401(k) Plans and Liability Exposure for Plan Sponsors

By Jay G. Sanders

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DECEMBER 2005 - The SEC and Department of Labor (DOL) have recently reported several high-profile investigations regarding mutual fund companies and 401(k) plan service providers. The substance of these investigations may expose plan providers to liability for participant investment losses as well as regulatory penalties.

An ongoing SEC investigation has found, among other things, that several billion dollars of revenue-sharing fees are being hidden annually from plan sponsors and plan participants through internal charges against plan assets invested in mutual funds. When compounded over time, hidden revenue-sharing costs will likely usurp a meaningful percentage of the value of a retiree’s plan. As of 2003, 42 million workers participated in 401(k) plans which held a total of $1.9 trillion in assets.

Hidden costs are only one of several trouble spots currently concerning regulators. The others are the general investment savviness of participants and the present condition of the Social Security system. 401(k) plans, for example, pass investment risk on to participants only so long as the employer/sponsor complies with ERISA section 404(c). A recent Dalbar study reported that the average investor managed a 3.51% return while the S&P 500 returned 12.98% over the last 20 years. That’s not a good sign for retirement security. Federal Reserve Chairman Alan Greenspan’s August 2004 testimony before Congress called for immediate changes to Social Security benefits. The essence of his presentation was that benefits should be reduced and moved further out, and that the sooner action is taken, the better. The combination of hidden 401(k) costs, poor investment results, and a weak Social Security system spells trouble for baby boomers, making additional enforcement and regulation more likely.

Complicating this situation is the mistaken belief held by the vast majority of employers that they have no liability with regard to their 401(k) sponsorship. This is patently false. Plan sponsors have three major responsibilities under ERISA. They are, first, to select appropriate investment alternatives and, second, to continually monitor these alternatives for continued suitability. These two exposures can’t be delegated. The third responsibility is compliance with ERISA section 404(c).

Plan sponsors can take the following steps to mitigate their exposure:

  • Implement and follow an investment policy statement;
  • Make prudent investment alternative selections;
  • Continually monitor investment alternatives, by reviewing investment-alternative results against appropriate benchmarks and performing a comprehensive cost analysis of the plan and the investment alternatives;
  • Conduct a section 404(c) audit; and
  • Consult an insurance broker about the availability of fiduciary coverage.

Implement and Follow an Investment Policy Statement

ERISA states that plans must “provide a procedure for establishing and carrying out a funding policy in a method consistent with the objectives of the plan.” This has been interpreted to mean that qualified retirement plans, including defined contribution plans, should have established procedures for plan investment-related decision making. Fiduciaries that have not described those procedures in a written investment policy statement (IPS) and documented the plan’s procedures leave themselves open to participant and DOL actions. The DOL will routinely ask to see a plan’s IPS in the process of a plan audit.

An IPS is a “how to” procedures manual for managing plan assets. The IPS, at a minimum, will include procedures for selecting investments, monitoring investments (frequency and methodology), establishing performance expectations (benchmark selection), and specifying the criteria for adding and deleting investments. An IPS sets the ground rules for both the plan sponsor and its service providers.

A sample IPS can be found at the Profit Sharing/401(k) Council of America’s website, www.psca.org, under “plan tools.” Other excellent sources for background on IPS issues are two articles in the Journal of Financial Planning by Boone and Lubitz: “A Review of Difficult Investment Policy Issues” (www.fpanet.org/journal/articles/2003_Issues/jfp0503-art8.cfm) and “Developing an Investment Policy Statement for the Qualified Plan” (www.fpanet.org/journal/articles/1992_Issues/jfp0492-art5.cfm).

Make Prudent Investment-Alternative Selections

ERISA requires a plan fiduciary to discharge his duties with respect to the plan “solely in the interest of the participants and beneficiaries.” ERISA states that the fiduciary should act “with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and like aims; by diversifying the investments of the plan so as to minimize the risk of large losses.”

This is referred to as the “prudent expert” rule, because ERISA requires that the fiduciary act not just with prudence but with the prudence that someone familiar with such matters would exercise. ERISA’s definition of fiduciary implies that investment alternatives must be diversified so as to minimize loss. ERISA section 404(c) provides that investment alternatives must be selected in a manner that allows participants a reasonable opportunity to materially affect the potential return and degree of risk on their investments.

Investment Monitoring

Evaluating investment results periodically and continually is one of the nondelegable responsibilities that ERISA imposes on plan sponsors. Alternative-investment-option results must be compared against appropriate benchmarks and should also be compared to competing funds with similar styles. Identifying appropriate benchmarks and competing funds is relatively easy on the Internet. Funds are classified by investment style (for equities: growth, core, and value; for bonds: high, medium, and low quality), and sites such as Morningstar, Quicken, and Yahoo can perform the style classifications and competitive fund comparisons.

A benchmark index is defined as a stock, bond, or other index used to compare specific investment results with that of the market or economy. Primary benchmarks generally consist of broader indexes, and are often not style-specific; the S&P 500 is the prime equity example and the Lehman aggregate bond is the prime debt example. The purpose of the primary benchmark is to enable an evaluation of the money manager’s performance in comparison to the broader market. A “best-fit” benchmark is the benchmark that represents the best basis for evaluating the money manager’s performance by style and peer group. Note that the benchmark and competing fund information also include other important data, such as alpha, beta, R2, and standard deviation, which are helpful tools in evaluating risk-adjusted returns.

Plan sponsors should use both primary and best-fit benchmarks, at a minimum, in their investment-alternative evaluations. It’s important to remember that indexes listed in the Wall Street Journal typically do not include reinvested dividends, which will be needed for comparison with qualified plan returns. Morningstar has a comprehensive list of total return indexes at screen.morningstar.com/index/index
. Please note that documenting the evaluation process is highly recommended, as ERISA appears to require such documentation.

Cost Analysis of the Plan and the Investment Alternatives

Monitoring plan investments goes beyond evaluating investment results and requires an analysis of investment costs. High investment costs erode the value of a plan, so plan fiduciaries have a duty to keep them low. Costs attributable to plans are classified as either administrative or investment. Administrative costs are those associated with maintaining the plan; investment costs are the direct charges for carrying a specific investment. For example, the Vanguard 500 Index Investor Shares have a carrying charge of 0.18%, called its expense ratio. The expense ratio is the percentage of fund assets paid for operating and management fees, including 12b-1 fees (distribution costs), administrative fees, and all other asset-based costs incurred by the fund. It does not include brokerage costs. Expense ratios are useful because they show the actual amount that a fund takes out of its assets each year to cover costs. Plan sponsors should note not only the current ratio but also the trend in fund costs. Certain kinds of funds, such as foreign-stock funds, have higher costs and therefore higher expense ratios. With bond funds it’s critical to look for lower expenses; higher-cost funds tend to be more risky because managers may take on greater risk in the hunt for higher returns to offset their higher expense ratios.

Based on expense ratios, one would think that it should be simple to analyze investment costs. That’s not the case, however, for several reasons. First, mutual funds have some discretion as to what costs are included in the calculation of the expense ratio and its components. This discretion leads to expense ratios that may be inconsistent from fund to fund. Mutual funds, in addition, may have different share classes that are distributed through different channels and often carry different expense ratios. For example, a given plan may be entitled to a share class with a lower expense ratio, but the service provider may receive greater compensation from another share class, and so the participants may end up carrying that extra cost. Finally, service providers and the mutual funds in a plan sometimes share revenues through a portion of the 12b-1 fees. This revenue sharing effectively shifts investment costs to administrative costs and obscures them from the plan sponsor.

The shifting of costs—hidden revenue-sharing—is highly problematic for plan sponsors, which may be doing business with service providers who are earning hidden fees that have not been explicitly disclosed to the sponsor. A sponsor’s ignorance of these arrangements is not going to be an adequate defense in a litigation action. There are a number of places to learn about these hidden sharing arrangements, like subtransfer fees, shareholder servicing fees, and directed brokerage:

Conduct a Section 404(c) Audit

The third requirement to shift investment liability to plan participants is compliance with the requirements of ERISA section 404(c). Section 404(c) is a specific set of rules that, when followed, effectively transfer responsibility for selecting among plan investment options. When a plan complies with section 404(c), sponsors are relieved of their fiduciary liability for investment losses on transactions made by their participants. The essence of the section 404(c) regulations requires that: 1) participants actually exercise control with respect to the investment transaction, and 2) any losses are directly and necessarily a result of investment instructions given by the participant.

Before a plan participant can make an informed investment decision, she needs information. In section 404(c) parlance, this is called “information that must be provided” and consists of 11 requirements. These requirements focus on how the plan is intended to function; a description of investment alternatives, with risk and return characteristics; investment prospectuses, where applicable; information on voting, tendering, and similar rights, if applicable; and, finally, how to give investment instructions. A participant provided with such information is capable of making an investment and may do so. Section 404(c) has a further five requirements that it calls “information to be provided on participant request.” These requirements focus on the annual operating costs of each investment alternative; copies of the latest financial statements, reports, or prospectuses; details of the alternatives’ underlying assets and values; past and current investment performance of the alternatives; and the value of shares or units in the participant’s account. This information must be provided in sufficient time for the participant to utilize it in making an investment decision.

When and how frequently participants can enter into transactions is critical in determining if participants are free to exercise control of transactions. In addition to the timing requirements of “information that must be provided” and “information to be provided on participant request,” participants must also be given the opportunity to change investments as often as the volatility of the investment requires (the general volatility rule). Most sponsors are unaware of this requirement. For example, if the markets are crashing, participants need to be given the opportunity to protect themselves and bail out.

Other section 404(c) requirements are related to the sponsor’s responsibilities to carry out investment instructions and to the “broad range of investment alternatives” requirement. The former spells out what transactions sponsors do not need to process, and the latter discusses, from the participant’s perspective, the ability through investment alternatives to diversify assets and minimize the risks of loss under the “prudent expert” standard.

Useful sources of information for section 404(c) and other ERISA compliance, and the source for this compliance discussion, may be found at the website of Reish, Luftman, Reicher and Cohen (www.
) and at the 401(k) Help Center (www.401khelpcenter.com).

Fiduciary Insurance

Losses can be avoided, mitigated, or transferred. Potential losses arise from the perils of not complying with ERISA section 404(c), poor investment selection, and poor oversight. Complying with ERISA and taking seriously the “prudent expert” standard can mitigate potential losses. An alternative is to transfer the risk to an insurer, in the form of fiduciary insurance.

The typical insurance clause reads as follows: “The Company shall pay on behalf of the Insured all Damages on account of a Claim first made during the Policy Period for an actual or alleged Wrongful Act.” The definition of an insurance claim in a fiduciary policy includes, among other standards like civil and criminal proceedings, a formal administrative or regulatory proceeding. The definition of a wrongful act in a fiduciary insurance policy is a breach of fiduciary duty by the insured with respect to an employee benefit plan, including but not limited to:

  • Breach of duties, obligations, and responsibilities imposed by ERISA or COBRA, or by any related or similar state, local, or foreign law or regulation, in the discharge of the insured’s duties with respect to an employee benefit plan;
  • Any other matter claimed against an insured solely because of the insured’s status as a fiduciary as respects an employee benefit plan; and
  • Negligent acts, errors, or omissions of the insured in the administration of employee benefits.

A fiduciary insurance policy can provide plan sponsors with some important protections. It is important to remember, however, that liability policies like the one described above must be read very carefully by the plan sponsor and legal counsel. In addition, the fiduciary insurance application includes many underwriting questions about ERISA compliance which may in the end require one to truly become a “prudent expert” in order to qualify for the coverage.

Jay G. Sanders, CPA, CFP, CSA, is the founder of Maturity Planning, New York, N.Y. He is a member of the NYSSCPA’s Estate Planning and Personal Financial Planning committees.




















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