education: DOL’s Unworkable Investment Proposal for American Families and Retirees.” You noted that you are representing the U.S. Chamber of Commerce, of which you are a board member and are chair of the U.S. Chamber Small Business Council.
In your testimony, you identified yourself as President and CEO of Permac Industries, a precision machining manufacturer that services the global aerospace, defense, medical, high-reliability industrial and commercial industries. Permac now has nearly 30 employees and is looking to expand, but in order to do so, it must be able to compete with much larger companies for talented employees. You said one way you are able to compete is by offering employee benefits, including a retirement savings plan.
As a business owner, you noted that you are focused on the details of core business functions–sales, finance, and manufacturing oversight–and you use outside professionals to help you with supplemental business functions. For example, you use a CPA firm accountant to assist you with tax issues, attorneys to assist with legal issues, and a financial advisor to help you with your company’s 401(k) plan, to which 93% of eligible plan participants contribute as does your company through matching contributions.
My registered investment advisory firm enjoys working with companies like yours, where it’s apparent that the leadership really cares about its employees and takes a paternalistic approach–in the sense of being protective, even overprotective–toward plan participants whether they are in a 401(k), 403(b), 457(b), or 401(a) plan. This notion of “protecting” plan participants comports with my own definition of what it means to be a fiduciary, which I wrote about in my Morningstar Fiduciary Focus column.
A number of times in your testimony, you noted that you have a trusted relationship with your financial advisor, e.g.: “When I work with my financial adviser, I am aware that he is providing a service for a fee and selling a product.” It should be noted, however, that it’s much more likely that you pay a commission to your advisor rather than a fee. This distinction, while a seeming quibble, goes to the very heart of the debate in which you have participated through your testimony.
Your financial advisor, whether or not you know it, is someone who probably doesn’t want to (or cannot) be a fiduciary, so he must adhere to a non-fiduciary business model. The adherents to this model include stockbrokers, insurance agents, and the like, who are not fiduciaries to a retirement plan but are fiduciaries to the company they work for and that company’s shareholders. As a result, they are pledged to (in fact, must, by law) maximize revenue for the entities to whom they owe fiduciary duties–their employer and its shareholders–versus those to whom they owe no fiduciary duties: plan participants (and their beneficiaries).
This model, sad to say, is one big muddled conflict of interest: Is my advisor recommending the investment options for the retirement plan I sponsor because that enhances his compensation rather than another set of investment options that doesn’t pay him or his third-party masters as much? Is my advisor selling me this insurance policy because it’s the best thing for me or because she makes a big commission? Even if I think that she has placed my interests ahead of her own, how can I actually be sure? The variation in compensation–the differing, often complex commission structures–associated with the dizzying array of available products makes many such questions inescapably unresolvable.
The non-fiduciary model is perfectly fine in the commercial world where caveat emptor(“let the buyer beware”) reigns. That’s capitalism and, as a small businessman, believe me, I have a very high regard for the profit motive just as you do, no doubt, in your capacity as the head of a small but important and vital company.
But you seem to be lumping together the caveat emptor setting in which your business operates with the setting in which the 401(k) plan sponsored by the company you lead must operate when you say: “I would not be able to run a successful business if I were not able to understand when I am involved in a sales discussion–particularly, if it follows a basic disclosure that an advisor is selling a proprietary financial product, that the advisor is paid to sell the product, and the advisor is not providing fiduciary advice.”
But your 401(k) plan cannot be operated in a caveat emptor setting because the law– the Employee Retirement Income Security Act of 1974, as amended (ERISA)–will not allow it. Further, although you associate a CPA firm accountant (which assists you with tax issues) and attorneys (which assist you with legal issues) with the kind of a financial advisor that helps you with your company’s 401(k) plan, they are not comparable. The accountants and attorneys are fiduciaries under the law, while the kind of financial advisor you use is not.
In distinct contrast to the non-fiduciary model followed by your trusted advisor is the fiduciary model required by ERISA. The heart of the ERISA fiduciary framework is found in ERISA section 404(a), which requires plan fiduciaries to operate retirement plans such as a 401(k) plan “solely in the interest” of plan participants for the “exclusive purpose” of providing benefits to them and defraying the costs of administering the plan (which must be “reasonable”). These fiduciary duties are derived from the trust law standard, which the U.S. Court of Appeals for the Second Circuit characterized in a 1985 case as “the highest known to the law.”
When a retirement plan is operated by plan fiduciaries according to ERISA fiduciary precepts in this way–ideally by knowledgeable discretionary fiduciaries to the plan– not only are plan participants (and their beneficiaries) protected in an optimal way but, as a by-product, so too are the entity–the company you lead–and flesh-and-blood people, fiduciaries like you.
The upshot is that even if someone like me, who is always a discretionary fiduciary to the retirement plans we serve, were to hate every single one of the thousands of participants in those plans, I would still be required by the law to obey the sole interest and exclusive purpose rules of ERISA section 404(a). You could say that my investment behavior is, in effect, hemmed in by the law requiring me to act solely in the interest of your plan participants. To act otherwise in any manner would risk my reputation and personal net worth.
Conversely, even if your trusted advisor were to love without condition every one of the participants in your 401(k) plan, the business model he follows would negate his noble impulses and keep him from legally acting upon them to help plan participants. This model gives your trusted advisor a lot more leeway in his investment behavior– often to the detriment of plan participants.
I don’t want to leave you with the impression that adherents to the non-fiduciary model such as your financial advisor are not allowed to operate in the world of qualified plans governed by ERISA. Indeed, the maximization of revenue inherent in that model is, unfortunately, permitted by ERISA.
The non-fiduciary model, however, is distinctly suboptimal for your employees who participate in your company’s 401(k) plan. Indeed, plan participants are the center of the ERISA universe and deserve to be serviced by those that are adherents to the fiduciary model. Plan participants should be offered plan investment options that are legally sound, academically based, cost-efficient and even morally defensible–in the sense of doing the right thing for plan participants, if for no other reason than it’s usually a lot easier to do the right thing than the wrong thing.
I felt compelled to write this letter to you because it’s readily apparent that you truly care for your employees: “My current employees are like family and I want to be able to help them. Just as importantly, I want to be able to attract new employees.” In my view, helping your employees begins by protecting them and, in doing so, you protect yourself and the viability of your business. Getting it right for participants (and their beneficiaries) gets it right for plan sponsors like you.
Much of that protection comes from working with an advisor that will be a fiduciary to your plan–and to obtain the greatest protection for you and your employees, a discretionary fiduciary to your plan. Your non-fiduciary advisor just cannot legally do that, even though he may personally be a very nice person and helpful in advising you about implementing a SAR-SEP and transitioning to a 401(k) plan.
But even if your trusted advisor were to give you highly sophisticated advice, it’s of little value because he cannot back it up with legal fiduciary accountability; his business model just will not legally allow it even if he personally wished it could. But wishing it were so doesn’t hold much sway under the law of ERISA. That’s why I believe that the ultimate protection for a sponsor of a retirement plan like you lies in making sure that your plan participants (and their beneficiaries) are protected.
If you’ve gone to the trouble and expense of sponsoring a retirement plan–much less providing a corporate match–why not do it right? After all, not adhering to the fiduciary business model with respect to the implementation of retirement plans is often a waste of precious corporate assets. Retirement plans served by loyal, prudent, independent investment fiduciaries that know how to act with knowledge and skill, and are willing to be legally accountable for their decisions, are far better for plan participants. Such plans usually have lower costs (there’s no reason why ERISA’s legal requirement of “reasonable” costs–in relation to the level and quality of services provided–cannot be low costs) and are far better diversified to reduce risk (and ultimately boost return). That’s the very best way to protect your plan participants (and their beneficiaries), your company, and yourself.
Very truly yours,
W. Scott Simon
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™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.