W. Scott Simon
The Pension Protection Act, signed into law by President Bush in August 2006, provides safe harbors for the sponsor of a qualified retirement plan if the sponsor follows the necessary procedures to implement the limited protections of section 404(c) of the Employee Retirement Income Security Act of 1974 and a qualified default investment alternative.
These safe harbors protect a plan sponsor against certain risks at the participant level of decision-making. While that’s nice, it does nothing to reduce or mitigate the inherent risks at the plan level of decision-making. Yet it’s at the plan level where an investment advisor to retirement plans can really provide significant value to plan sponsors. ERISA attorneys advising plan sponsors can provide critical help in this area.
Mother Always Said to Eat Your Spinach
The Employee Retirement Income Security Act of 1974 requires, among other things, that the fiduciaries of a qualified retirement program such as a 401(k) plan provide plan participants with a prudent variety of diversified investment options. This can be likened to a duty to provide participants with a menu of healthy foods.
ERISA also requires plan fiduciaries to ensure that participants make prudent asset allocation decisions for their plan accounts. This can be likened to a duty to make sure that participants actually eat the healthy food provided to them. If a participant fails to eat its food (makes imprudent asset allocation decisions), plan fiduciaries can incur liability.
A way for fiduciaries to avoid liability for the risk that plan participants might fail to eat their food is to secure the limited protection of ERISA section 404(c). (To obtain such protection, a 401(k) plan must be “participant-directed,” which is conditioned on a plan participant “exercising informed control” over the investments in its account which is conditioned on the ability of the participant to have the opportunity to choose from a “broad range” of investment options.) ERISA section 404(c) has been available to sponsors since 1992, and certain of its limited protections have been clarified and extended in the Pension Protection Act.
Spinach Spoiled by High-Cost, Under-Diversified, Poorly Performing Investment Options
The Pension Protection Act provides safe harbors, as noted, if a plan sponsor follows the necessary procedures to implement the protections of ERISA section 404(c) and a qualified default investment alternative. This protects a plan sponsor at the participant level because it allows the sponsor to avoid liability for the stupid investment mistakes that might be made by plan participants.
While these safe harbors are all fine and dandy, in many cases they really don’t have much value to plan sponsors (or plan participants, for that matter). Why? Because their value is predicated on the assumption that plan fiduciaries will do a prudent job of selecting and monitoring (and replacing, if necessary) the investment options of the retirement plan for which they’re responsible.
As we’ve seen in far too many cases over the last few years such as the ones involving some Fortune 500 companies, that assumption couldn’t be more wrong. These companies have large human resources staffs at the beck and call of plan fiduciaries commanding huge salaries and bonuses, yet somehow they haven’t been able to figure out that they’ve been overcharged–sometimes a lot and sometimes for a long time–for their menus of underdiversified, poorly performing plan investment options.
Come on, now: If my registered investment advisory firm can secure wholesale institutional pricing for the relatively small ($130 million and in some cases even down to $10 million) 401(k) plans that we advise, it doesn’t take a genius to see that multibillion dollar 401(k) plans at Fortune 500 firms should never have been invested in these much pricier retail mutual funds in the first place.
An Advisor’s Value as an ERISA Section 3(38)-Defined Investment Manager
Successful utilization of ERISA section 404(c) and a qualified default investment alternative in retirement plans no doubt gladdens the hearts of plan fiduciaries since they then receive protection from (1) the stupid investment mistakes such as imprudent asset allocation decisions that might be made by plan participants and (2) participants’ failure to make such decisions altogether, which is the sole purpose of a qualified default investment alternative. This allows plan sponsors to be excused from the heavy lifting of making sure that participants, in effect, actually eat the food provided to them.
Yet what good is it to a plan sponsor to be able to legally avoid the duty to ensure that plan participants actually eat their food if the menu of healthy foods that it has the duty to provide to participants is actually composed of unhealthy foods? Put another way, the safe harbor protections (ERISA section 404(c) and a qualified default investment alternative) afforded to plan sponsors at the participant level by the Pension Protection Act are of little use to them if they haven’t exercised the protections afforded them at the plan level that allow them to legally avoid the duty to select a variety of investment options for a plan.
An independent investment advisor to retirement plans fortunately is able to protect plan sponsors from their own mistakes that they might make such as selecting imprudent menus of investment options at the plan level (rather than protecting them from mistakes such as making imprudent asset allocations in their plan accounts at the participant level that might be made by plan participants). The way for such an advisor to provide this valuable service is to become an ERISA section 3(38)-defined “investment manager” (and, in so doing, to become an ERISA section 405 (d)(1)-defined “independent fiduciary”).
An ERISA investment manager accepts from plan fiduciaries a transfer of responsibility (hence, liability) for prudently selecting and monitoring (and replacing, if necessary) the investment options of a retirement plan. This allows such fiduciaries to offload a significant amount of responsibility that they would otherwise have to bear under ERISA. The transfer must be conveyed in writing and the investment advisor must accept discretionary authority for the specific duties promised. At the same time, the investment advisor helps to advance the interests of plan participants by putting itself on the line to ensure that participants are actually provided with a prudent variety of diversified investment options–that is, a menu of healthy foods.
There’s a certain irony at work here. The central concern of all ERISA fiduciaries is plan participants (and their beneficiaries); after all, participants are deemed to be the center of the ERISA universe by ERISA section 404(a)). Plan fiduciaries must therefore always be concerned with getting it right for the participants for whom they’re responsible. Yet even when an investment advisor concentrates on getting it right for plan fiduciaries such as when it accepts transfer of ERISA section 3(38) responsibilities from these fiduciaries, thereby helping to minimize the fiduciaries’ responsibilities (hence, liability) and enhance their fiduciary prudence to boot, the advisor gets it right for plan participants. Appealing to the self-interest of even the most selfish plan sponsor can have the effect of helping give participants a better shot at having a successful investment experience in their plan. The more prudent a plan sponsor, then, the more likely plan participants will be successful investors.
The Critical Services Provided by an ERISA Attorney
No plan sponsor can avoid the duty to make sure that the investment manager to which it has off-loaded ERISA section 3(38) selection and monitoring responsibilities (and liability thereof) continues to be a prudent manager. Many sponsors, however, don’t understand how to evaluate or review the services provided by an investment manager or, for that matter, any other service provider they have retained for the plan. Such sponsors lack understanding of oversight procedures, let alone the ability to document what has been done to meet their oversight responsibility.
In the absence of any relevant documentation, it’s not hard to imagine that a creative plaintiffs’ attorney will attempt to establish, on behalf of disgruntled participants, that the menu offered by a plan is loaded with unhealthy foods. An ERISA attorney retained by a plan sponsor can provide the sponsor with the necessary documentation to show that the retirement plan is being invested and managed prudently. One piece of such documentation could be a fiduciary blueprint outlining a plan’s procedural prudence. This document can be used by the sponsor to memorialize annually what all parties have done in service to the plan.
These critical services provided by an ERISA attorney help close the loophole of fiduciary liability that the plan sponsor would otherwise be exposed to under ERISA section 3(38). In so doing, the ERISA attorney provides invaluable aid in helping ensure that a menu of healthy foods is served to all plan participants.
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.