296059.21FIDUCIARY RESPONSIBILITYEXECUTIVE SUMMARYThe objective of ERISA’s fiduciary provisions for investments is to provide secureand meaningful retirement benefits for participants. The key to accomplishingthat objective is for each participant’s account to be well invested. That is, eachparticipant’s account should hold a portfolio of quality and moderately pricedinvestment funds that is appropriate for that participant’s risk tolerance and returnneeds. As explained in this White Paper, plan fiduciaries are ultimatelyresponsible for the prudence of the participant investment decisions. To managethat risk, fiduciaries should acknowledge the need of many participants for helpwith their investments and should design the plan’s investment menu andservices in a manner that supports prudent investment decisions by participants.One alternative for such a design is to offer only well-balanced portfolios(sometimes called asset allocation models or lifestyle funds) for participantchoice. Combined with help for selecting the appropriate portfolio, thisarrangement has a high probability of resulting in participants being prudentlyinvested and, therefore, in fiduciaries satisfying their duties under ERISA.INTRODUCTION AND LEGAL PRINCIPLESThe purpose of this “White Paper” is:• to provide an overview of the legal requirements for investments inparticipant-directed plans, such as 401(k) plans;• to highlight areas of exposure to officers of plan sponsors who serve asfiduciaries; and• to evaluate the use of professionally designed investment vehicles (“assetallocation models”) as a method of managing that exposure.Investment Fiduciaries and Their DutiesThe Employee Retirement Income Security Act (ERISA) is the federal law thatgoverns investments in almost all U.S. private sector retirement plans. (The mostnotable exceptions are one-person owner-only plans and church plans.)ERISA accomplishes its regulatory objective by classifying investment decision-makers as “fiduciaries,” by imposing specific duties on those fiduciaries, and byestablishing a high standard for measuring their conduct.
296059.22The definition of fiduciary is found in ERISA section 3(21)(A). Fiduciary activitiesinclude, for example, the management of plan assets, the operation of the plan,and the appointment of other fiduciaries.A person may become a fiduciary by:• being named as such in the plan document;• being appointed as such by another fiduciary,; or• making fiduciary decisions, even if not named or appointed (a “functional”or “de facto” fiduciary).For most plan sponsors, the primary fiduciaries for plan investments are eitherthe committee members (who are appointed, usually by the Board of Directors)or officers who make investment decisions on behalf of the plan sponsor. If theBoard is responsible for appointing the committee, the Board members areconsidered ERISA fiduciaries for that purpose.ERISA section 409(a) imposes personal liability on fiduciaries who breach theirduties. The significance of that provision was recently illustrated by the Enronsettlement where the outside members of the Board of Directors and the chair ofthe plan committee contributed to the settlement from their personal assets.ERISA section 404(a)(1) requires that fiduciaries conduct themselves accordingto specified standards. Fiduciaries must act in the sole interest of participantsand:• for the exclusive purpose of providing retirement benefits (and defrayingreasonable expenses);• according to the prudent man rule (see below);• to diversify investments; and• in accordance with the plan documents (unless it would be imprudent todo so).The prudent man rule mandates that fiduciaries act:“. . . with the care, skill, prudence, and diligence under thecircumstances then prevailing that a prudent man acting in a likecapacity and familiar with such matters would use in the conduct ofan enterprise of a like character and with like aims; . . .”Surprisingly, the prudent man rule does not mention “investments” or “participantdirection.” As a result, the broad provisions of the prudent man rule must beinterpreted through government guidance and court decisions. In that regard, theDepartment of Labor and the courts have concluded that:
296059.23• Fiduciaries must prudently select, monitor, remove and replace theinvestment options offered to participants. (See, e.g., the Preamble to theFinal 404(c) Regulation, 57 F.R. 46906, 46924, footnote 27.)• ERISA’s investment provisions are based on the principles of modernportfolio theory. (See Tittle v. Enron, 284 F.Supp. 2d 511 (S.D. Texas2003).)• In applying the prudent man rule to investment decisions, fiduciariesshould use generally accepted investment theories and prevailing industrypractices. (See, e.g., DOL Interpretive Bulletin 96-1 and its Preamble.)• Fiduciaries must select investments which are suitable and appropriate forthe participants, taking into account the needs of the plan and theparticipants. (See the Preamble to the Final 404(c) Regulation, 57 F.R.46906.)• Fiduciaries must seek expert advice where they lack the skill toadequately perform their job. (See Liss v. Smith, 991 F. Supp. 278, 297(S.D.N.Y. 1998).)Participant Direction and Fiduciary ResponsibilityWhile plan sponsors and fiduciaries generally accept their responsibility forselecting and monitoring 401(k) investment options, most are unaware thatfiduciaries are also responsible for the prudence of investment decisions madeby participants. That is, if a participant invests imprudently, the fiduciaries may beliable for any losses (which would include insufficient gains).This unexpected result is due to the structure of ERISA’s fiduciary provisions.Sections 403(a) and 404(a) put investment responsibility squarely on the backsof the fiduciaries. As a result, even if participants direct their investments, thefiduciaries remain responsible for both the prudency of the investment optionsand for their appropriate selection by the participants. However, if the plansponsor and the fiduciaries want to transfer part of that legal responsibility to theparticipants, they can do so--by complying with ERISA section 404(c) and the 20to 25 requirements in the 404(c) regulation. As the judge said in the September30, 2003 Enron decision:“If the plan does not qualify as a § 404(c) [plan], the fiduciariesretain liability for all investment decisions made, including decisionsby the plan participants.”(Tittle v. Enron, 284 F.Supp. 2d 511, 578 (S.D. Texas 2003).)While the apparent answer may be to comply with the 20 to 25 detailedrequirements of the regulation, that is easier said than done. In fact, few planscomply with all of the 404(c) conditions. My law firm audits plans for 404(c)
296059.24compliance, and we seldom find that a plan has satisfied all the rules. In theEnron case (where you would assume that the committee was advised bycompetent ERISA counsel), the defendants (i.e., the fiduciaries) asserted thatthey were protected by 404(c). In its brief, the DOL pointed out that it hadreviewed the plan records and did not find evidence of satisfaction for a numberof the requirements.Beyond the issue of 404(c) protection, there are other fiduciary threats caused byimprudent participant investments. For example, fiduciaries are protected in404(c)-compliant plans only if the investments offered to participants are prudent,suitable and appropriate. In last year’s Enron decision, the court explained:“Even if the Savings Plan were to qualify as a § 404(c) plan,relating to the Savings Plan and the ESOP in the Department ofLabor’s Final Regulation Regarding Participant Directed IndividualAccount plans, Preamble, 57 Fed. Reg. 46,906,924 n. 27(1992),the agency emphasized, [T]he act of designation investmentalternatives ... is a fiduciary function ... [and] [a]ll of the fiduciaryprovisions of ERISA remain applicable to both the initialdesignation of investment alternatives and investment managersand the ongoing determination that such alternatives and managersremain suitable and prudent investment alternatives for the plan[emphasis added].”As a result, even those few plans that satisfy 404(c) are left with the issue ofwhether they remain liable for participant investments because of the issue ofwhether the investment choices are “suitable and prudent” for their plan and theirgroup of participants. Unfortunately, these terms are not well defined. There is agrowing body of evidence that the average participant may have difficultyunderstanding and investing in a 401(k) menu of more than a few individualfunds (perhaps three to six). (See, e.g., Agnew, Julie and Szykman, Lisa R.(2004), Asset Allocation and Information Overload: The Influence of InformationDisplay, Asset Choice and Investor Experience, Center for Retirement Researchat Boston College; and Iyengar, S., Jiang, W. and Huberman, G. (2003), HowMuch Choice is Too Much?: Contributions to 401(k) Retirement Plans; WorkingPaper 2003-10, the Wharton School, Pension Research Council.) Is it prudent,then, to offer more than that number of funds? That question has not beenanswered.There are surveys and studies that show that many participants lack basicinvestment knowledge, for example, don’t understand the difference betweengrowth and value styles; don’t realize that, when in interest rates go up, bonds godown. (See, e.g., the annual surveys performed by The John Hancock.) While itseems inconceivable that it would be inappropriate to offer growth and valueequity funds, or to offer bond funds, a prudent fiduciary should arguably offerservices to assist participants in properly using those funds. Going beyond the
296059.25basic funds, though, there remains the question of whether it is prudent to offeremerging market funds, high yield bond funds, or other non-basic funds, toparticipants who lack the investment abilities to properly use those options inbuilding portfolios in their accounts? That is also an unanswered question.The purpose of raising these issues is to point out that there are unansweredquestions about what are prudent, suitable and appropriate investments formany, and perhaps most, participants. In light of this uncertainty, the bestcourse--and perhaps the only course that is safe--is for fiduciaries to assume ahigher level of responsibility for the prudence of participant investments.MANAGING THE RESPONSIBILITYOverview: A plan’s investment fiduciaries may decide to manage their risk forparticipant investments in order to minimize their legal exposure, or because theyaccept a general responsibility to help employees who lack investment skills, orboth. In that case, the goal is to place each participant in a well-constructedinvestment portfolio based on information reasonably available to the fiduciaries(such as the participant’s age).Unfortunately, as discussed earlier in this paper, many participants lack the basicinvestment knowledge and skills necessary to successfully use typical 401(k)investment lineups. That is, they do not know how to properly combine differenttypes of mutual funds to produce a portfolio that is appropriate for their needs. Asa result, the odds of a well-invested account are slim. To further complicatematters, many participants are not investing in a manner that would support awell-balanced portfolio. The 2003 Hewitt study, “How Well Are Employees Savingand Investing in 401(k) Plans,” notes that 14% of the participants were investedin one asset class (e.g., type of investment) and another 20% were invested inonly two. The study notes that lifestyle funds (i.e., professionally designed assetallocation vehicles) are assumed to invest in five--and many invest in more thanthat. Thus, investment professionals seek to manage and balance risk and returnby combining five or more asset classes, while many participants either takeunnecessary risk or accept low returns by using only one or two asset classes.(See, also, Building Futures IV, Fidelity Institutional Retirement ServicesCompany, 2003.)Those participants have little, if any, chance of developing prudent portfolios intheir accounts. This places investment fiduciaries in the awkward position ofbeing at risk for the participants’ investment inadequacies. To manage this risk,the fiduciaries should design their plan’s investment structure to minimize thepossibility of improperly invested accounts.While ERISA does not offer detailed guidance about the definition of a prudentportfolio, it does provide general guidance. For example, both the DOL and the
296059.26courts have noted that ERISA’s investment provisions are based on ModernPortfolio Theory. (See, e.g., DOL Interpretive Bulletin 96-1, and Laborers Nat.Pension Fund v. Northern Trust Quantitative Advisors, Inc., 173 F.3d 313 (5thCir. 1999).) And both have commented on the need to adhere to generallyaccepted investment principles and prevailing investment industry practices.Thus, in effect, ERISA points fiduciaries to the practices of competentprofessional investors, consultants and advisors.As a result, to satisfy 404(a)’s fiduciary standards, fiduciaries should managetheir plan’s investment activities in a manner that results, to the greatest possibleextent, in their participants being invested in portfolios that adhere to thosestandards. Since most participants lack the level of investment knowledgeneeded to assemble a portfolio of funds that is appropriate for their needs andrisk tolerances, fiduciaries would be well-advised to offer professionally designedvehicles, such as asset allocation models and lifestyle funds. When a participantis invested in an appropriate portfolio, the fiduciary’s investment duties underERISA section 404(a) are satisfied, regardless of whether the plan meets the404(c) conditions.The lack of participant investment abilities has been known for some time, butwas “concealed” for most of the early years of 401(k) plans because of the bullmarket for both stocks and bonds for most of the 1990s. Even then, though, planproviders and consultants delivered investment education programs to most401(k) participants. In the latter half of the 1990s, internet investment adviceservices began to appear. Unfortunately, studies now show that investmenteducation has had little effect on most participants. And, the actual utilization ofinternet investment advice has not been significant. Interestingly, the primaryusers of investment advice have been the more knowledgeable participants who,at least in theory, needed to the least amount of help.Use of Asset Allocation ModelsOverview: To increase the likelihood of participants being invested in prudentportfolio, some have suggested offering only asset allocation models toparticipants. In that way, the participants could only choose among professionallydesigned investment vehicles. Their choice would be limited to selecting theoption which best reflected their personal circumstances. Such an offering raisestwo ERISA issues: Is it prudent under ERISA section 404(a)? Does it satisfy theconditions of ERISA section 404(c), should the fiduciaries seek that additionalprotection?ERISA’s fiduciary responsibility rules do not mandate the number or types ofinvestment options that must be offered in participant-directed plans. However,
296059.27many industry commentators look to the DOL’s 404(c) regulation, and its “broadrange” proviso, for guidance. In relevant part, that regulation states:“(3) Broad range of investment alternatives.(i) A plan offers a broad range of investment alternativesonly if the available investment alternatives are sufficient toprovide the participant or beneficiary with a reasonableopportunity to:(A) Materially affect the potential return on amounts inhis individual account with respect to which he ispermitted to exercise control and the degree of risk towhich such amounts are subject;(B) Choose from at least three investmentalternatives:(1) each of which is diversified;(2) each of which has materially different riskand return characteristics;(3) which in the aggregate enable theparticipant or beneficiary by choosing amongthem to achieve a portfolio with aggregate riskand return characteristics at any point withinthe range normally appropriate for theparticipant or beneficiary; and(4) each of which when combined withinvestments in the other alternatives tends tominimize through diversification the overall riskof a participant’s or beneficiary’s portfolio;(C) Diversify the investment of that portion of hisindividual account with respect to which he ispermitted to exercise control so as to minimize therisk of large losses, taking into account the nature ofthe plan and the size of participants’ or beneficiaries’accounts.”The objectives of that provision are:• The opportunity for a participant to affect the likely investment result;• The opportunity for a participant to balance risk and return; and• The use of diversification to minimize the risk of large losses.As a general statement, asset allocation models are portfolios that are designedby investment professionals to accomplish those purposes. As a result, theyappear to accomplish the objectives of the 404(c) regulation. Similarly, well-designed asset allocation models would satisfy the literal terms of the regulation.
296059.28For most of the provisions, that conclusion is clear, e.g., diversification andmaterially different risk-and return characteristics. In fact, the only two provisionsthat warrant discussion are (B)(3) and (4). That is because they suggest thatparticipants would combine plan options to achieve the goal of balancing risktolerance and investment returns, while asset allocation models are eachdesigned to be used as the sole vehicle for a participant’s account. Having saidthat, though, the regulation does not preclude a participant from investing in onlyone option and, of course, the regulation does not preclude an investment option,standing alone, from satisfying a participant’s needs. Because the use of assetallocation models are designed to satisfy 404(c)’s broad range provisions, theprotections of that section should be available to the investment fiduciaries, if theplan satisfies the remaining requirements of the regulation.Turning to the responsibilities under 404(a), the fiduciaries will also have satisfiedthe duty to offer participants a reasonable set of investment alternatives to beused by the participants to accomplish their investment goals--in terms of thenumber and types of funds. While it is the province of investment experts, ratherthan ERISA attorneys, to determine the right number of asset allocation models(and the appropriate combination of investments within each model), theobjective of both the investment experts and ERISA is to allow participants toselect a portfolio which would reasonably allow each participant to place himselfat the appropriate point on the risk-and-reward spectrum. When combined withappropriate services (e.g., a well-designed questionnaire and guidancematerials), the use of an investment menu consisting solely of asset allocationmodels will provide participants with an investment structure that they use toinvest prudently. Finally, the fiduciaries must engage in a prudent process toselect and monitor the provider of the asset allocation models and to select andmonitor the mutual funds underlying the models.Selection and MonitoringOverview: Fiduciaries have a duty to prudently select and monitor the plan’sinvestments and providers. That does not require that the fiduciaries becomeinvestment experts, but instead that they engage in a prudent process, that theyobtain at least a basic understanding of the services provided and that theyperiodically evaluate their quality, cost and effectiveness. This portion of theWhite Paper discusses key issues for fiduciaries to consider when engaging inthat process.In evaluating the selection of asset allocation models, fiduciaries should take thefollowing steps:• Obtain and review information about the provider of the asset allocationmodels, including:
296059.29the credentials of the key personnel at the organization. They (ortheir consultants or providers) should have the education andexperience to competently design the models.the methodology used to design the models. It should be basedprimarily on modern portfolio theory, and should use generallyaccepted investment theories.the resources used by the organization to design the models. Thiswould include databases, software, consultants and providers.These resources should be from sources highly regarded in theinvestment industry.obtain references and contact those references to learn aboutparticipant satisfaction, delivery of the service, investmentperformance (e.g., have the conservative options performed moreconservatively that the growth or moderate options) and riskmanagement.For additional information on the selection of investmentprofessionals, see, the court decision of Whitfield v. Cohen, 682F.Supp. 188 (S.D.N.Y. 1988).In addition to determining that the providers has the competency to design theasset allocation models, the fiduciaries should evaluate the method used fordelivery of the models to the participants. For example, are conservativeparticipants being properly placed in options consistent with their objectives? Thekey is whether the process (often a questionnaire) for directing participants to theappropriate option was designed according to modern concepts of behavioralfinance. The fiduciaries should satisfy themselves that it was and that thecredentials of the investment professional who did that work are appropriate. Thesecond step is for the fiduciaries to understand how the participant response isimplemented.Next the fiduciaries need to obtain a sense of the effectiveness in terms of theutilization by participants. Initially, this can be done by contacting referencesgiven by the provider and asking about their experiences. Once the arrangementis in place, the regular (perhaps annual) monitoring of the program shouldinclude an evaluation of the performance, of the models and of their appropriateusage by the participants.In addition to evaluating the models, fiduciaries need to prudently select andmonitor the underlying funds--or to work with an investment advisor or manager(“advisor”) who will perform that task. If the advisor agrees to serve as an ERISAfiduciary for that purpose, it reduces the exposure of the primary plan fiduciaries.Even then, though, the primary fiduciaries must prudently select and monitor theadvisor, using a process similar to the one described earlier in this paper.Fiduciaries should make sure that the advisor has a well-defined process for theselection, monitoring and removal of the investment funds. In addition, the
296059.210fiduciaries should review that process to evaluate whether it uses generallyaccepted investment principles and is consistent with prevailing industrypractices. Most quality providers will give the fiduciaries descriptions of theirprocess and its underpinnings in conventional investment practices.CONCLUSIONAs explained in this paper, ERISA fiduciaries are responsible for both theselection of a 401(k) plan’s investment options and for the use of those optionsby the participants. Many fiduciaries believe they are protected from participantdecisions by ERISA section 404(c). However, as discussed in this paper, thatprotection is illusory because:• few plans comply with the 20 to 25 requirements in the 404(c) regulation;and• even for those that do, there is no protection if the investments are notprudent and suitable for the participants in a given plan (and many--perhaps half or more--of the participants in the typical plan lack basicinvestment knowledge).Fiduciaries should consider actively managing their risk, rather than relying on alegal “shield” that may not be available. The key to managing the risk is to haveas many participants as possible invest in professionally designed portfolios thatare appropriate for the participant.One method of accomplishing that goal is for a 401(k) plan to offer only assetallocation models. As explained in this paper, such models may be offered in away that satisfies the requirements of ERISA section 404(a) (e.g., the prudentman rules) and that meets the broad range requirement of 404(c).