The fiduciary duty to monitor – 401(k) plan investments

August 12, 2015

In our prior article we reviewed the basic principles of an ERISA fiduciary's duty to monitor persons it appoints to carry out plan-related functions. In this article we discuss the application of those principles to the selection of plan investments and investment managers. We are going to consider this issue exclusively in the context of a 401(k) plan intended to comply with ERISA section 404(c), in which participants choose investments from a fund menu.

Unique duty-to-monitor issues presented by participant choice plans

In a ‘traditional’ defined benefit plan, the duty to monitor looks a lot like the duty to monitor investments in a traditional trust. Generally, the plan fiduciary must monitor investments for their continued prudence. Thus, the plan fiduciary has a duty to monitor for, e.g., changes in the plan’s needs, the performance of investments and the conditions of the market that may require that the plan dis-invest in investments that it has previously made. That process is relatively intuitive – it looks something like what an ordinary investor might do with his or her own money.

In 404(c)-401(k) plans, the monitoring process is different and less intuitive. In a 401(k) plan, if the requirements of ERISA section 404(c) are met, the plan's investment fiduciary is not "liable under the fiduciary responsibility provisions of ERISA for any loss, or by reason of any breach, which results from [a] participant's or beneficiary's exercise of control [over assets in his account]." If, in a plan that meets the requirements of ERISA section 404(c), the participant imprudently elects to invest 100% of her assets in an equity fund and loses money, plan fiduciaries generally are not liable.

Thus, implementation of a 404(c)-401(k) plan frames the duty to monitor in a unique way. In this sort of plan, the plan fiduciary must (1) monitor for continued compliance with 404(c), (2) if the fiduciary is satisfied that the plan complies with 404(c), then its obligation to monitor individual (participant) investment decisions (e.g., with respect to asset allocation) is generally eliminated, but (3) the fiduciary does have a residual obligation to monitor for the ongoing prudence of the inclusion of the funds in the fund menu.

Compliance with 404(c)

Under ERISA section 404(c), a plan must provide a "broad range of investment alternatives." To comply with that requirement a plan must offer at least three investment alternatives:

  1. Each of which is diversified;
  2. Each of which has materially different risk and return characteristics;
  3. Which in the aggregate enable the participant ... by choosing among them to achieve a portfolio with aggregate risk and return characteristics at any point within the range normally appropriate for the participant; and
  4. Each of which when combined with investments in the other alternatives tends to minimize through diversification the overall risk of a participant's ... portfolio.

Initial decisions with respect to these issues should be reviewed from time to time. That is, for instance, the plan fiduciary should (re)consider: does the plan have at least three investment alternatives that in the aggregate enable the participant to "achieve a portfolio with aggregate risk and return characteristics at any point within the range normally appropriate for the participant”?

Prudence of funds included in the fund menu

Generally, sponsors think about the fund menu as including the following possible categories of funds: (1) the default investment (for participants who do not make an affirmative investment decision); (2) ‘core’ funds (designed to permit the participant to make basic asset allocation decisions); (3) other funds (sometimes left over from prior fund menus, sometimes responding to specific participant concerns, sometimes simply ‘add-ons’); and (4) special purpose funds (e.g., company stock and stable value).

Under ERISA most believe that, except with respect to funds only available through a brokerage window, the plan fiduciary has an obligation to determine the prudence of the inclusion of any fund in the fund menu. [For a (possibly) different view, consider the decision in the Deere case.] In this article we will sometimes refer to this exercise as the determination of the ‘general prudence’ of the inclusion of a fund in the fund menu.

Determining prudence here involves the four issues we identified in our prior article: performance, cost, competence and suitability.

Performance. Plan fiduciaries will generally want to have a process for reviewing fund performance against a peer group/benchmark and for removing funds that underperform. Of course, finding an appropriate benchmark is often complicated and may in some cases be unrealistic. (We note that performance is generally only an issue with respect to actively managed funds, although it is certainly possible for, e.g., an index fund to underperform.)

Cost. 401(k) investment fees have been the target of litigation for some time now, and the reasonableness of the fees with respect to each fund should be regularly reviewed. Generally (in our view) ‘prudence’ litigation in this area has been driven by issues of proof. And, in that regard, the most vulnerable fiduciary decisions are those where a plaintiff's lawyer can make an A vs. B argument. (We will return to this issue in a subsequent article when we discuss monitoring of record keeper and revenue sharing arrangements.)

One area of risk that has emerged is retail funds. For plans of any size, the use of a retail mutual fund where an (identical) institutionally priced fund is available has been a litigation target. Plaintiffs were successful in Tibble with just this argument; retail funds were also an issue in the Wal-mart fee litigation. If an ‘institutional-sized’ plan is using retail funds, generally its fiduciaries will want to review the basis for doing so. There may be defensible reasons for the decision; but the fiduciary should generally make sure that those reasons have been identified and continue to apply.

We also note that passive investments generally can be subjected to an A vs. B analysis: one S&P 500 index fund should (more or less) perform the same as another. Thus, if the S&P 500 index fund included in the fund menu has a higher expense ratio than other available S&P 500 index funds, an analysis similar to the one for retail funds should be made: there may be defensible reasons for the decision to use a higher priced index fund; but the fiduciary should generally make sure that those reasons have been identified and continue to apply.

Competence. Plan fiduciaries should, in the monitoring process, be satisfied that the conclusions they came to about the fund manager's competence when the fund was initially selected (e.g., that the manager had demonstrated expertise in the fund's investment style) continue to apply. Most obviously, if there has been significant turnover in management, the fiduciaries should be satisfied that the new management's expertise is adequate.

Suitability. There is, theoretically, some risk of litigation over ‘suitability’; some have argued that some investments/investment funds are un-suitable for retirement investment, e.g., because they are too speculative or volatile. In addition, plan fiduciaries will want to review the suitability of the inclusion of funds in the fund menu for practical reasons. Every fund added to the fund menu creates an additional review burden. And funds that present unusual or hard-to-evaluate risks can be especially problematic.

The duty to monitor and investment policy statements

Most plan fiduciaries have adopted an investment policy statement, and typically the investment policy statement (IPS) will describe criteria for the review of fund performance and what to do if a fund is underperforming. We're not recommending any particular criteria; but it is critical that the fiduciary decision-making process reflect what is said in the IPS and that the IPS reflect the fiduciary decision-making process.

* * *

In addition to the general duty to monitor the (continued) prudence of the funds in the fund menu, 401(k) plans often present several ‘special’ investment issues: QDIAs; company stock; and brokerage windows.

QDIAs

Typically (and especially if the plan provides for automatic enrollment), a plan will provide for a default investment (typically, a target date fund (TDF)) designed to meet the requirements of DOL's qualified default investment alternative (QDIA) rules.

Does the plan's default comply with the QDIA rules? Under those rules, the TDF generally must be:

An investment fund product or model portfolio that (1) applies generally accepted investment theories, (2) is diversified so as to minimize the risk of large losses, and (3) is designed to provide varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed income exposures based on the participant’s age, target retirement date (such as normal retirement age under the plan) or life expectancy.

The plan's investment fiduciary should review, from time to time, whether the plan's default continues to meet these requirements.

TDFs and general prudence. A TDF will also present special issues for the general prudence review discussed above. This is because the prudence of a particular TDF (its inclusion in the fund menu and use as a default) is a function both of the prudence of the TDF's component funds (their performance, cost and suitability and the competence of their (the component fund's) managers) and of the TDF's glide path. In this regard, one issue that has gotten attention is whether the ‘target’ of the target date fund – a ‘to retirement’ vs. ‘through retirement’ glide path – has been adequately communicated.

Company stock

Company stock has been a nearly constant source of 401(k) litigation. The triggering event is, typically, a precipitous drop in the stock price (hence the name ‘stock drop’ cases), although precipitous increases in price after a stock fund is terminated/sold off have also produced litigation (‘reverse stock drop’ cases). Generally, as a single stock investment, company stock is more risky than investment in a diversified fund. That greater risk can produce bigger gains, and bigger losses. Big losses produce plaintiffs.

With respect to publicly traded company stock, post-Fifth Third, plan fiduciaries should generally monitor for ‘special circumstances’ that would lead them to believe that the market has over- or undervalued the stock. It remains to be seen how frequently lower courts will find such ‘special circumstances.’ For a more detailed discussion of these issues, see our articles on Fifth Third, Tatum v. R. J. Reynolds Tobacco Company and Harris v. Amgen.

As a practical matter, fiduciaries' ability to mitigate company stock litigation risk may be limited, given the inevitable risk of large losses.

Brokerage windows

For a very long time most believed that plan fiduciaries had no duty to review investments in a brokerage window. As discussed in our article Information on brokerage windows requested by DOL, beginning in 2012 DOL began to raise questions about a fiduciary's obligation with respect to brokerage window investments. Since then, DOL appears, however, to have ‘backed off’ on this issue, at least with respect to the use of brokerage windows in plans that provide an adequate non-brokerage window fund menu.

Plan fiduciaries will want to review the general terms of the brokerage window for reasonableness. And, because (to repeat) because big losses create plaintiffs, (i) fiduciaries will want to make sure that participants who use the brokerage window understand the risks in doing so, and (ii) they may want to consider, where possible, ways to mitigate those risks (e.g., by limiting the percentage of a participant's account that may be invested via the window).

* * *

To repeat what we said in our prior article: ERISA prudence is, critically, about process and documentation. With respect to plan investments, plan fiduciaries should have a manageable process that deals with all the issues; they should then follow that process; and documentation (e.g., committee minutes) should reflect that process.

Our next article will discuss the duty to monitor non-fiduciary service providers and revenue sharing arrangements.

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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