Reduce Your Exposure to
ERISA Fiduciary Liability:

                   Responsible Management
              of Employee...

The following document is not intended to be a legal opinion. Rather, it is an interpretation
of a number ...
Table of Contents

Fiduciary Responsibility and Your Financial Advisor
As the person responsible for handling your                 ERISA: Pro...
undergone interpretation by the DOL, the IRS,              are subject only to the prohibited transaction
and the courts. ...
Who Should Manage the                                              Provide participants with education so they
Wisc. 1979); Donovan v. Bierwith, 538 F.Supp. 463 (E.D.N.Y.            Furthermore, the IRS can impose an income
1981), mo...
Your Investment Policy Statement: Put It In Writing
A written Investment Policy Statement is                They should no...
Your Financial Advisor Can Draft Your Policy Statement
            A Financial Advisor well versed in the investment plann...
Studies have shown that the historical                     In addition, the fiduciary will be held to a
probability of a c...
The 'Safe Harbor' Rule                                                       The prudent selection of investment
broad latitude in their overall investment                           If a fiduciary chooses to use a Financial
approach. I...
Diversify, Diversify, Diversify                              diversification did not exist and a loss occurred.
ERISA stat...
Some court decisions would lead one to                   If there are sufficient assets, the fiduciary
believe that the wo...
Monitor Your Plan Investments                                             Effective monitoring of a professional money
or mutual fund?” First of all, one quarter, six        Avoid Prohibited Transactions:
months, or even one year of poor per...
ERISA continues with general items a fiduciary                        Interestingly enough, there is one specific
cannot u...
With smaller pension plans (assets less than
$5.0 million), there is a tendency for the fiduciary
that these consulting fees be paid with “soft dollar”    employee benefit plans have become logical
or “commission recaptu...
SAM               Investment Policy Statement

       PLE                                  For

Time Horizon

Investment objectives are long-term in nature, with an estimated time horizon of more
than 10 years.

Asset ...
3.      The Investor prefers that only debt issues of investment grade or better be purchased.
        However, discretion...
The Investor should continually review liquidity needs and should notify Asset Management Ser-
vices as soon as possible o...
Investment Advisory Services
    Member New York Stock Exchange / SIPC
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Reduce Your Exposure to ERISA Fiduciary Liability:

  1. 1. Reduce Your Exposure to ERISA Fiduciary Liability: Responsible Management of Employee Benefit Plan Assets
  2. 2. Acknowledgment The following document is not intended to be a legal opinion. Rather, it is an interpretation of a number of sources believed to be accurate, relating to the management of assets in qualified retirement plans in accordance with ERISA standards. There is no one set of black letter law which clearly defines ERISA standards. If this document presents issues of which you are unaware, the only prudent course of action is to consult a qualified attorney. Investment Advisory Services gratefully acknowledges the legal and/or editorial assistance in this edition by: William R. Allbright, JD, CPA, CIMC (Co-author: The Management of Investment Decisions) (Published by Irwin Professional Publishing, 1996) and for the legal and/or editorial assistance originally provided by: Catherine S. Bardsley, Esq. Lillian Fischer, Ph.D. Martin Silfen, JD Copyright © Raymond James & Associates, Inc. 2002. All rights reserved. 2
  3. 3. Table of Contents Page No. Introduction ........................................................................................................ 4 Background......................................................................................................... 4 Which Plans are Affected ................................................................................. 5 Fiduciary and Co-fiduciary Defined ............................................................... 5 Participant-Directed or Trustee-Managed Plans........................................... 6 Prudence.............................................................................................................. 6 Liability Under ERISA ..................................................................................... 7 Investment Policy Statements Should be in Writing .................................... 8 Asset Allocation.................................................................................................. 9 Investment Decisions Must be Made as if by a Prudent Expert .................. 10 Investment Assets Must be Diversified ........................................................... 13 Plan Investments Must be Monitored ............................................................. 15 Prohibited Investment Transactions Must be Avoided................................. 16 Transaction Costs and Other Services ............................................................. 18 Sample Investment Policy Statement .............................................................. Appendix 3
  4. 4. Fiduciary Responsibility and Your Financial Advisor As the person responsible for handling your ERISA: Protection for Employees firm’s qualified retirement plan, you may be Today there are over seven million qualified considered to be a fiduciary. At a minimum, you retirement plans and welfare plans with assets probably assist fiduciaries in the fulfillment of totaling more than $5 trillion. These retirement their duties. In the course of executing your plans hold more than 25% of all U.S. traded fiduciary responsibilities, you may have selected equities and 33% of U.S. corporate bonds. The several well-qualified professionals to assist in the need for prudent management of these assets establishment, management, and maintenance of cannot be overemphasized. If these assets are not your plan. You may have retained an attorney to prudently managed, the average worker will be draft the plan and provide legal oversight, a plan left to inadequate government entitlements to administrator for the maintenance of the plan, supplement retirement benefits during his or her and an accountant to audit the plan and file the retirement years. For this reason, the necessary Internal Revenue Service (“IRS”) Department of Labor (DOL) and the IRS have documents. You may have, however, overlooked continued to step-up auditing and enforcement the need to add one more professional to your efforts against employee benefit plans. “team”—namely a Financial Advisor. This advisor can assist you with meeting your legislatively ERISA was enacted “to protect the ... imposed fiduciary responsibilities regarding the interests of participants in employee benefit plans management of the assets in the plan. A number and their fiduciaries by requiring the disclosure and of top consulting firms have estimated that well reporting to participants and their beneficiaries of over 90% of small plans are probably not in financial and other information with respect compliance with the Employee Retirement thereto, by establishing standards of conduct, Income Security Act of 1974 (“ERISA”) responsibility, and obligation for fiduciaries of principles pertaining to the management of employee benefit plans, and by providing for those assets. The enforcement of these standards appropriate remedies, sanctions, and ready access continues to be on the rise through governmental to the federal courts.” (ERISA Section 2(b). 29 oversight and plan participant demands. U.S.C.A. 1001(b).) The IRS also has an interest in qualified plans because of the tax-deferred status of the plan assets. Section 4975 of the Internal Though the fiduciary can never be fully Revenue Code of 1986 (“Code”) mirrors several of insulated from liability, nor transfer the the same standards contained in the Labor full responsibility for compliance to provisions (Title 1) of ERISA. someone else, exposure to ERISA The provisions of ERISA Sections 402 liability can be greatly reduced by through 412 and Section 4975 of the Code are employing a complete team of intended, among other things, to provide a basis knowledgeable advisors. for standards of conduct for plan fiduciaries. As with most black letter law, these sections have 4
  5. 5. undergone interpretation by the DOL, the IRS, are subject only to the prohibited transaction and the courts. In summary, these standards are: provisions of the Internal Revenue Code, Section 1) Investment policy statements should be in 4975. Original ERISA language states that the writing statute, and the regulations promulgated 2) Investment decisions must be made against a thereunder, were adopted to protect the interest “‘prudent expert” standard of participants. 3) Plan assets must be diversified Thus, a plan involving the fiduciary, and 4) Plan investment performance must be monitored no one else, was not originally regulated under 5) Prohibited investment transactions must be ERISA and, therefore, unenforceable by the DOL. avoided However, in 1978 jurisdiction of sole participant 6) Duties must be discharged for the exclusive plans was transferred to the DOL in order to purpose of providing benefits to participants insure investment compliance would be uniform. and to defray reasonable administrative Responsibility for oversight of plan funding, as expenses well as participation and vesting of benefit rights, is the domain of the Department of Treasury. 7 Plans Affected by ERISA Law The Department of Labor possesses regulatory Specifically, ERISA provisions cover fiduciary authority to oversee fiduciary obligations. Both responsibilities for the following employee benefit Departments, however, possess enforcement plans: powers. Profit Sharing Plans Money Purchase Pension Plans Who are Fiduciaries Defined Benefit Plans and Co-fiduciaries? Target Benefit Plans A fiduciary includes any person who has Cash or Deferred 401(k) Plans discretionary authority or control over the Funded Welfare Benefit Plans including: management of a plan, or the management medical, dental, prepaid legal services, or disposition of plan assets. A co-fiduciary unemployment, vacation benefits, day care is any other person with such discretionary centers, scholarship funds, workers’ authority with respect to the same plan. compensation, and death and disability funds Depending on the facts and circumstances, Simplified Employee Pension Plans co-fiduciaries may include the plan’s (sometimes) accountant, plan administrator, attorney, and/ Plans maintained by governmental bodies or Financial Advisor if the individuals have are exempt from ERISA, but most states have any influence over the management of plan imposed their own standards that closely follow assets. Anyone with investment oversight the ERISA requirements. Plans maintained by responsibility has a duty to ensure that churches and non-qualified deferred compensation appropriate procedures are followed on an plans set up by employers are also generally initial and ongoing basis. To do otherwise exempt. begs for problems and litigation and exposes Individual Retirement Accounts anyone possibly related to the management (“IRAs”) and one-participant plans, in which the of the plan assets to liability. sole participant and/or spouse own the business, 5
  6. 6. Who Should Manage the Provide participants with education so they can make intelligent choices between and Money in an ERISA Plan? among investment options. This education All employee benefit plans can be broken into two component should include, as a minimum: categories: 1) plans that allow for participants to direct how their monies should be invested Information on investment fundamentals, (usually from a menu of choices) and 2) plans that including the importance of diversification are trustee-directed (usually through the use of an and the asset allocation decision. employer investment oversight committee). The The relationship between risk and return. first type (participant-directed plans) typically The impact of the investment time horizon takes the form of a defined contribution plan (e.g. and the effect of inflation on investment 401(k) plan) while the second type is generally a growth. defined benefit or trustee-directed defined Instruction on the time value of money, contribution plan (e.g. traditional pension plan). particularly the effects of compounding. Either type still requires that appropriate prudent Discussion of the securities that make up procedures be followed. each of the different investment options. For participant-directed plans, these procedures may especially be critical if an employer is attempting to avail itself of the The Law Requires Documented Prudence protection afforded by ERISA Section 404 (c) that ERISA standards revolve around one basic permits a plan fiduciary to avoid liability for a theme—documented prudence. The courts view participant’s poor investment choices. These compliance with ERISA standards as more requirements are as follows: significant than subsequent investment performance Provide an opportunity for participants to choose results. A fiduciary is rarely surcharged by the from at least three investment options, each of courts for poor performance results if his/her which must have a unique risk/return profile. For investment decisions were prudently undertaken example, a plan that offered as investment options and properly documented. [See e.g., Donovan v. a money market, small-cap, and an international Mazzola, 716 F.2d 1226 (9th Cir. 1983); Sandoval v. fund would probably not satisfy the requirement Simmons, 622 F.Supp. 1174 (D.C. Ill. 1985); Davidson v. because of the common risk/return characteristics Cook, 567 F. Supp. 225 (E.D. Va. 1983), aff’d mem., 734 F. of the two equity funds. A plan sponsor that offers On the 2d 10 (4th Cir.), cert. denied, 469 U.S. 899 (1984).] its own stock as an investment option must still other hand, there are numerous cases where a offer three additional investment options. fiduciary has been held liable for taking imprudent Provide an opportunity for participants to risks that resulted in losses or substandard “exercise control” over the assets in their performance. The cases have always found individual accounts—this is defined as the liability because deficient documentation and/or opportunity to change investment options at poor procedures were followed in making the initial least quarterly. (There are those who believe investment decisions. [See Marshall v. Teamsters Local 282 that the volatility of the equity markets war- Pension Trust Fund, 458 F.Supp. 986 (E.D.N.Y. 1978); rant the ability for participants to make Freund v. Marshall & Ilsley Bank, 485 F.Supp. 629 (W.D. changes more frequently.) 6
  7. 7. Wisc. 1979); Donovan v. Bierwith, 538 F.Supp. 463 (E.D.N.Y. Furthermore, the IRS can impose an income 1981), mod. on other grounds 680 F.2d 263 (N.Y. Ct. App. tax on the plan’s earnings. 1982), cert. denied, 103 S. Ct. 488, 459 U.S. 1069, 74 L. Ed. 2d 631; Palino v. Casey, 664 F.2d 854 (Mass. Ct. App. 1981); but ERISA specifically addresses the extent of see Brock v. Walton, 794 F.2d 586 (11th Cir. 1986); Bidwill v. your personal liability: Garvey, 943 F.2d 498 (4th Cir. 1991); Meinhardt v. Unisys “Any person who is a fiduciary with respect Corp., 1994 U.S. Dist. LEXIS 12713 (E.D. Pa. 1994) and In re to a plan who breaches any of the Unisys Savings plan Litigation, 74 F. 3d 420 (3rd. Cir.), cert. responsibilities, obligations, or duties imposed denied, 117 S. Ct. 56 (1996).] upon fiduciaries by this title shall be personally liable to make good to such plan Liability & Exposure Under ERISA any losses to the plan resulting from such breach, What is your exposure if you do not prudently and to restore to such plan any profits of such manage the assets in your plan? First and fiduciary which have been made through use of foremost, you may have to face an unhappy assets of the plan by the fiduciary, and shall be employee if plan assets do not grow at an subject to such other equitable or remedial relief acceptable pace. Plan assets represent the as the court may deem appropriate, including most significant savings most employees will removal of such fiduciary.” have for their retirement years. Participants (ERISA Sec. 409(a). 29 U.S.C.A. in your plan can bring suit against you for 1109(a).) (Emphasis added.) failing to properly fulfill your duties as a fiduciary, and they can sue for performance losses and court costs. The number of court cases brought by participants is The courts are quick to assign increasing dramatically, especially as liability for investment losses or participants become more sophisticated poor performance when it can be about investment performance, the benefits of supported by imprudent or diversification, modern portfolio theory, and inappropriate actions. Therefore, have immediate access to relative performance prudence dictates that results. Second, the DOL and IRS can audit documented, appropriate steps your plan at any time. Both federal agencies have an interest in the management of your be undertaken. plan assets. If the DOL finds fault with the management of your plan assets, they can file suit against you personally. The DOL can also impose a 20% penalty against any amounts recovered due to a breach of fiduciary duty. The IRS can also disqualify the plan if it finds that the plan’s assets have not been managed for the exclusive benefit of the Participants. Plan disqualifications may be made retroactive to the initial compliance problem. 7
  8. 8. Your Investment Policy Statement: Put It In Writing A written Investment Policy Statement is They should not be confused with the Investment important in assisting fiduciaries in discharging Policy Statement, which should be in writing. their responsibilities in compliance with ERISA. There are two principal reasons why an ERISA mentions the necessity of a written investment policy should be developed in writing. investment policy under several provisions: First, investment decisions should be made “Every employee benefit plan shall provide a pursuant to the strategies developed in the procedure for establishing and carrying out a investment policy. Without an investment policy, funding method consistent with the objectives of fiduciaries may make ad hoc or knee-jerk the plan and the requirements of this subchapter.” decisions based on market emotion and/or a (ERISA Sec. 402 (b)(1). 29 U.S.C.A. 1102(b)(1).) persuasive salesperson. Having an investment policy provides the fiduciary with a well thought-out “A fiduciary shall discharge his duties with framework from which to build the investment respect to a accordance with the portfolio. Second, a written investment policy documents and instruments governing the plan.” establishes a rationale against which subsequent (ERISA Sec. 404(a) (1)(D). 29 U.S.C.A. 1104(a).) judgments can be made and evaluated. If the program is spelled out, then actions can later be The DOL has not specifically mandated the justified as part of the overall strategy. In development of a written statement, however, each addition, if the plan’s needs change, the objectives fiduciary is measured against the standard in of the plan can be evaluated and modified to existence in the industry. Investment Policy conform to the present situation. Statements are now so commonplace that DOL While the Investment Policy Statement officials have indicated that the absence of a does not have to be long and complicated, it written Investment Policy Statement makes should be specific enough to address the plan’s compliance with ERISA standards virtually needs. The policy statement should cover the impossible. In the case of an audit by the DOL or plan’s: the IRS, a fiduciary will be asked to produce a Goals and objectives written investment policy as part of the Time horizon examination. This document is probably the best Acceptable levels of risk insurance against liability—assuming it is correctly Liquidity and income needs drafted, implemented, and followed. Procedures for selecting “prudent experts” The fiduciary should distinguish between to manage the assets having a written Investment Policy Statement and Procedures for monitoring and evaluating the requirement that plan documents be in the “prudent experts” writing. The plan documents, which must Procedures to be followed to review and always be in writing, are the trust documents that amend any of the items listed above establish the plan that are filed with the IRS. 8
  9. 9. Your Financial Advisor Can Draft Your Policy Statement A Financial Advisor well versed in the investment planning process should draft the policy statement. The development of the investment policy will require several meetings and should represent a meeting of the minds of all involved. An abbreviated sample written investment policy follows. As with any plan document, it should be carefully reviewed by all the professionals involved in the plan’s maintenance and management. Allocate Assets to Attempt to Maximize Yield The investment policy addresses the allocation of energy. (Financial Analysts’ Journal, May-June assets among stocks, bonds, and cash. (Other asset 1991.) classes that may be used in plans include gold, real A problem every fiduciary must face when estate, equipment leasing, oil and gas, and developing an investment policy is the need to focus guaranteed investment contracts.) Asset allocation on two related, but often conflicting, investment is the process of distributing assets among various goals: (1) the need to protect the principal value of investment classes to attempt to yield maximum the portfolio, and (2) the need to enhance return within the established risk parameters. performance of the portfolio. A plan’s overall The basic premise behind efficient asset portfolio should maintain purchasing power (i.e., allocation is that asset classes do not move in keep up with inflation). This suggests the inclusion lockstep with one another and that losses sustained of equities in a portfolio with a long-term by one asset class can be offset by gains in a investment horizon. different asset class. The overall effect is to attempt to reduce the volatility in portfolio performance (e.g. reduction of the overall standard deviation). This is the core of modern Sample Asset Allocation Model investment portfolio theory. Respected studies of performance results of investment portfolios have shown that asset allocation decisions have the greatest impact on overall long-term portfolio performance. One study revealed that 91.5% of portfolio performance was attributed to asset allocation, 5% to the individual selection of stocks, This is one example of how a professional portfolio manager might allocate assets to diversify holdings in bonds, etc., and 2% to luck. Even though only 4.6% an attempt to dampen volatility and preserve capital, of the performance is attributed to individual stock while taking advantage of equity opportunities in a and/or bond selection, this is the area where many portion of the portfolio. fiduciaries mistakenly spend most of their time and 9
  10. 10. Studies have shown that the historical In addition, the fiduciary will be held to a probability of a cash or bond portfolio keeping up high standard of conduct in his capacity as the with inflation over as short a period of time as five overseer of plan assets: years is approximately 50%. As the time horizon “[A fiduciary shall discharge his duties with respect to increases, the probability of cash and bond a plan solely in the interests of the participants and portfolios keeping up with inflation becomes even beneficiaries and...] with the care, skill, prudence, and less, whereas the probability of equities keeping diligence under the circumstances then prevailing that a abreast of inflation increases. (Past performance prudent man acting in a like capacity and familiar does not guarantee future results.) Proper asset with such matters would use in the conduct of an allocation can enhance the value of the portfolio enterprise of a like character and with like aims.” relative to inflation while still investing within (ERISA Sec. 404(a)(1)(B). 29 U.S.C.A. stated risk tolerances. 1104(a)(1)(B).) Select a Prudent Investment Advisor Section 404(a)(1)(B) is commonly referred As mentioned earlier, plan assets may represent to as the “prudent expert” rule. This rule states the single most significant source of funds on that investment decisions will be evaluated against which workers will depend during their the standards of a “prudent expert,” e.g., an retirement years. It is crucial that investment experienced professional investment advisor. In decisions be made with utmost diligence. It is for addition, the fiduciary has the right to rely on this reason that Congress, the IRS, and the courts professionals to assist with investment decisions and have strongly encouraged the appointment of to pay those advisors fair compensation. In professional investment advisors to manage plan reviewing disputed transactions, the courts have assets. A fiduciary may even insulate himself/ herself from liability if an investment advisor(s) consistently held fiduciaries to the higher “prudent has been prudently selected and monitored. person” test versus the “business judgment” rule. Under ERISA, employment of an advisor, ERISA deals directly with the use of in addition to helping the fiduciary discharge his/her professional investment advisors by plan responsibilities, reduces the fiduciary’s personal fiduciaries: liability to the extent justifiable reliance is placed on “Any employee benefit plan may provide that such advisor: a named fiduciary may employ one or more persons to “If an investment manager or managers have been render advice with regard to any responsibility such appointed under Section 402(c)(2), then, fiduciary has under the plan; or that a person who is notwithstanding subsection (a)(2) and (3) and named fiduciary with respect to control or subsection (b), no trustee shall be liable for the acts management of the assets of the plan may appoint an or commissions of such investment manager or investment manager(s) to manage (including the managers, or be under an obligation to invest or power to acquire and dispose of any assets of a plan).” otherwise manage any asset of the plan which is (ERISA Sec. 402(c)(2). 29 U.S.C.A. 1102(a)(2).) subject to the management of such investment manager.” (ERISA Sec. 405(d)(1). 29 U.S.C.A. 1105(d)(1).) 10
  11. 11. The 'Safe Harbor' Rule The prudent selection of investment managers can be best accomplished with the Section 405(d)(1) is referred to as the “safe harbor” assistance of a competent Financial Advisor. rule. Fiduciaries, however, must still establish an Specifically, there are advisors who serve as investment policy, prudently select money managers, and monitor and evaluate the “managers of professional money managers.” Such performance of the selected manager(s). an advisor can assist the fiduciary in developing the written Investment Policy Statement and then In interpreting these provisions, the courts identifying those investment managers and/or have been direct about the necessity of a fiduciary mutual funds most appropriate to the investment using an investment manager. For example: objectives of the policy. The use of the advisor appointment of an investment manager was a court-imposed remedy in order to protect the plan should allow the fiduciary to adequately address assets and the interests of participants and such issues as broad as expected returns over time and as specific as who will vote proxies for beneficiaries. [See e.g., Donovan v. Mazzola, 716 F.2d 1226 (9th Cir. 1983) cert. denied 104 S. Ct. 704, 79 L. Ed. 2d 169.] holdings in the plan. It is imperative that appropriate procedures be followed in selecting If a fiduciary takes responsibility for investment investment managers. If these procedures are not decisions, he/she shall be measured by the standards of performance of professional followed, liability will be present. [See Whitfield v. Cohen, 682 F.Supp. 188 (S. D. N.Y. 1988).] investment managers knowledgeable in their The fiduciary who attempts to select specific area (i.e., prudent real estate investor, investment managers or mutual funds without the prudent mortgage lender, etc). [See e.g., Davidson v. assistance of a Financial Advisor should be aware Cook, 567 F. Supp. 225 (D.C. Va. 1983), aff’d 734 F.2d 10 (4th of several pitfalls. First, the marketing material Cir. 1984), cert. denied 105 S. Ct. 275, 83 L. Ed. 2d 211; Marshall v. Glass/Metal Ass’n and Glaziers and Glass Workers of managers may not provide sufficient Pension plan, 507 F.Supp. 378 (D.C. Hawaii, 1980); Donovan information, and the available information in v. Walton, 609 F.Supp 1221 (S.D. Fla. 1985), aff’d 794 F. 2d some cases may not even be accurate. The Securities and Exchange Commission (SEC), 586 (1lth Cir. 1986); Katsaros v. Cody, 744 F. 2d 270 (2nd Cir. 1984); GIW Industries v. Trevor, Stewart, Burton & Jacobsen, which oversees all registered investment managers, has not enforced a uniform format Inc. 10 EBC 2290 (S.D. Ga. 1989), aff’d 895 F. 2d 729 (11th Cir. 1990).] which must be used by managers when reporting performance. As a result, it may be difficult to compare one manager’s reported performance with that of another manager. The Association of Investment Management and Research (“AIMR”) Case law and prevailing industry has adopted uniform standards required to be standards strongly favor the use of used by investment managers effective January 1, investment managers for some portion 1993. However, the managers still have broad or all of the plan assets, since fiduciaries discretion about composite calculations and the will be judged according to such level of verification of results. In addition, some standards. returns may not be net of fees and transaction costs, whereas other reported returns may be net of such costs. Likewise, mutual funds may have 11
  12. 12. broad latitude in their overall investment If a fiduciary chooses to use a Financial approach. Items that become important are style Advisor, procedures in the plan’s Investment adherence (or drift), expense ratios, peer Policy Statement will be stated for selecting and performance, illiquid investments, and manager evaluating money managers and/or mutual funds. tenure and stability. Suggested criteria include: Another pitfall the fiduciary faces is that it 1. Selecting only those managers that have is very difficult to identify those managers who been managing portfolios for at least 10 to 15 achieved spectacular performance as a result of years. This criterion is more likely to reveal the mere luck. Most fiduciaries lack the time, manager’s ability to manage funds in both rising experience, and expertise to meet with an and falling markets. investment manager face-to-face and determine 2. Selecting only those managers that have whether the manager has the skills to seek above- specific, realistic investment strategies and have average performance in the future. Obviously, followed these strategies consistently throughout the the fiduciary who selects an investment manager firm’s history. The fiduciary should avoid who has the skill and knowledge stands a greater managers who are chasing investment fads. chance of achieving superior results over the long Furthermore, the fiduciary will find it impossible to run than the fiduciary who hires a manager who monitor performance if the manager is not is simply enjoying a streak of good luck. committed to a specific investment strategy. In addition, prior performance in and of 3. Additional information that should be itself should not be the only factor by which to considered: research procedures, decision making measure an investment manager. Equally guidelines, control disciplines, transaction important in the selection of an investment guidelines, background and turnover of key manager is the risk associated with achieving the individuals, reference accounts, fee variations, disclosed performance. For example, two performance deviation, composite performance investment managers may report an identical 10% returns, and (if individually managed) a review of compounded annual rate of return over five years. sample portfolios to insure that the manager Thus a $1,000,000 investment at the beginning of employs the strategies described in the firm’s the first year grew to $1,610,510 at the end of the marketing material. fifth year with each manager. However, Manager #2 achieved this result with the following respective It is worth repeating that the fiduciary can annual rates of return: 15%, 15%, - 28%, 30%, and reduce his or her liability by hiring an 30%. If Manager #1 achieved his performance investment manager, but the fiduciary with a consistent 10% return per year, then remains liable for the failure to select a unquestionably the returns were generated with responsible investment manager(s) and for less volatility. Therefore, standard deviation, the failure to monitor the performance of the scatter diagrams, rolling time period evaluations, selected manager(s). etc. may be necessary in order to truly evaluate an investment manager’s performance. Rate-of- return performance alone may be misleading. 12
  13. 13. Diversify, Diversify, Diversify diversification did not exist and a loss occurred. ERISA states that a fiduciary must diversify the [See Marshall v. Glass/Metals Ass’n and Glaziers and Glass plan’s assets. While the DOL has established certain Workers Pension plan, 507 F. Supp. 378 (D.C. Hawaii 1980) (23% of the plan’s assets were invested in a single real estate standards for diversification, no specific limits have project). Freund v. Marshall & Ilsley Bank, 485 F.Supp. 629 been set. However, informal limits do exist and (W.D. Wisc. 1979) (unsecured promissory notes, even though have been utilized by enforcement officials. In high interest bearing). Donovan v. Guaranty National Bank, 4 determining whether the assets have been EBC 1686 (S.D. W.Va. 1983) (80% of plan assets in mortgage properly diversified, the DOL will use the loans). Brock v. Berman, 673 F.Supp. 634 (D.C. Mass. 1987) objectives outlined in the plan’s Investment Policy (28% in oil and gas exploration and 17% in oil and gas Statement. This standard of measurement again concerns). Donovan v. Mazzola, 716 F.2d 1226 (Ca. Ct. App. underscores the importance of drafting a well- 1983) cert. denied 104 S. Ct. 704, 79 L. Ed. 2d 169 (too large a thought-out, realistic, comprehensive investment proportion of the plan’s assets in loans when other investment policy. alternatives were available including stocks, bonds and real “[... a fiduciary shall discharge his duties with respect to a plan solely in the interest of the Editorial note: The DOL expert estate). participants and beneficiaries and..] (C) by witness in the Donovan case testified the diversifying the investments of the plan so as to DOL’s position to be “...investment minimize the risk of large losses, unless under the diversification requires the identification of circumstances it is clearly prudent not to do so...” different classes of investments, that is, (ERISA Sec. 404(a)(1)(c). 29 U.S.C.A. categories of investments with different 11094(a)(1)(c).) characteristics and opportunities for risk and The Conference Report on ERISA makes return.” Marshall v. Teamsters Local 282 Pension Trust Fund, 485 F.Supp. 986 (E.D.N.Y. 1978) (high-risk real estate clear that once a plaintiff proves a failure to venture began with 15% of plan assets and would increase to diversify, the burden shifts to the defendant to 36% of current plan assets upon conclusion of project). GIW demonstrate that non-diversification was prudent Industries Inc. v. Trevor, Stewart, Burton & Jacobsen, Inc., 10 under the circumstances (H. Rep. No. 93-1280, EBC 2290 (S.D.Ga. 1989), aff’d 845 F.2d 729 (11th Cir. 1990) 93rd Cong., 2d Sess. at p. 304). This is supported (investment of 70% of plan assets in government bonds was by case law. (Metzler v. Graham, 112 F. 3d. 207 (5th Cir. inappropriate and imprudent diversification) but cf. Withers 1997) and Reich v. King, 867 F. Supp. 341 (D. Md. 1994).) v. Teachers’ Retirement System of the City of New York, 447 F.Supp. 1248 (S.D.N.Y. 1978) (purchase of New York City The courts have been quick to find bonds to stave off city bankruptcy was acceptable); Sandoval fiduciary liability when it was apparent that v. Simmons, 622 F.Supp. 1174 (D.C. Ill. 1985) (investment manager’s corporate stock holdings, although in high The Conference Report on ERISA percentages, did not necessarily reflect imprudence); and makes clear that once a plaintiff Meinhardt v. Unisys Corp., 1994 U.S. Dist. LEXIS 12713 proves a failure to diversify, the (E.D. Pa. 1994) and In re Unisys Savings plan Litigation, 74 F. burden shifts to the defendant to 3d 420 (3rd. Cir.), cert. denied, 117 S. Ct. 56 (1996) (non- demonstrate that non-diversification performing GIC investments held in participant-directed plan was prudent under the circumstances. were acceptable given facts and circumstances).] 13
  14. 14. Some court decisions would lead one to If there are sufficient assets, the fiduciary believe that the word “diversification” means both should also consider the advantages of diversifying asset allocation and diversification. However, the assets among several different investment two are not synonymous. Asset allocation managers within the same investment class. In guidelines determine the distribution of assets other words, two or three different equity among various investment classes to attempt to managers would manage the equities portion. yield the greatest possible return consistent with the Again, the prudent fiduciary would realize that portfolio’s risk parameters. Diversification is the no single investment style is going to be in favor risk-reduction process of choosing a broad range with the market all the time and that managers of different individual investments within a with different strategies can complement one particular investment class. For example, if a another. The fiduciary should consider: fiduciary determines that 30% of the assets should be placed in equities, then within that equity 1. Dividing the assets among different portfolio, assets should be diversified among a investment objectives may lower overall range of equity issues. investment risk without lowering potential long-term returns; An analysis of the proper diversification of assets would consider the following criteria: 2. The fiduciary can select managers skilled Plan design in different strategies, e.g., value or Plan size growth-oriented, top-down, bottom-up Current market and financial conditions and global; and Existing economic conditions relative to any given investment 3. Managers who fail to perform can be Geographic distribution of assets and terminated more easily when they are investments managing only a portion of the assets. Dates of maturity (fixed income, cash portfolios) The drawback is that superior Volatility of each asset class investment managers may have set high Liquidity of assets, especially measured minimum account sizes ($10 million or more) to against short-term liabilities reduce the number of portfolios they must actively Potential portfolio return compared with manage. Certain investment advisors, however, the funding objectives of the plan. have been able to negotiate lower account size minimums because of the administrative and This analysis should be plan-specific; two client support services they can provide. Using plans holding the same assets may be evaluated these investment advisors would not only facilitate differently. The goals and the objectives and the the selection of prudent managers, but also give return and risk parameters of the two plans will the fiduciary access to managers otherwise not determine which is more prudently diversified and available. managed. 14
  15. 15. Monitor Your Plan Investments Effective monitoring of a professional money A fiduciary has an ERISA-mandated manager will again be facilitated if the fiduciary responsibility to manage plan assets prudently. utilizes an investment advisor. A competent ERISA promotes the development of an Investment advisor should be able to monitor and evaluate the Policy Statement, recommends the use of investment activities of a professional money manager and advisors, and requires the diversification of plan assets. report the following objective measurements: If the above procedures are followed, a fiduciary’s What was the time-weighted return of the exposure to liability can be significantly reduced— portfolio? assuming the fiduciary continually monitors the What effect did the market have on activities of selected managers or the performance of return? assets managed by the fiduciary. How did asset allocation impact the The courts have interpreted this continuing return? duty liberally when invoking fiduciary liability. How much risk is the manager taking? [See e.g., Brink v. DaLesio, 496 F.Supp. 1350 (D.C. Md., What was the manager’s contribution to 1980) (a union pension and welfare trustee was return (selection and timing)? held jointly liable with a consultant for improper How do the results compare with appro- receipt of commissions because the trustee failed priate market indices? to monitor the consultant’s compensation and How does the manager’s performance performance). See also Whitfield v. Cohen, 682 F.Supp. compare with the results obtained by 188 (S.D.N.Y. 1988); Leigh v. Engle, 727 F. 2d. 113 (7th Cir. managers of similar investment style? 1984); Atwood v. Burlington Industries., 18 EBC 2009 (M. D. Are performance results, levels of risk, and asset allocations consistent with the plan’s N. C. 1994); Newton v. Van Otterloo, 756 F. Supp. 1121 (N. D. investment policy? Given the appointment of an Ind. 1991).] Most importantly, however, the following investment advisor, the plan trustee retains question must be asked: Has the manager followed oversight responsibility for the performance of his or her stated investment strategy or the manager. The fiduciary must put in place a methodology? If not, then by implication the reporting, monitoring, and evaluation procedure. written investment policy statement is not being Reliance on IRS Form 5500 as a monitoring device adhered to and the fiduciary significantly increases has been judged insufficient for this purpose. [See his/her exposure to personal liability. e.g., Brock v. Berman, 673 F.Supp. 634 (D.C. Mass. 1987).] One question that often arises is, “When is it prudent to replace a professional money manager Most investment managers will supply quarterly performance reports. Coupled with these reports may be a statement about the portfolio’s calculated rate of return. Simply reviewing this information, Most important is the question: however, does not fulfill the ERISA requirement Has the manager followed his or that portfolio performance be monitored; the her stated investment strategy or analysis must go deeper. methodology? 15
  16. 16. or mutual fund?” First of all, one quarter, six Avoid Prohibited Transactions: months, or even one year of poor performance No Current Benefits for Fiduciaries would not in itself necessitate the firing of a With large dollar amounts accumulating manager. In fact, most financial consultants for retirement years, it is only natural that certain would agree that a manager should be given at least individuals would devise ways of making these two years to perform, assuming the other dollars work for them today. The government investment policy criteria used in the manager seeks to ensure that fiduciaries receive no such selection have not been violated. When poor current benefit. This forms the basis for the rules performance is observed, the initial prudent relating to prohibited transactions. course of action would be to note and Prohibited transactions always involve a acknowledge the performance data, and then party-in-interest, which includes any person who document explanations for such performance. An directly or indirectly controls or is controlled by a analysis will demonstrate whether the manager fiduciary; any officer, director, partner, or made bad investment decisions or whether the employee of the firm sponsoring the plan; and any market has not yet reflected the manager’s good close relatives of the foregoing. Obviously, a decisions. It would be advisable to place such a fiduciary must not direct services of the plan to a manager on a “watch list” to continue to friend in exchange for other consideration. determine if the plan objectives will be met. Furthermore, the friend must not charge higher There are times, however, when it may rates for services than competitors, and the be prudent to fire a professional money manager friend’s quality of service must not be inferior to that or replace a mutual fund immediately. The most offered by competitors. common reason would be a change in the ERISA is specific in dealing with these manager’s investment style, methodology, types of arrangements: strategy, or personnel—such as key decision- “Except as provided in Section 408: makers are no longer in place. Particularly, those (1.) A fiduciary with respect to a plan shall not managers suffering from performance anemia cause the plan to engage in a transaction, if he have a tendency to undergo an evolutionary knows or should know that such a transaction change to a new strategy. A fiduciary does not constitutes a direct or indirect: want to be an experimental tool for a manager’s (a) sale or exchange, or leasing, of any new program, nor can a fiduciary effectively property between the plan and a party-in- monitor the activities of the manager if the interest, manager is not following a specific strategy or (b) lending of money or other extension of methodology. Often the manager who sees credit between the plan and a party-in- performance sinking relative to the market will try interest, to redeem himself and his performance by taking (c) furnishing of goods, services or facilities inordinate risks. This inevitably compounds between the plan and a party-in-interest, or investment errors and degrades performance. (d) transfer to, or use by or for the benefit of, a party-in-interest, of any assets of the plan.” (ERISA Sec. 406(a). 20 U.S.C.A. 1106(a).) 16
  17. 17. ERISA continues with general items a fiduciary Interestingly enough, there is one specific cannot undertake: ERISA mandated investment that cannot be made (1.) “A fiduciary with respect to a plan shall not: by a plan: (a) Deal with the assets of the plan in his “Except as authorized by the Secretary by regulation, own interest or for his own account, no fiduciary may maintain the indicia of ownership of (b) In his individual or in any other any assets of a plan outside the jurisdiction of the capacity, act in any transaction district courts of the United States.” involving the plan on behalf of a (ERISA Sec. 404(a)(2)(b). 29 U.S.C.A. party (or represent a party) whose 1104(a)(2)(b).) interests are adverse to the interests of the plan or the interests of its partici- Because of the high standard to which a fiduciary is held, the pants or beneficiaries, or courts have been quick to find prohibited transactions when (c) Receive any consideration for his the fiduciary of a plan has received current economic benefit. own personal account from any [See Lowen v. Tower Asset Management, Inc., 829 F.2d 1209 party dealing with such plan in (2nd Cir. 1987) (fiduciaries invested in companies in which connection with a transaction they owned substantial equity interests). Donovan v. involving the assets of the plan.” Dillingham, (D.C. Ga. 1-17-84) (administrator’s retention of (ERISA, Sec. 406(b). 29 U.S.C.A. 1106(b).) excess between contributions paid in and cost of Guaranteed Investment Contract was prohibited compensation). Lambos Like all great legislative enactments, there are v. Commissioner, 88 T. C. 80 (1987) (leases between profit exceptions. The following are listed in ERISA as sharing plan and sponsor’s majority shareholder and wife are being permissible: prohibited transactions). Marshall v. Carroll, 2 EBC 2491 “1. Contracting or making reasonable arrange- (N.D. Cal. 1980) aff’d without op. 673 F.2d. 1337 (9th Cir. ments with a party-in-interest for office space 1981) (plan assets placed on deposit in a financial institution to legal, accounting, or other services necessary procure loans for president of financial company).] Even for the establishment or operation of the plan, though an investment would qualify as prudent when judged if no more than reasonable compensation is by the highest fiduciary standard, this does not exempt the paid therefore, and transaction from being prohibited, even if the plan benefited 2. The investment of all or part of a plan’s assets from the transaction. Code Sec. 4975 does not incorporate a in deposits which bear a reasonable interest prudent investment standard. [See Lieb v. Commissioner, 88 rate in a bank or similar financial institution T. C. 83 (1987). See also Rutland v. Commissioner, 89 T.C. 80 supervised by the United States or a State, if (1987) (one transaction led to two prohibited transactions for such bank or other institution is a fiduciary purposes of the 5% excise tax and the tax applied regardless of of such plan and if [such investment is the good faith action by the disqualified person acting on the expressly authorized.]” advice of attorneys and investment counselors).] (ERISA Sec. 408(b). 29 U.S.CA 1108(b).) 17
  18. 18. With smaller pension plans (assets less than $5.0 million), there is a tendency for the fiduciary Transaction Costs and to play several different roles—agent of the plan, Other Services administrator, trustee, plan sponsor, and/or plan participant. A prohibited transaction is likely to The fiduciary is responsible not only for ensue when the fiduciary attempts to play these developing an investment policy and selecting roles simultaneously. “prudent experts” to implement that policy, but he/she is also responsible for ensuring that The more common prohibited investment transactions are executed at best cost, transactions include: and that commission dollars pay for services that 1. The sale, exchange, or leasing of land between benefit the plan and participants. the plan and the fiduciary. An example would be a doctor who owns his own professional ERISA deals with this issue and states: building and sells the property to the plan. “[...a fiduciary shall discharge his duties with respect 2. Foreign investments: It is forbidden to take to a plan solely in the interest of the participants and plan assets out of the country. It is permissible beneficiaries] [for the exclusive purpose of:] (ii) to buy foreign investments through a U.S. defraying reasonable expenses of administering the intermediary such as a mutual fund or a bank. plan.” 3. Loans from a plan to a plan participant may be (ERISA Sec. 404(a)(1). 20 U.S.C.A. 1104(a)(I).) permitted, but will always be carefully scrutinized in an audit. For a loan to pass In ERISA Technical Release 86-1, the inspection, the plan documents must authorize Pension and Welfare Benefits Administrator loans, the loan must be in writing, it must be at addressed the issue of brokerage commissions and a reasonable interest rate, and it must be their use to provide other services: backed by sufficient collateral. Loans must be “Where an investment manager directs brokerage made on the same terms and on the same basis transactions through designated broker-dealers to to all participants (e.g. not just for executives provide goods and services on behalf of the plan and or officers). In addition, to avoid adverse tax for which the plan would otherwise be obligated to consequences, such loans must comply with pay, such use of brokerage commissions ordinarily the stringent provisions of the Code Sec. 72. would not violate the fiduciary provisions of ERISA provided that the amount paid for the brokerage and Of all the ERISA standards mentioned in other goods and services is reasonable and the this text, this area in particular may require investment manager has fulfilled its duty to obtain the additional legal and accounting expertise. A best execution for the plan's securities transactions." fiduciary should always be able to answer in the negative when asking: “As the plan fiduciary, do I When commissions are used to pay for stand to benefit or gain personally, either directly investment advisory services, the appropriate term or indirectly, by the handling of the plan assets?” is “soft dollars.” It is an accepted industry practice 18
  19. 19. that these consulting fees be paid with “soft dollar” employee benefit plans have become logical or “commission recapture” arrangements. This is targets. A plan that is disqualified for compliance not, however, to be confused with “soft dollar” reasons would cause its assets to be taxed as if arrangements whereby a money manager accumu- disbursed. The government is very interested lates credits for the placement of brokerage busi- that plans be administered correctly given the ness with a brokerage firm that can be used for dollars involved, the impact on financial markets, publications, quote services, to make up for trad- and the ability plans have to lessen the ing errors or be used for other questionable ser- dependence of retirees on the Social Security vices. This area has come under SEC and DOL scrutiny and has become the subject of enforcement system. action because of its abuse. Fortunately, the competitive nature of the brokerage business has When one considers the size of the assets allowed for these advisory services to be part of the held for retirement and the complexities of bundle of services received through a brokerage properly maintaining an employee benefit plan, commission arrangement or a wrap fee arrangement plan fiduciaries will increasingly find themselves a (fee in lieu of commission), provided the target for litigation. When a fiduciary is called arrangements are within the confines of permissible into court, the fiduciary’s accountant, attorney, SEC, DOL, and NASD guidelines. Recent SEC plan administrator and Financial Advisor are likely regulations require that appropriate disclosure to be included in the litigation. Plan participants information be provided to clients under these are becoming more sophisticated about arrangements. This is satisfied by delivering a “appropriate investment results.” This expectation “Schedule H Brochure” disclosure document to of competitive returns carries a heavy the client. responsibility (and liability) on the part of the The requirement that transactions be done fiduciary. It is prudent, therefore, that the fiduciary at “best execution” does not necessarily mean reduce exposure to liability while increasing the lowest commission cost. A fiduciary must take into likelihood of meeting or exceeding the plan’s account whether the brokerage firm offering the objectives by securing a professional, competent deepest discount has the capacity to offer the best investment advisor and following the prudent “market prices” for the plan’s securities, and procedures mandated by the marketplace. The whether the firm offers ancillary services such as risks are too great to not follow a prudent course security research/analysis and investment advice. of action. Both the DOL and the IRS have increased their auditing and enforcement efforts of employee benefit plans. With concerns over appropriate employee build up of retirement assets and the push towards federal fiscal responsibility (the desire to achieve stand alone revenue generation by enforcement and regulatory agencies), 19
  20. 20. SAM Investment Policy Statement PLE For ABC Co. Retirement Plan Purpose This document summarizes the investment philosophy of ABC Co. Retirement Plan (hereinafter referred to as Investor) based upon information provided by the Investor within the investment policy statement questionnaire. It also establishes the investment guidelines and performance objectives for the investment managers hired by the Investor. At the writing of this document, the total Portfolio value is approximately $1,000,000. These assets are for the main purpose of providing retirement funds for employees of the Investor. Investment Philosophy and Objectives The Investor’s primary objective is to maximize long-term returns while accepting the likelihood of short-term losses and quarterly performance volatility. Growth of the assets should, at the very least, keep pace with the Consumer Price Index plus 8%. This Statement will be revised to reflect changing financial objectives of the Investor. However, the Investor does not believe it is wise to react to short-term situations in a manner which contradicts the long-term policy adopted in this document. 20
  21. 21. Time Horizon Investment objectives are long-term in nature, with an estimated time horizon of more than 10 years. Asset Allocation The Investor expects that 100% of Portfolio assets will be under the supervision of one or more professional investment managers in the future. The target allocation of the Portfo- lio is as follows: Equities 80% Fixed Income 20% There are no asset classes or individual stocks that are unacceptable for the Investor’s Portfolio. The Investor realizes that this asset allocation may fluctuate as market conditions and management style dictate. The Investor reserves the right to alter the above asset alloca- tion guidelines at any time as portfolio objectives and market conditions necessitate. Equities Equities may be selected from the NYSE, AMEX and regional stock exchanges or NASDAQ. Only the stock of companies with reasonable market liquidity should be purchased. Short sales, margin transactions or similar investment activities are prohibited. No assets should be invested in securities whose issuers have filed a petition for bank- ruptcy. Within the above guidelines, the Investment Manager(s) have full responsibility for security selection and diversification. However, the Investment Manager(s) should, on a best-efforts basis, not invest more than 10% of the total Portfolio in an individual security and not more than 50% in a single industry. Fixed Income Investment in fixed income securities may be selected from appropriately liquid preferred stocks, corporate debt securities, and obligations of the U.S. Government and its agencies and securities convertible to equities. These investments will be subject to the following limitations 1. No issues may be purchased with more than 30 years to maturity. 2. Investments in securities of a single issuer (with the exception of the U.S. Government) should not exceed 10% of the portfolio’s total market value. 21
  22. 22. 3. The Investor prefers that only debt issues of investment grade or better be purchased. However, discretionary Investment Manager(s) may purchase issues of lesser quality as long as these purchases represent less than 10% of that particular portfolio’s assets. Investment Manager Selection The Investor seeks professional money management firms that have a long-term time horizon, and that hold assets through periods of short-term volatility. The average portfolio turnover should not exceed 50% per year. Investments are to be made in several asset classes, changing the relative weights to favor those which appear to be the most productive. Investment manager(s) will be committed to being fully invested at all times, building cash only when attractive purchases are not available. The Investor feels most comfortable diversifying the assets among more than 4 investment managers. Those chosen should employ both a top-down and bottom-up methodology in security selection. International investments may be included in the Investor’s portfolio. Each investment manager is subject to all restrictions and investment guidelines within this document. However, each manager will have full discretion over the purchase and sale of individual securities and the selection between equity securities and cash equivalents. Asset Manager Performance Review The Investor understands that some risk must be assumed to achieve long-term investment goals. The Investor would consider firing an investment manager for the following reasons: 1. Departure of one or more of the firm’s key investment personnel, 2. Deviation from the firm’s stated investment discipline, 3. Poor investment performance over a “reasonable” period of time (one year minimum, with three to five years being a more appropriate period under normal circumstances). The Investor will not consider terminating a manager on the basis of performance during a single quarter or less than one year. The Investor plans to monitor performance using the quarterly statements provided by Asset Management Services (AMS). The Investor will maintain a file of the written confirmations of every transaction and the quarterly statements documenting the total assets, including gains and/or losses in each security since original purchase date. 22
  23. 23. The Investor should continually review liquidity needs and should notify Asset Management Ser- vices as soon as possible of any significant changes in anticipated needs as set forth in this docu- ment. The Investor will review this document annually to ensure its continued relevance and to make changes as new conditions dictate. The Investor and Financial Advisor will meet quarterly to discuss the progress of the portfolio. I, fiduciary for ABC Co. Retirement Plan, Investor, do affirm that this document accurately reflects my investment objectives. ____________________________________________ _____________________ ABC Co. Retirement Plan Date 23
  24. 24. Investment Advisory Services OF RAYMOND JAMES & ASSOCIATES, INC. Member New York Stock Exchange / SIPC 880 Carillon Parkway ♦ St. Petersburg, FL 33716 (727) 576-1000, ext. 64627 ♦ (800) 248-8863 6/02