Lessons for 401(k) Plan Fiduciaries

Common fiduciary practices may prove costly.

By Steven Friedman and Stefanie Kastrinsky Nov 1, 2012
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mployee Retirement Income Security Act (ERISA) fiduciaries have numerous investment responsibilities—not the least of which are performing their duties solely in the interests of participants and for the exclusive purpose of providing benefits to participants and beneficiaries. They also must defray the reasonable expenses of administering the plan.

Fiduciaries must adhere to the "ERISA prudent man rule." This means they must perform their duties with, as the act puts it, 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 with like aims."

These phrases, which derive from ERISA and case law, are seemingly simple but not terribly helpful in determining what a fiduciary should and should not do. As the 5th U.S. Circuit Court of Appeals explained in Donovan v. Cunningham (716 F.2d 1455 (5th Cir. 1983)), it is not enough for ERISA fiduciaries to act with "a pure heart and an empty head." Given the number of recent challenges by 401(k) plan participants—contesting either the reasonableness of fees charged in connection with investment options offered under the plans or the adequacy of the investment options—today's fiduciaries need to know what is required of them and act in accordance.

A district court decision in March, ABB Inc. v. Tussey (No. 2:06-CV-04305 (W.D. Mo. 2012)), which held a company's 401(k) plan fiduciaries liable for $35 million in damages, is a useful guide to the key responsibilities of an ERISA fiduciary, as some of the Tussey fiduciaries' practices are commonplace.

Fundamentals for Fiduciaries

When a 401(k) plan permits participants and beneficiaries to direct the investment of money in their individual accounts, the fundamental duties of the plan's investment fiduciaries include the following:

  • Prudently select, monitor, remove and replace investment options.
  • Provide a broad range of investment options.
  • Act in accordance with the documents governing the plan, to the extent the documents are consistent with ERISA.

In fulfilling these obligations, the act's prudence standard is that of a "prudent fiduciary with experience dealing with a similar enterprise." This is often characterized as the standard of a knowledgeable investor.

A Case Study

In Tussey, ABB Inc. sponsored two 401(k) plans for its employees, with combined assets exceeding $1 billion.

ABB's Pension Review Committee was the named fiduciary and was responsible for selecting and monitoring the plans' investment options. The options included mutual funds offered by Fidelity Investments; Fidelity Research was an investment advisor to the mutual funds, and Fidelity Trust was the record keeper for the plans. Collectively, the three entities were referred to as "Fidelity." Fidelity was paid through revenue sharing derived from the plans' assets as well as per-participant fees.

Sounds like a typical 401(k) plan and fiduciary setup, right? So where did the plan fiduciaries go wrong?

Failure to monitor, benchmark or determine the reasonableness of record-keeping costs.

The court found that the plan fiduciaries never calculated the dollar amount of the record-keeping fees that the plans paid to Fidelity through the revenue-sharing arrangement, nor did they obtain a benchmark cost when they first implemented the arrangement for purposes of assessing whether revenue sharing was a reasonable method of paying the plans' administrative costs. The plan fiduciaries also did not monitor the reasonableness of those fees, even after an independent consultant advised them that Fidelity's fees exceeded market rates.

Failure to follow the terms of plan documents.

The plans' investment policy statement contained several requirements. First, it required that revenue sharing, to the extent permissible, be used to offset or reduce Fidelity's administrative costs to the plans. However, the court found that the plan fiduciaries never attempted to do this.

Second, the investment policy statement required that a "winnowing process" be used when removing and replacing an option in the plans' menu of investment options. A winnowing process involves monitoring investment funds' performance, putting poor performers on a "watch list" and removing poor performers from the investment lineup if their performance does not improve. The court found that the fiduciaries did not conduct a full and proper investigation, including a winnowing process, before replacing one option, the Vanguard Wellington Fund, with the Fidelity Freedom Funds. The court found that if the fiduciaries had reviewed the Vanguard Wellington Fund's performance during the period prior to de-selection, they would have learned that except for one year, the Vanguard Wellington Fund had been a "stellar" and "consistent" performer. The court, believing that the replacement was motivated by a desire to reduce company fees rather than fees related to the 401(k) plans, also took issue with the fact that the substitution occurred despite minimal research and review of the Fidelity Freedom Funds.

Third, the plans required that, when selecting a mutual fund that offered a choice of share classes, the plan fiduciaries were to select the share class with the lowest cost. The court concluded that the plan fiduciaries violated this obligation because they did not do this in some instances.

Plan fiduciaries who do not have any of the above language in their investment policy statement or plan documents should not necessarily breathe a sigh of relief. Plan participants and beneficiaries can claim—and have claimed—that a fiduciary is required, as a matter of prudence, to take an active role in evaluations of plan investments. This analysis must take into account more than generic information about mutual funds and must look specifically at what makes sense for the particular 401(k) plan, given the plan's size, population and current investment option lineup.

Improper use of the plans' revenue sharing to pay for or subsidize certain corporate services.

A plan's assets are to be used for the exclusive benefit of that plan's participants and beneficiaries. Using plan assets to benefit a party in interest, like the employer or another plan, would constitute a breach of fiduciary duty and a prohibited transaction. In Tussey, revenue sharing was used to pay for or subsidize corporate services, including employee payroll services and the costs of administering the employer's nonqualified plans, health and welfare plans, and defined benefit retirement plan. Since this arrangement would constitute a prohibited transaction under ERISA and the Internal Revenue Code, the transaction must be "unwound" and subjects the employer to payment of excise tax penalties.

Tussey Takeaways

The Tussey case has generated consternation within the employee benefits community because many of the practices undertaken by the plan fiduciaries are commonplace. Plan fiduciaries should consider taking the following steps to help avoid the type of liability found in this case:

Read and follow governing documents

. Dust off the plan document, trust agreement, service provider agreements, investment policy statement, committee bylaws or charter, and summary plan description. One or more fiduciaries should agree to review these documents regularly to determine what they require. If ambiguities exist, documents should be revised.

Learn about the plan's retained service providers.

As part of a plan's administration, it may be prudent to schedule standing discussions on the performance of a service provider to review and evaluate the adequacy of the services as well as the administrative fees charged.

Monitor service providers and fees.

Fees are a focus of plaintiff litigation in the ERISA arena, not just in Tussey. This information is available in the plan's Form 5500 Schedule C. In addition, the U.S. Department of Labor's regulations on the disclosure of retirement plan service provider fees and expenses, which became effective July 1, should help fiduciaries understand what service providers are being paid and whether the fees are commensurate with the services.

Follow the governing procedure.

Courts have held that it is not whether fiduciaries reached the correct determination but whether they followed governing documents and applied prudence in making a determination. This is probably a relief for fiduciaries, because it means they are responsible for events they have control over—their ability to follow a protocol and act prudently—not how an investment option fares in the future.

What procedures should employers follow with respect to plan investments?

Establish a fiduciary committee that meets to specifically discuss plan investments.

Populate the committee with at least one or two individuals who are knowledgeable about plan investments, such as a member of a treasury function or an outside registered investment advisor.

Prepare an investment policy statement that can provide guidance to plan fiduciaries with respect to their responsibilities. Keep in mind, however, that a statement can do more harm than good if it is ignored.

Meet quarterly to evaluate all plan investments.

Review and deliberate a decision before adoption. This involves investigating an investment option's prior performance, current managers and investment strategy before adding it to, or removing it from, the plan's investment lineup.

Adopt a change by taking appropriate steps—generally, a fiduciary vote and plan amendment, where applicable.

Memorialize the committee's decision-making, including the reasons for keeping or dropping an investment, not just the final result. For example, a committee's meeting minutes should document why a fund was removed and replaced. ERISA fiduciaries should always assume that their procedures and decisions will be scrutinized by a court and that their counsel will need to rely on documentation to defend their actions.

Remember that ERISA plans are separate and distinct legal entities from each other and their sponsoring companies.

Fiduciary duties are owed separately to each plan, and fiduciaries cannot permit one plan to be advantaged at the expense of another. Nor may fiduciaries permit the sponsor of an ERISA plan to leverage that plan for its own financial advantage. To illustrate this point, the fact that the participants in a 401(k) plan and medical plan are largely the same does not justify permitting higher fees to be charged in the 401(k) plan because the 401(k) plan participants may benefit from administrative cost savings under their medical plan.

Follow the golden rule.

ERISA was enacted to safeguard employees' retirement assets. Being an ERISA fiduciary involves the administration of other people's money, and possibly the fiduciary's as well. As a fiduciary, one should strive to treat participants' and beneficiaries' money as one would expect a third party to treat his or her own retirement assets.

The purpose of this discussion is not to scare 401(k) plan fiduciaries but rather to remind them of the importance of process, prudence and following plan documents when performing fiduciary duties. Keep in mind that Tussey is just one case and that the district court's decision in Tussey will not likely be the last word, as the Tussey fiduciaries have appealed the district court's findings to the 8th U.S. Circuit Court of Appeals.

The authors are attorneys in Littler Mendelson's New York office. Steven Friedman chairs the firm's Employee Benefits Practice Group.

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