Outsourcing of defined contribution plan fiduciary function

October 30, 2014

Sponsor outsourcing of fiduciary obligations is getting some attention. There is, of course, a broad, long-term outsourcing trend as firms continue to focus on core businesses and core competencies. With respect to defined contribution (DC) plans, the current trend towards the ‘institutionalization’ of investments (e.g., using more collective trusts, separate accounts and ‘white label’ funds), has made the DC plan fiduciary's job more demanding, and outsourcing is one solution to meeting those increased needs. Responding to increased benefit plan outsourcing activity, the ERISA Advisory Council this year held hearings on "Outsourcing Employee Benefit Plan Services.”

In this article we begin with some background on the DC fiduciary outsourcing issue and then briefly consider the issues DC fiduciary outsourcing presents under ERISA.

Background

By way of background, let's discuss two questions: What is driving the DC outsourcing trend? And why is DC fiduciary outsourcing different from, say, defined benefit (DB) fiduciary outsourcing?

The outsourcing trend

There's always been outsourcing of some sort in DC plans: when an outside manager is hired to manage a fund offered under a plan, the task of managing that fund has, in effect, been ‘outsourced.’ Similarly, DC plans have traditionally "outsourced" record keeping.

More recently, however, when sponsors and providers talk about DC fiduciary outsourcing, they mean something more comprehensive, often involving the outsourcing provider taking over such basic fiduciary decisions as fund menu design, design of the plan's target date fund (TDF) and TDF glide path, and selection and monitoring of fund managers. Much of this trend is in response to a move away from off-the-shelf or ‘retail’ plan investments and towards more sophisticated investment strategies. The latter take various forms, including (as mentioned) the use of collective trusts, separate accounts and white label funds, but also including ‘bespoke’ strategies such as combining management of the sponsor's DB and DC plan assets. These strategies commonly go by the name ‘institutionalization.’ There are many reasons for the emergence of institutionalization, but certainly one is the constant pressure on sponsors – from regulators and litigators – to reduce plan fees.

Institutionalization presents a number of issues for the sponsor. Obviously, analyzing, designing and picking managers for ‘non-retail’ (and non-standardized) funds can be a challenge. But communications (explaining how these funds work and reporting performance), implementation and administration (setting up procedures for the interactions between the fund managers, the record keeper and the trustee) are also much more difficult for these sorts of funds than they are for a mutual fund. In that context, hiring someone – the outsourcing provider – with expertise in solving these problems looks like a good call.

Why DC fiduciary outsourcing is different

There has been a meaningful amount of DB outsourcing for some time. Why is DC outsourcing all of a sudden an issue? Because in DC plans the fiduciary stakes are higher.

While ERISA's fiduciary rules apply both to DB and DC plans, in DB plans, generally, investment losses (and losses due to, e.g., excessive fees) ‘flow to the sponsor.’ That is, if because of investment underperformance a DB plan has a funding shortfall, the sponsor must make it up. With certain obvious exceptions (e.g., a distress termination), participants are unaffected by fiduciary-caused losses. And since the sponsor is (again, with certain obvious exceptions) the fiduciary responsible for the loss, there's really no one to sue.

In DC plans, on the other hand, investment losses ‘flow to the participant.’ If the sponsor-fiduciary has selected an underperforming or overpriced fund, the participant loses. And the participant has someone to sue – the sponsor.

This relationship between DC fiduciary responsibility and participant losses is what makes DC fiduciary outsourcing more problematic.

Effect of 404(c)

One other aspect of current DC fiduciary-investment practice has to be taken into account as we consider DC outsourcing. Whereas, in the typical DB plan, the investment fiduciary is investing plan assets generally (or a discrete ‘slice’ of plan assets), in the typical DC plan the investment fiduciary is simply managing an ‘investment option’ – what assets the fiduciary will manage will depend on how many participants select that option. That feature of DC plans takes advantage of ERISA section 404(c).

ERISA section 404(c) provides that, if a participant controls the investment of assets in his or her account, then no fiduciary will be liable for any loss resulting from the participant's exercise of control and the participant him- or herself will not be a fiduciary. Thus, in a 404(c) plan, fiduciaries are generally off the hook for the negative consequences of participant investment choices.

Generally, in order to use 404(c) a plan must provide a broad group of investment choices (at least three funds with meaningfully different risk/return profiles), participants must be given the ability to move assets back and forth between investment funds at least quarterly (and more frequently if the volatility of the investment warrants it) and participants must be given information sufficient to make an informed choice between available investments (generally, a summary of each fund's risk/return characteristics and certain fee information, and with respect to mutual funds a prospectus upon the first investment by the participant in the fund). In addition, participants must be notified that the plan is a 404(c) plan.

In a DC plan that allows participant choice (and meets the requirements of ERISA section 404(c)), the residual sponsor-fiduciary responsibility is the responsibility for choosing the funds/menu options available under the plan. Most of the fiduciary litigation – with respect to ‘underperforming funds’ and ‘excessive fees’ – focuses on the selection and monitoring of the funds and fund managers. And it is that responsibility that DC sponsor-fiduciaries would like to outsource.

Can DC investment fiduciary responsibility be ‘totally’ outsourced?

A basic question that many sponsors ask is: can the sponsor-fiduciary transfer its liability to an outsourcing provider and thereby avoid getting sued?

Let's be clear right at the beginning of this discussion: we do not know the extent to which a sponsor can transfer its fiduciary responsibility to an outsourcing provider. Certainly some responsibility can be transferred. Very likely (although some would challenge this), some responsibility will be retained. We will (unfortunately) probably need more litigation in this area before we have a more precise answer.

There are some who suggest that the plan document may designate an outsourcing provider as the plan's named fiduciary, and that this approach in effect ‘takes the sponsor off the hook.’ This theory relies on treating the sponsor's adoption of a plan with the outsourcing provider as the named fiduciary as a ‘settlor function’ rather than a fiduciary function. That is, in designating the outsourcing provider as the named fiduciary (in the plan document), the sponsor is not acting as a fiduciary. This theory has not been tested in the courts.

As we understand it, there are also some who believe that a similar result – ‘full outsourcing’ of investment fiduciary responsibility – can be achieved by entering into a trust agreement appointing a trustee to manage plan assets. In this regard, note that, generally, under ERISA, the trustee is responsible for investing plan assets, unless (1) the plan expressly provides that the trustee is subject to the direction of a named fiduciary (e.g., a sponsor-fiduciary) or (2) authority to manage plan assets is delegated to an investment manager appointed by a named fiduciary. This theory has also not been tested in the courts.

With regard to these ‘no liability at all’ theories, we would emphasize that there are many who reject any notion that a sponsor might be able to select a named fiduciary or trustee without any responsibility to prudently appoint or monitor.

What sort of responsibility might be retained?

If a sponsor-fiduciary cannot delegate/outsource all fiduciary responsibility, what is the scope of the liability that it must retain?

It is generally understood that a named fiduciary (e.g., a sponsor-fiduciary) may (under properly drafted plan documents) delegate fiduciary responsibilities. In that circumstance, the named fiduciary is generally responsible for the prudent selection and monitoring of the performance of the delegate.

A simple version of the application of this rule occurs in the selection of an investment manager of a fund or of a plan service provider. In that circumstance, the named fiduciary is responsible for the prudent selection and monitoring of the fund manager or service provider. Whether the named fiduciary has met that standard depends on the facts. We do have litigation applying this standard, e.g., in cases like Tussey v. ABB. In those cases, the allegation is (and sponsor-fiduciary liability is premised on a claim) that the named fiduciary either imprudently selected, or imprudently monitored, a fund or plan service provider.

In those cases, the named fiduciary is held liable for, among other things, analyzing and evaluating the cost and quality (e.g., investment performance) of the funds and services involved. The idea behind outsourcing is that that duty itself – the responsibility for appointing and monitoring fund managers or service providers – would be outsourced. In theory, the sponsor would then be left with the sole duty of prudently appointing and monitoring the outsourcing provider.

Does that work? Is it an improvement over the prior situation? It should be, in two respects. First, the duty to appoint and monitor five or ten different managers and service providers should be reduced to a duty to appoint-and-monitor only one. And, second, the level of scrutiny involved should be more general. That is, in this situation, the sponsor fiduciary should only be obligated to review the general performance of the outsourcing provider and not be obligated to review, e.g., the arrangements (including fee arrangements) it (the outsourcing provider) has made (on behalf of the plan) with respect to specific fund managers and service providers.

Just how all that will work, and how much deference courts will give to the delegation/outsourcing process, has also not been tested.

A fluid situation

Thus, we are in a fluid situation. At the ERISA Advisory Council, many witnesses asked that DOL provide guidance on those issues we have identified as untested in court. Some advocated for a ‘freedom to contract’ – that sponsors and providers be allowed to allocate responsibilities among themselves, without burdening the sponsor with a legally imposed, non-delegable responsibility.

There are certainly those, however, who would prefer that the employer always retain some residual responsibility for the choice of plan funds and service providers. And in hard cases – say, where a thinly capitalized outsourcing provider made obvious mistakes – courts may be willing to stretch to find sponsor-fiduciary liability.

We expect further developments in the rules for outsourcing. But, whatever the legal case, the business case for outsourcing – e.g., the need to involve experts in the more technical decisions required in a fully ‘institutionalized’ plan – remains strong. In that context, generally a sponsor's best strategy (as it often is under ERISA) is to rely on process, to fully vet outsourcing provider candidates and to consider and monitor all aspects of its (the sponsor's) and its participants' relationship with the outsourcing provider.

October Three Consulting, LLC is a full service actuarial, consulting and technology firm that is a leading force behind the reemergence of defined benefit plans across the country. A primary focus of the consultants at October Three is the design and administration of comprehensive retirement benefits to employees that minimize the financial risks and volatility concerns employers face.

Through effective plan design strategies October Three believes successful financial outcomes are achievable for employers and employees alike. A critical element of those strategies is the ReDB® plan design. The ReDefined Benefit Plan® represents an entirely new, design-based approach to retirement and to the management of both the employer’s and the employee’s financial risk, focusing on maximizing financial efficiency and employee value.

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