W. Scott Simon
The week before last, I received a phone call from a congressional staffer who invited me to testify at a subcommittee hearing July 26. “Why pick on me,” I asked. Well, it seemed that my June Morningstar column had garnered some attention in Washington and at least some solons wanted to hear about it from the horse’s–uh, mouth. Would I like to come to Washington and testify? Let me see now: leave my home north of San Diego where it was sunny and in the high 70s with no humidity to fly clear across the country to a city where the forecast was 116 degrees on the day of my testimony with the kind of humidity that would make that seem like 250 degrees. Having lived through two Washington summers, it took me less than two seconds to decline the invitation politely.
Among those who did testify before the House subcommittee on health, employment, labor and pensions at that July 26 hearing was Phyllis Borzi, the assistant secretary of labor for the Employee Benefits Security Administration. It’s worthwhile to go through some of her written testimony to get a better handle on the great ongoing wrestling match over whether the definition of fiduciary investment advice under the Employee Retirement Income Security Act of 1974 will, in fact, be changed.
The ERISA Fiduciary Structure and How It Bears on the Wrestling Match
Borzi (who, by the way, I believe is earnest in her efforts, unlike many others in this great wrestling match, to protect plan participants and their beneficiaries) notes at the outset of her testimony that ERISA “expressly provides that a person paid to provide investment advice with respect to assets of a private-sector employee benefit plan is a plan fiduciary.”
Furthermore she states, “ERISA and the [Internal Revenue Code] prohibit . employee benefit plan . fiduciaries from engaging in a variety of transactions, including self- dealing–when a fiduciary puts his or her own financial interests first–unless the relevant transaction is authorized by an ‘exemption’ contained in law or issued administratively by the Department of Labor.”
Borzi’s testimony here reflects the underlying historical anomaly of ERISA’s fiduciary structure: Unlike all other countries in the world, only the United States allows an employer/plan sponsor to be a fiduciary of a qualified retirement plan. In all other countries, only independent fiduciaries can run a plan. In Europe, for example, employers can’t get involved with their retirement plans at all.
But America’s employers made it clear during ERISA’s drafting stage in the early 1970s that, whatever final form ERISA eventually took, they wanted to be actively involved in running their retirement plans. That made sense since the contributions made by employers on behalf of participants in defined benefit plans (no glimmer of a 401(k) plan was in anyone’s eye in those days) was employer money–at least before it was plopped into the plan–so they wanted some control over it. But this stance created an obvious problem: allowing employers to run their own retirement plans would result in lots of conflicts of interest, many related to whether an employer was acting as a fiduciary to the participants (and their beneficiaries) in its plan or acting as a fiduciary to its shareholders. (For additional information on this subject, please see my interview with Jeffrey Mamorsky, one of the drafters of ERISA, in my October column.)
The solution to this problem was an agreement between the federal government and employers: In exchange for the government allowing employers to control their retirement plans, they would be required to be fiduciaries acting in the interests of the participants (and their beneficiaries) in those plans. This trade-off formed the backbone of ERISA as reflected in the basic fiduciary law of section 404(a)(1)(A) and its great “sole interest” and “exclusive purpose” rules which require employers to act not merely in the “best” interests of plan participants (and their beneficiaries) but much more crucially, act in their “sole” and “exclusive” interests.
The ERISA section 404(a) language concerning the necessity that fees be “reasonable” and the “diversification against large losses” requirement also form this backbone. Borzi reminds us of other fiduciary duties in ERISA section 404(a): “ERISA additionally subjects fiduciaries who advise private-sector employee benefit plans to certain [fiduciary] duties, including a duty of undivided loyalty to the interests of plan participants and a duty to act prudently when giving advice.”
To me–just as to anyone who takes seriously their work in the retirement plan business–these essential provisions of section 404(a) are like the Declaration of Independence and the Constitution of qualified retirement plans because they help guide fiduciaries in prudently implementing the fundamental underlying objective of ERISA: providing plan participants with retirement income security.
ERISA also requires employers to follow prudent fiduciary rules to help ensure that they act solely and exclusively in the interests of plan participants (and their beneficiaries). With respect to the prohibited transaction rules (ERISA section 406 (Title I) and IRC section 4975 (Title II)), any transaction between a plan and a “party in interest” or a “disqualified person” will result in a “prohibited transaction,” unless such transaction fits into a statutory exemption or a regulatory exemption (for example, a class exemption). Loans to participants in 401(k)s and investing in company stock are among the most common prohibited transactions; both activities have been granted class exemptions. In a sense, then, the way in which ERISA is structured deems many fiduciaries as well as fiduciary and nonfiduciary service providers involved in qualified retirement plans to be criminals until they can prove their innocence.
The Central Question
Given that an advisor paid to provide investment advice with respect to a qualified retirement plan is a plan fiduciary, Borzi notes the central question in this wrestling match: “The [existing] law on its face is simple enough: Advisors should put their clients’ interests first. But as always the devil is in the details–in this case, in the question of what constitutes paid investment advice.”
Borzi then discusses why this question has arisen: “In 1975, the Department of Labor issued a five-part regulatory test defining ‘investment advice’ that gave a very narrow meaning to this term. The regulation significantly narrowed the plain language of the statute as enacted, so that today much of what plainly is advice about investments is not treated as such under ERISA and the person paid to render that advice is not treated as a fiduciary [unless each of the five elements of this test is satisfied for each instance of advice].”
She further says, “The [EBSA’s] current initiative will amend a flawed 35-year-old rule under which advice about investments is not considered to be ‘investment advice’ merely because, for example, the advice was only given once, or because the advisor disavows any understanding that the advice would serve as a primary basis for the investment decision. Consequently, the [EBSA] believes there is a need to re-examine the types of advisory relationships that should give rise to fiduciary status on the part of those providing investment advice services.”
In discussing the current five-part regulatory test defining “investment advice,” Borzi mentions the critical need for “impartial” or “disinterested” investment advice no less than four times in the following two brief passages: “The 1975 regulation contains technicalities and loopholes that allow advisors to easily dodge fiduciary status. Plan fiduciaries, participants . are entitled to receive impartial investment advice when they hire an advisor.”
Furthermore, she writes, “Investors . should be able to trust their advisors and rely on the impartiality of their investment advice. That is the promise written into law in 1974. The [EBSA’s] initiative sets out to fulfill this promise for America’s current and future retirees. Prudent, disinterested advice can reduce investment errors, steering investors away from higher-than-necessary expenses and toward broad diversification and asset allocations consistent with the investors’ tolerance for risk and return. Accordingly, it is imperative that good, impartial investment advice be accessible and affordable to plan sponsors and especially to the workers who need it most.”
What’s most interesting and significant about these passages is Borzi’s identification of the need for impartial investment advice as the “promise” written into ERISA ever since it was signed into law 37 years ago next month. She then notes that the EBSA’s proposed rule changing the definition of investment advice will “fulfill” that promise.
The Promise: Fulfilled or Unfulfilled?
Borzi should be applauded for so clearly illuminating the issues at stake in this wrestling match, including showing how advisors can easily dodge fiduciary status under the current rule. Her case to junk that rule is a powerful one because it cites the widespread corruption, which likely anyone in the retirement plan business can see, that helps destroy the promise of ERISA: the promise that plan participants will have access to impartial investment advice.
It’s doubtful, however, that this promise will be restored by the proposed rule. As I’ve noted in my last three columns, advisors can effectively dodge fiduciary status just about as easily under the proposed rule as the current one. One way is through the seller’s exemption, which I’ve described as the exemption that swallows the rule. Stockbrokers are successful under the brokerage firm model when they sell products, including those manufactured by their own broker/dealers. Those sales, however, cannot take place unless a broker has established a bond of trust with its intended customers. It’s true that the seller’s exemption requires a nonfiduciary to provide written notice to an existing customer (with whom it already has a relationship) or a potential customer (with whom it would like to develop a relationship) that it isn’t a fiduciary and that it has interests adverse to the customer’s plan or the plan’s participants. But it’s unrealistic to think that such disclosures would really slow down a nonfiduciary intent on doing business with a qualified retirement plan.
Some readers may remember my April column in which I waxed poetically about the quality (and obvious expense) of the lamb chops that I devoured as a young pup politico-in-training at a trade association reception in a congressional hearing room on Capitol Hill. That association was the Securities Industry Association which now goes by its modern name: Securities Industry and Financial Markets Association. Back then, even us pups knew that the SIA had lots of money behind it and therefore lots of political power. Its modern version is just as flush plus now there are even more SIAs attempting to impose their will in this great wrestling match.
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.