Publications

July/August 2002

Prudent Management of 401(k) Plan Fund Selection

By Sheldon M. Geller

Plan Fiduciaries

Many plan sponsors are unaware of their responsibilities as ERISA fiduciaries, regarding the prudent selection and monitoring of plan asset investments. The continuing bear market, the ENRON bankruptcy and related congressional hearings, as well as recent lawsuits, has caused plan sponsors to focus on fiduciary issues.

In order to understand ERISA's requirements regarding fiduciary liability, we need to review how an individual becomes a plan fiduciary liability, we need to review how an individual becomes a plan fiduciary. An individual is an ERISA fiduciary with respect to a qualified 401(k) plan either by being named in plan documentation or on the basis of functions performed for the plan. Most notable among the class of named fiduciaries assuming fiduciary status because of job title are trustees. In the alternative, functions giving rise to fiduciary status include an individual who exercises discretionary authority or control respecting the management of the plan.

ERISA's legislative history suggests a broad construction of the term 'fiduciary' to include any person who is an investment advisor to a plan as well as those who have discretionary authority regarding management or administration of a plan. ERISA fiduciaries need to discharge their duties for the exclusive benefit of plan participants, diversifying the investments of a plan so as to minimize the risk of large losses. Trustees and other ERISA fiduciaries are held to the standard of prudent experts.

Trustees may never be relieved of fiduciary investment responsibilities if they are working with someone other than a bona fide investment manager on their plan asset investments.

Officers of the plan sponsor may become functional fiduciaries by selecting investments for the plan, even if he or she is not formally given that responsibility by the plan. The members of the Board of Directors or partners of a partnership are also fiduciaries to the extent that they appoint committee members or other decision makers respecting plan management. These fiduciaries have the obligation to prudently select and monitor appointments under the plan. Nevertheless, individuals who are responsible for performing administrative functions that require no discretion are not plan fiduciaries.

Admittedly, there are circumstances where a broker or the person might be found to be a fiduciary based on advisory functions performed that were relied upon by the trustees. Nevertheless, even where trustees can establish that the broker or the person they are working with is a fiduciary, the trustees are not relieved of their investment responsibilities and will remain primarily liable for any losses to the plan. Plan asset investment is one area of trustee responsibility that is non-delegable other than to an investment manager who is a registered investment advisor.

Retention of investment manager

The one area of responsibility that may be delegated by trustees with respect to plan asset investment is the retention of an investment manager who acknowledges this status under ERISA in a written document. When an investment manager is retained, trustees are relieved of their fiduciary responsibility in connection with assets allocated to the investment manager so long as the trustees were prudent in their selection of the manager, the trustees established prudent guidelines for their manager's investment of plan assets and the trustees monitor their manager on a regular basis to assure compliance with the guidelines and performance standards established by the trustees (in an investment policy statement).

An ERISA fiduciary must utilize appropriate methods to investigate the merits of a proposed investment, including the use of experts familiar with the specific type of investment in question. Procedural prudence requires the trustee to analyze the proposed investment, to negotiate contract provisions for the investment as well as to explore the possibility of competing alternatives. The fact that a fiduciary sincerely believes that he or she is making an excellent investment in the best interest of the plan does not overcome a failure to follow the appropriate methods to investigate the merits of a particular investment. The sincerity of a fiduciary's belief cannot rectify its failure to properly evaluate an investment and exercise procedural prudence.

Certain plan fiduciaries are considered investment fiduciaries. The investment fiduciaries select and monitor the investment options offered to plan participants. An investment package with investment options promoting one management company or that offers limited availability of funds from outside providers may cause problems with fund selection and monitoring. Because investment management companies often follow the same investment philosophy for all of their funds, many of the mutual funds managed by the same company may concentrate in the same stocks, making it difficult to achieve appropriate diversification.

Additionally, if providers force plans to choose a certain number of their own proprietary funds, it may be difficult for the fiduciary to fulfill their duties to monitor plan asset investment because a suitable replacement may not be available if a fund under performs. Fiduciaries should determine whether the investment package offers a sufficient number and a variety of choices so that if an investment options were to under perform, it could be replaced by another qualified fund of the same type.

Notwithstanding the retention of an investment manager, the employer and ERISA fiduciaries need to establish investment policy as well as to select and monitor investments or, in the alternative, to appoint an investment manager to provide these services. Further, the employer needs to educate plan participants either directly or through and investment professional. The employee is given the responsibility to select among the available investment options.

Safe Harbor

The Department of Labor announced the ERISA safe harbor for plan asset investments under the ERISA Regulation Section 2550.404(a)(1). This regulation provides that the ERISA prudence requirement is satisfied with respect to an investment if the fiduciary gives appropriate consideration to the facts and circumstances that he or she knows or should know relevant to a particular investment course of action.

The regulation defines appropriate consideration as a determination that the investment is reasonably designed as part of the portfolio to further the purposes of the plan assessing the risk of loss, the opportunity for gain and investment alternatives. Therefore, each investment is not reviewed in isolation when it is part of an integrated portfolio that is reasonably calculated to further the purposes of a plan taking into consideration the risk of loss, opportunity for gain and the composition of the portfolio with regard to diversification.

Therefore, an investment should be made pursuant to an investment policy statement and guidelines established by the plan fiduciary. An investment made pursuant to an investment policy will be deemed to be prudent, providing that procedures are employed in making the investment that are reasonably designed to cause the specific investment to conform with the policy and guidelines.

ERISA Section 404(c) compliance is optional, and applies only to defined contribution plans. To relieve a fiduciary from liability, the plan must permit participants to give investment instructions to the plan fiduciary, change investment choices at least quarterly, choose from at least three diverse investment options and have enough information to make informed investment decisions.

Participants need to have full or partial control over all or part of their retirement accounts. Fiduciaries are permitted to refuse a participant's investment direction if it is a prohibited transaction, because of likely loss to participant retirement accounts or if the plan will be disqualified. A fiduciary is not relieved of fiduciary liability when a loss occurs due to the fiduciary's breach of fiduciary responsibility or the investment performance or other related service that is not what a reasonable person would expect under similarly situated circumstances.

Plan fiduciaries need to provide employees with an explanation of Section 404(c) Safe Harbor, a notice that the fiduciaries are seeing 404(c) protection and a description of the various investment options offered under the plan. The description needs to include investment objective, risk and return characteristics as well as the type and diversification of the investment option. The description also needs to identify the portfolio managers.

Plan Fiduciary Requirements

ERISA fiduciaries need to establish a prudent process for selecting investment alternatives and service providers. Fiduciaries need to ensure that fees paid to service providers and other expenses of the plan are reasonable in light of the level and quality of services provided. Fiduciaries need to select investment alternatives that are prudent and adequately diversified. Fiduciaries also need to monitor investment alternatives and service providers once they are selected to determine that they continue to be appropriate choices.

Investment Policy Statement

ERISA fiduciaries need to establish a framework for making investment decisions and managing fiduciary risk. Fiduciaries should prepare a written investment policy statement to identify plan investment goals, appropriate asset classes, role of each asset class, the process of selecting, monitoring and terminating investment options as well as any restrictions upon plan asset investment. Although investment policy statements are not required, trustees would appear to be compelled to implement an investment policy statement to comply with the procedural prudence requirement under ERISA.

Diligent plan fiduciaries will thus prepare and implement investment policy, document the processes to derive investment decisions, diversify portfolio assets with respect to specific risk and return objective, use professional money managers, monitor money managers as well as account for all investment expenses.

Diversification

ERISA trustees need to spread a portfolio over many investments to avoid excessive exposure to one source of risk. There are two levels of diversification, the first of which is at the portfolio level of all fund choices integrated under a plan menu and the second of which is a single investment and the diversification therein.

The equity market presents economic and political risks as well as industry and financial statement risks. Whereas, fixed income securities present credit risk and interest rate risk. no two investment options should vary the same way. Rather a portfolio should combine securities with a specific style of investing that will reduce the variability of the total portfolio of securities. Plan asset investment choices need to be correlated taking into account definitive asset classes and styles of investing. Combining investments that are not perfectly correlated will provide lower risk for accomplishing desired returns over the long term.

Section 401(k) plan Investment Menus need to provide adequate asset allocation among asset class and investment style. Fund choices should include large-cap growth, large-cap value, mid-cap growth, mid-cap value, as well as small-cap growth and small-cap value in the domestic market. Further, investment options should include large-cap growth and large-cap value funds in the international market. The plan should offer a short-term fixed income options as well as a core fixed income option. Fund menus may also include emerging markets as well as high-yield. If a portfolio offers a sector fund such as real estate, finance, health or technology, it should offer a number of sector funds enabling participants to achieve diversification.

Fund Selection Process

ERISA fiduciaries need to define a specific investment mandate. Thereafter, fiduciaries need to set objective and subjective criteria for screening funds. Trustees need to determine the desired style of investment, and thereafter choose funds that are in the first or second quartile based upon performance over three-year and five-year time frames. Trustees need to review these funds against their peers on a risk-adjusted basis and determine consistency of returns. The trustees need to review track records as well as managed fees.

Thereafter, trustees need to review consulting ratings as well as the quality of the money management firm. A short list is then established to review dispersion among portfolios, the experience and background of the money management team, the ownership and retention of key people as well as portfolio and operational risk controls.

Finally, the trustees will have selected the best combination of investment options based upon a well-defined process. Now, the trustees need to implement a monitoring process.

Monitoring Process

Trustees need to implement a disciplined process for evaluating manager success or failure. Key aspects in the monitoring process include continuous review, comprehensive guidelines, defined courses of action as well as clear decision rules. Trustees need to define rules for responding to changes respecting performance objectives. Trustees need to review whether a fund is performing below its peers, or performing below and index or presenting excessive risk. Ownership changes in the management of the fund as well as the loss of key investment people may prompt a fund review. Declining assets under management may prompt a fund review as well.

Trustees should define responses to changes in a fund by designating the funds to a watch list or to terminate that fund as an option under the plan. The watch list may be based upon performance, three year peer ranking below the medium for three consecutive quarters, three year index under performance for three consecutive quarters, violating risk guidelines, style drift for three quarters or loss of key investment people.

Outside Plan Counsel

At least 50% of the plan sponsors surveyed by a major service provider use an outside consultant. Beyond state and SEC requirements, there are no standard credentials required under ERISA. Investment Advisors are hired by fiduciaries to take advantage of ERISA's exculpatory relief provision for the appointment of advisors. These advisors provide performance measurement, asset allocation, investment policy as well as manager analysis and search services. investment advisors are paid a fee for services by the project or on retainer. Advisors may implement a fee arrangement that is performance based and that is a percentage of plan assets or a hard dollar amount.

Diligent Plan Fiduciaries

Diligent plan fiduciaries will prepare and implement investment policy, and document the process used to arrive at investment decisions. Diligent plan fiduciaries diversify portfolio assets with respect to specific risk and return objectives, use professional money managers, monitor money managers as well as control an account for all investment expenses. The cost of professional services varies widely.

There are no good rules of thumb as to what trustees should be paying for any given professional service. Common sense offers trustees the best guide in comparing prices and determining a fair fee for professional investment advice. ERISA not only permits trustees to use professional advisors but encourages them to do so. Moreover, the Department of Labor and the courts have suggested that, under certain circumstances, the assistance of professional advisors, experts in their respective fields, may be essential to the trustees' proper discharge of their fiduciary responsibility. ERISA permits trustees to utilize professional investment advisors in discharging their plan responsibilities. As a necessary corollary, ERISA also permits trustees to compensate professional advisors from plan assets.

Fiduciary protection

Fiduciaries can manage their risk by following procedural prudence, seeking expert assistance, documenting procedures as well as procuring insurance. ERISA permits the purchase of fiduciary liability insurance. If the insurance is purchased with plan assets, the insurance policy must permit recourse by the insurer against the fiduciary. Recourse enabled the insurer to collect from the fiduciary if a breach is determined to have occurred. A non-recourse rider to eliminate the insurer's right of recourse may result in additional costs, which may not be paid with plan assets.

The employer may procure directors and officers insurance to cover fiduciary breaches. The employer may also purchase errors and omissions insurance to protect against liability for administrative errors and omissions. This insurance typically covers third-party administrators, accountants and attorneys.

With few exceptions, an ERISA fiduciary or other person who handles funds or other plan assets must be bonded under ERISA. This regulation requires a bond to reimburse the plan for losses resulting for fraudulent or dishonest acts by plan fiduciaries and other who handle plan assets. The Department of Labor allows the use of plan assets to pay for an ERISA bond.

Summary

A retirement plan benefit is one of the most important benefits that an employer can provide its employees. Nevertheless, a retirement plan carries with it particular responsibilities and challenges for plan fiduciaries.

Employers and ERISA fiduciaries need to prudently investigate, document and monitor all decisions affecting the plan, the investments and service providers. The fiduciaries need to follow ERISA and the regulations associated therewith, as well as seek expert assistance when appropriate. An employer's retirement plan will be successful in helping employees secure their financial future, provided ERISA fiduciaries manage the responsibility associated with plan management.