W. Scott Simon
Once an individual retail investor signs an account application agreement with a provider of investment products and services such as a stockbrokerage firm, that person enters into a world in which the deck is largely stacked against him. The vast asymmetrical information advantage enjoyed by such firms in these agreements and the valuable business practices they are able to secure as a result can have a significantly harmful impact on investors. It’s just not a fair fight.
It’s bad enough that many individual investors are woefully ignorant about the possible ramifications that may befall them as a result of entering into such agreements. Any harm that ensues, however, will have an impact only on each investor and its family.
But when decision-makers–gate-keepers–for a retirement plan are woefully ignorant (or are lazy or just don’t care) about the possible deleterious consequences that may impact hundreds, thousands, tens of thousands, perhaps even hundreds of thousands of participants in retirement plans over which such decision-makers hold sway, that, as they say, is a whole different kettle of fish.
Background
Back in the “olden days” (a phrase often used by the great pool hustler Minnesota Fats) of 2007-08, I wrote an eight-part series of columns on the fleecing of participants in 403(b) plans. A 403(b) plan, like a 401(k) plan, is a tax-deferred retirement plan. It is available to employees of educational institutions (e.g., public school districts for grades K-12), such as teachers, school administrators, custodians, and librarians. Many of these employees contribute to a defined benefit plan over their careers and in return receive fixed periodic payments (often indexed for inflation) during retirement. In this arrangement, then, 403(b) plans are a supplement to traditional pension plans. By law, school districts ordinarily have no fiduciary responsibility to ensure that their employees receive the kinds of protections afforded participants in 401(k) plans.
In that multi-part series of columns, among other things, I proposed what a model 403(b) plan should look like for K-12 school districts. At least one large consortium of school districts took notice and incorporated the following language into its Request for Proposal to describe its vision for offering a single vendor 403(b) plan:
“During the process we used to develop this request for proposal, we began to form a vision for what our new 403(b) plan might look like. The vision was very different from the traditional 403(b) plans that currently exist in public schools… The essence of what we believe to be in the best interest of our Districts’ plan participants is that the ideal 403(b) plan should be a single vendor model that (1) operates solely in the interest of plan participants and their beneficiaries for the exclusive purpose of providing them with retirement plan benefits, (2) has transparent costs, each of which is reasonable versus the service provided in return, and (3) features broadly diversified investment options designed, within a portfolio context, to reduce risk and increase return. Our beliefs were developed from what we believed to be right and affirmed by a series of articles “Fiduciary Focus: Fleecing 403(b) Plan Participants (Parts 1-7 [part 8 appeared in 2008 after the RFP])” by W. Scott Simon (Morningstar Advisor Edition, 4-5-07 thru 11-11-1-07). These articles will give you a real sense of our vision.”
Agreements Between an Insurance Company and a K-12 School District for a 403(b) Plan
I have had the opportunity to review and analyze a series of agreements between a large, well-known insurance company (Big Insurance Company) and a K-12 school district (School District). These agreements–services agreements and trust agreements–pertain to each of three kinds of retirement plans authorized under the U.S. Internal Revenue Code (IRC) that the School District offers to its employees: an (1) IRC section 403(b) retirement savings plan, (2) IRC section 457(b) deferred compensation plan, and (3) IRC section 401(a) money purchase retirement savings plan. In the interest of limiting the subject matter of this column and any subsequent ones to a total length of something less than 1 million words, I will cover only the 403(b) plan’s services agreement and trust agreement.
It should be noted at the outset that the School District is not a “plan sponsor” because none of the three plans is subject to the requirements of the Employee Retirement Income Security Act of 1974 (ERISA). Rather, the School District “establishes” and “maintains” the plans, making them “available” to the thousands of employees of the School District that are eligible to participate in the three plans.
Nonetheless, 403(b) plans established and maintained by K-12 school districts are often subject to the fiduciary laws of the state in which a school district is located. And it is usually the case that these laws track virtually verbatim the language of section 404(a) of ERISA. This is reflected in the plan trust agreement between Big Insurance Company and the School District:
(1) [the custodial trustee] and any [ERISA section] 3(38) [investment manager] appointed by the [School District] Committee shall: “(i) discharge its duties hereunder with the care, skill, prudence and diligence required under the circumstances; (ii) subject to the investment funds specified in the Plan, if any, and to the extent required by applicable law, diversify the investments of the Trust Fund so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so;
(iii) discharge its duties in accordance with the provisions of the Plan and this Trust Agreement insofar as such provisions are consistent with applicable law;” (2) the plan assets shall be held for the “exclusive purpose” of providing benefits to plan participants (and their beneficiaries) and defraying the “reasonable” expenses of administering the plan; and (3) [Trust Company] and any 3(38) appointed by the Committee shall not engage in any transaction which it knows or should know violates the prohibited transaction rules of the Internal Revenue Code–unless there is an exemption to the transaction.”
Based on the foregoing seemingly cut-and-dried language in the trust agreement, it would seem that only two entities are fiduciaries of the School District 403(b) plan: the custodial trustee (Big Trust Company) and any ERISA section 3(38) investment manager appointed by the School District Committee. This apparently keeps the School District and Big Insurance Company–which doesn’t want to be in the same room where the word “fiduciary” is even thought of–out of the fiduciary ranks.
But the trust agreement also states: “[The School District] has designated one or more persons as the fiduciary(ies) who have general responsibility for administration of the [403(b)] Plan and for reviewing the investment and performance of the [associated 403(b)] trust hereunder…” This arguably draws the School District into the fiduciary orbit. What is crystal clear, however, is that Big Insurance Company is not a fiduciary to the School District 403(b) plan in any way, shape, or form nor, to my knowledge, is any other insurance company to any such plans in America.
The Cast of Characters in the Agreements
Before ending this month’s column and beginning to delve into the details of the services and trust agreements between Big Insurance Company and the School District in next month’s column, I thought it would be a good idea to preview the cast of characters that appear in the agreements. First, there’s Big Insurance Company, which makes clear–repeatedly–that it’s not a fiduciary. Then there’s the School District, which isn’t a fiduciary either–or is it? Third, the School District Committee is composed of fiduciaries appointed by the School District, thereby making it an open question whether the School District can escape fiduciary status. The fourth member of the cast is Big Trust Company (a non-discretionary fiduciary custodian), which is the principal of Big Insurance Company; as such, Big Insurance Company has signed the trust agreement as agent of Big Trust Company. Rounding out this group is what I call the Non-Fiduciary Advice-Giver. Stay tuned.
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.