Once upon a time, people kept their retirement savings under mattresses or in a metal box buried in the backyard. Today, investors both modest and wealthy have found a better protection--investments under the shield of ERISA. This law also raised the bar for providing advice, with higher standards that even now are changing. Indeed, Congress is currently debating significant revisions to ERISA as it applies to the "providing of advice" and "employee participation in plans." Advisors working in an ERISA environment would do well to review the basics.
The General Standard of Prudent Investment Procedures was originally formulated as a general statement that would allow fiduciaries the flexibility appropriate to particular circumstances. This standard requires that reasonable care, skill and caution be applied to investments, not in isolation, but in the context of the total portfolio and as a part of an overall investment strategy which should incorporate risk and return objectives reasonably suitable to the trust.
As you are aware, a fiduciary can be an individual, corporation or association holding assets for another party, often with the legal authority and duty to make decisions regarding financial matters on behalf of the other party. The duties of a fiduciary: (1) conform to fundamental fiduciary duties of loyalty and impartiality; (2) act with prudence in deciding whether and how to delegate authority and in the selection and supervision of agents; and (3) incur only costs that are reasonable in amount and appropriate to the investment responsibilities of the trusteeship.
Each fiduciary must assume that his/her investment decisions will be examined in detail in the future. Documentation is critical and spans a wide array of both internal and external reporting requirements. Internal record-keeping functions require building an audit file that can be quickly produced and reviewed to verify compliance. External reports are required to satisfy plan participants and regulatory authorities.
Advisors should familiarize themselves with the five main duties of fiduciary responsibility:
Loyalty (ERISA Section 404(a)(1)(B)). ERISA requires fiduciaries of retirement plans to make decisions based solely on the best interests of plan participants. As long as the fiduciary can demonstrate through documentation that the employees' best interests were considered, a decision resulting in a loss to the participant doesn't necessarily mean that the fiduciary is in violation of ERISA. The main issue at the basis of the Act is whether the fiduciary acted in a procedurally prudent manner that reflects a loyalty to the participants of the plan.
Diversification (ERISA Section 404(a)(1)(C)). According to the rules and regulations, a qualified plan must offer a diversified investment menu that allows participants to minimize the risk of long-term losses. Fiduciaries must display knowledge of the investment marketplace; this means they will be held to an expert standard. In areas where they may be deficient, fiduciaries are expected to consult with or even hire financial experts to help them conduct a thorough analysis of their plan investment offerings. These experts can then alert the fiduciaries to add certain asset classes or demonstrate that it is prudent not to have those asset classes. This duty has been taking on more significance as new asset classes are considered, and as lifestyle and lifecycle investment options become more prevalent.
Management of Expenses (ERISA Section 404(a)). It is incumbent upon the fiduciary to know and understand all expenses of the plan and to make sure that the expenses are reasonable when compared with the market. An annual review of independent objective benchmarking studies can provide a comparison with similar plans and relevant demographics. Qualified plan investment expenses must be reasonable.
Determining whether expenses are reasonable does not mean that the expenses have to be the lowest, nor are fiduciaries automatically safe if their expenses are the lowest. However, if the costs are higher than the benchmark, the fiduciary should understand and document why the expenses are higher. It could be because of the geographic diversity of the group; it could be that the managers are particularly expensive because of their superior performance; or it could be because there are some additional benefits. These are all adequate reasons for higher expenses.
Monitoring and Oversight (ERISA Section 405(a)). The performance of qualified plan investments must be monitored and reviewed. While fiduciaries can delegate or shift responsibility for managing the retirement plan's assets to someone who's better qualified, they cannot delegate their duty to monitor the managers in a well-defined, consistent manner to ensure compliance with agreed-upon tasks, consistency of style, performance against benchmarks, and any significant changes. This oversight responsibility never goes away, and the penalties for abdicating that responsibility are very serious.
Avoidance of Prohibited Transactions (ERISA Section 406). Prudent management and oversight of the plan includes safeguarding against activities that constitute a conflict of interest. Such activities between the fiduciary and the plan or trust might in-clude the direct or indirect sale, exchange or leasing of property; lending money or other extension of credit; and furnishing of goods, services or facilities.
Advisors and trustees should familiarize themselves with modern investment theory practices, which are likely to become increasingly important because of their acceptance in the marketplace and their overall contribution to investment performance.
In addition, these investment practices enable fiduciaries to present objective numerical guidelines for trustees' examination and as responses for any subsequent litigation.
Consequently, there will be greater use of professional financial and investment advisors who employ modern investment theory concepts with increased use of noload or load-waived mutual funds as well as additional new investment strategies and/or asset classes. More rigorous selection and review procedures must be established by trustees who are now being held to a higher standard. Following these procedures can improve investment performance and decrease a growing vulnerability to litigation.
As Congress seeks to help retirement plan participants, it is likely that financial advisors will play a bigger role in providing guidance and advice to these participants. With this expanded marketplace come new opportunities to expand your role and attract new ERISA clients. As a result, financial advisors will find themselves assuming the role of fiduciary within an ERISA context. It is therefore even more critical that advisors understand what their liabilities and responsibilities are and how they can protect
themselves. This column is committed to educate financial advisors as to their roles and how they might further define their actions. Good luck.
Pushing Paper
Your ERISA clients should maintain the following supporting documentation regarding the decisions that you have made towards the plan:
o Journals, ledgers, account statements (including bank and trust statements), appraisals, etc. that support all plan assets/investments.
o Analysis and reports from investment managers, consultants and performance measurement data.
o Certificates, documents, statement of additional information (if a mutual fund), confirmations and any and all necessary items depicting evidence of ownership in the plan assets/investments.
o Annual copies of Form ADV for each money manager, along with certification by the manager that appropriate registrations under the Investment Advisers Act of 1940 and the State Securities Board are maintained. In addition, the manager should certify that there is no material litigation pending against the manager that involves allegations of a breach of fiduciary duty or securities law violations.
o Proof of bonding (ERISA Sec. 412(a)) requirements for all fiduciaries (including money managers and trustees) dealing with plan assets. Every fiduciary of an employee benefit plan and every person who handles funds or other property of such a plan...shall be bonded as provided in this section.
o A detailed report of investment transaction turnover, costs, fees and expenses.
Ken Ziesenheim, is President, Thornburg Securities, and Managing Director, Thornburg Investment Management, (Kziesenheim@thornburg.com, 863-381-0060). He is the author of Understanding ERISA--A Compact Guide to the Landmark Act.
