Introduction
As a person is growing up, they are always encouraged to become more responsible. In the world of employer-sponsored plans, the responsible party is called the fiduciary, and they are rightly held to a high standard to protect the participants’ best interests. Fiduciaries are actually personally liable for any wrong-doings. This knowledge creates a need to be laser-focused upon what can and cannot be done with plan assets. This is a good thing for plan participants, but the degree of restrictions creates a high hurdle for individuals to be willing to become a plan fiduciary. Because of this, there are some measures that can reduce the burden for a fiduciary. You will learn about some of the rules and methods of limiting fiduciary liability in this chapter.
The role of a fiduciary is being actively re-examined by both regulators and the courts. In one notable case currently before the Supreme Court, the question has been raised whether a fiduciary over an employee stock ownership plan (ESOP) (where employees own employer stock specifically with their retirement assets) is violating the participant’s best interests when the employer stock appears to be headed down with no immediate hope of reversal.1 This lawsuit is really questioning the viability of the ESOP plan type, but it is specifically questioning a fiduciary’s standard of prudence.
Learning Goals
Identify the scope of fiduciary rules in retirement planning.
Describe the affirmative duties of plan fiduciaries.
Explain the individual account plan exception that limits fiduciary liability.
Identify what the prohibited transaction rules are intended to accomplish.
Describe the impact of failing to satisfy the fiduciary standard and ways to protect plan fiduciaries.
Fiduciary Duty
Before we can discuss what a fiduciary does, we must first define who a fiduciary is. An entity is considered a fiduciary if they have discretionary authority over the plan assets, over distributions from the plan assets, or over the holistic plan administration. Discretionary authority means that they can take whatever action they so choose without seeking the approval of another. Someone could also be considered a fiduciary if they render investment advice to the plan for a fee.
The list of potential plan fiduciaries could include the plan sponsor (employer) itself, any plan trustees, any paid investment managers, or any officers of the company who pick the plan trustees or paid investment managers. While the employer could be considered a fiduciary, plan establishment or termination are not considered fiduciary acts. These are both simply business decisions.
Attorneys, accountants, external plan administrators (sometimes called third-party administrators or TPAs), or someone who simply sells investments to the plan without rendering advice are not considered fiduciaries. They are simply ancillary service providers. The broker where the plan assets are custodied (held) is also not considered a fiduciary. There is an ongoing debate about the role of investment managers as fiduciaries. It is generally understood that an investment manager, who only provides education and not advice to participants, will not be considered a fiduciary.
Why so much concern over whether or not an entity is considered a fiduciary? Being a fiduciary carries a tremendous amount of responsibility. On a very basic level, a plan’s fiduciary is responsible for managing the plan’s assets and the payment of any benefits to the participants. The fiduciary is responsible for making sure that the plan functions as it needs to. However, they are not required to do all of the physical work. If they are not an expert in an area, then they should hire a third-party expert to manage that function.
The concept of a fiduciary applies to all qualified plans and also to simplified employee pensions (SEPs), savings incentive match plans for employees (SIMPLEs), and 403(b) plans. Basically, the concept applies to all tax-advantaged retirement plans regardless of whether they are considered “qualified” or not. There is an exemption (why wouldn’t there be) for 403(b) plans without any employer contributions, for government-sponsored plans, for church-sponsored plans, and for plans that only cover a 100 percent either the owner or their spouse.
Earlier, it was mentioned that one of the fiduciary responsibilities is to manage the plan assets. While the term “plan assets” sounds intuitive, like everything in finance, it requires a unique definition. Of course, salary deferrals and any employer contributions are plan assets. It deserves mentioning that the any deferrals must be transferred from the company’s bank account to the plan’s account by the 15th of the month following the month in which the salary was earned. The salary deferred from the wages due September 30th must be deposited by October 15th of any given year. This prevents the employer from using the salary deferrals for their own gain.
What about an equity investment in another company? Do you need to include a proportionate amount of the investment’s balance sheet as “plan assets?” The answer is no, if it is a publically traded company. The answer is yes, if it is privately held. If the plan assets are used to purchase an ownership interest in a privately held company, then a minority interest in the investment’s balance sheet assets must be included as “plan assets.” It seems a bit technical, but technically it is a part of the rules.
Another duty incumbent upon fiduciaries lies in the selection of investments. The fiduciary is not responsible for the ultimate performance of investments held in an account where the employees pick from a list of choices. However, the fiduciary could be liable if they either did not pick a diversified-enough basket of choices or if the investments they chose have relatively higher internal fees than competing products. In Tibble versus Edison, the U.S. Supreme Court found that the fiduciaries can be held liable if they pick the retail class shares (Class A, B, etc.) as opposed to the investor class shares.2 The reason is that the retail class shares have materially higher internal fees that are paid by the participants. This ruling will likely encourage many 401(k) providers to alter their investment offerings in favor of the less-expensive investor class of shares.
Fiduciary Conflict Mitigation
Conflicts of interest are a significant part of what regulators try to “supervise” with respect to the conduct of fiduciaries. The core concept is known as the exclusive benefit rule, which states that a fiduciary must act in the sole interest of the plan participants (sometimes, also called plan beneficiaries). The regulators are laser-focused on searching for any collateral benefits that the fiduciary might receive. A collateral benefit is any personal, secondary benefit realized by the fiduciary as a result of making a transaction with the plan assets. Tangential to the exclusive benefit rule is the requirement that the fees paid by the plan assets be “reasonable” in nature. It is in the best interest of participants if the fiduciary hires help for areas where they are not an expert, but the fees paid to third parties must not be excessive.
In a practical application, conflicts of interest do sometimes arise. In such a scenario, the fiduciary should disclose any conceivable conflict of interest that cannot be eliminated. An example of a conflict that can easily be eliminated is gifts from investment managers. In the wide world of investment, it is common for the investment managers to offer meals, golfing packages, trips, and other incentives to the potential clients. Fiduciaries are obligated to avoid these enticements at all costs ... no matter how tempting the carrot being dangled.
If you have already studied investments, then you will likely understand the existence of 12 B-1 fees. These are essentially an advertising and marketing fee that is rolled into the expense ratio on mutual funds. Investors pay this “fee” behind the scenes, before investment results are reported to them. The investment managers often receive these fees as an incentive for recommending a given fund company to their clients. This trend is pervasive in the industry. It is not a conflict that can be eliminated, but it should be disclosed to the plan participants.
There is also a standard of prudence levied upon the fiduciary. They must behave as a prudent person would be expected to behave while conducting their duties. The standard of prudence is often linked to “care, skill, and caution.” A prudent fiduciary will display care, skill, and caution as they manage plan assets and supervise distributions to participants in retirement.
The Department of Labor (DOL) has compiled a list of factors that constitute “prudence” from their perspective. The first prudent factor is to consider the role of an investment as a part of the larger portfolio, essentially, the notion of asset allocation. The next factor is that an investment must be reasonably designed as a part of the asset mix. It would not be prudent to put 50 percent of the plan assets in a biotech startup. The next factor is that the fiduciary must balance the risk of loss with the potential for gain. You already learned about the risk-reward tradeoff. Fiduciaries must be careful to not assume needless risk. Related to the factors mentioned so far is the next factor—diversification. It is incumbent upon the fiduciary to ensure that the plan assets are properly diversified. The fiduciary must also be mindful of the liquidity needs of the plan and structure plan assets so that they meet the needs of the plan. One way to accomplish this DOL mandate is to match the projected returns of assets to the plan’s funding objectives.
With all of this oversight and focus on only employing investments that meet plan objectives, how is a fiduciary to function in an uncertain market? The logic behind each investment is judged based on the information available at the time that the investment decision is made and not based upon the end result. This is only prudent and fair. With this key feature in mind, fiduciaries must carefully document their rationale before making an investment in order to protect their own liability.
Other Fiduciary Disclosures and Requirements
The requirement of diversification does not mean throw in a bit of everything. This behavior could result in “diworsification” where the wrong assets are mixed together. There must first and foremost be diversification among the asset classes. The prudent fiduciary will look at how a benchmark, such as the Standard and Poor’s 500 Index, is allocated across the asset classes, and use this as a guide. They do not need to simply pick the same percentages in each category that the benchmark uses, otherwise, why not just purchase the index as the sole investment. The goal of the plan is probably more specific than simply tracking the benchmark, and it certainly will include less volatility than the market. The benchmark is simply one place to look for ideas on which sectors to invest in. At this point, diversification will be best thought of as minimizing beta and maximizing the Sharpe ratio. Both of these concepts are beyond the scope of this textbook.
Diversification within a single asset class is also key. For instance, if the fiduciary plans to include the category of healthcare, then they should be mindful to include some portion of insurance carriers, pharmaceuticals, medical device makers, and perhaps, biotechnology firms. If the fiduciary does not personally have this level of expertise, then it is their fiduciary’s responsibility to hire someone who does.
In general, the fiduciary must manage the plan assets in accordance with the plan document and the Investment Policy Statement (IPS). The fiduciary must be careful to not violate any specific prohibitions against certain investments or investment types. For instance, the IPS or the plan document might expressly forbid the use of derivatives or margin trading (buying assets with a loan secured by other plan assets in an attempt to amplify the investment results—riskier strategy).
Any fees that will be paid by the participants and not by the plan sponsor must be disclosed to the participants. This includes any administrative charges, fees for investment advice, and any charges for receiving paper statements as opposed to downloads. A schedule of fees must be presented annually, and the actual fees paid must be fully and clearly disclosed on a quarterly basis.
Effect of Participant-Directed Investing
Just ask any fish ... getting off the hook is a good thing. Section 404(c) is a mechanism to help alleviate some of the fiduciaries mandated responsibility. This rule removes the investment monitoring mandate from the fiduciary if the participants have the ability to direct their own investment selection and they exercise that ability. Section 404(c) does not exempt the fiduciary from offering prudent investment choices. This rule is most often employed in a 401(k) setting. The participants can choose their own investments and so, the fiduciaries’ only logical investment responsibility is to select a reasonable investment alternative for the participants to choose from.
In order for §404(c) to apply, the participants must be offered a broad range of investment alternatives. Now, it does not sound very broad, but the rules state that the participants must be offered at least three (3) different core investment options. The options offered must have materially different risk–return characteristics. For example, a large company mutual fund, a global mutual fund, and a bond mutual fund. It is perfectly acceptable to include the employer stock as an option as long as there are additional options that provide for the potential of diversification. Mutual funds are often chosen because they are, by default, more diversified than adding individual stocks to a few different industries.
There must also be an option for the participants to change their investments at least quarterly. If §404(c) is employed by a fiduciary, then participants must be notified of this fact. They must also receive specific information on each investment in order to be able to effectively choose between them. The “specific information” requirement can be satisfied by providing the mutual fund’s prospectus (their legal disclosures) and a schedule of past returns and risk measures (standard deviations, etc.).
What happens if alternative investment choices are made available, but the participants simply do nothing? Should the fiduciary still be held liable for investments in this scenario? A short answer is “yes.” Unless, the plan employs what is known as a qualified default investment (QDI) alternative. Regulation provides that if a plan employs a QDI, then the fiduciary is exempt from all investment responsibility except that they still will be required to provide a reasonable blend of different investments for the participants to choose between. The DOL provides a very loose definition of what a “qualified default investment” is exactly. We do know that they intend for it to be easy diversification for employees who do not know what they are doing and that it cannot invest directly in an employer’s stock.3 Procedurally, the fiduciary will typically use either a target date fund (like the Vanguard Target Retirement 2050 Fund), a lifestyle fund (like the Vanguard Life Strategy Moderate Growth Fund), a balanced fund (like Fidelity Balanced Fund), or they will offer an outsourced discretionary investment management service that will pick all of the participants investment options for a fee. By establishing one of these alternatives as the default investment if an employee fails to exercise their own investment selection rights, then the fiduciary is relieved of investment supervision responsibility. The QDI cannot be simply a money market fund.
Fiduciary Prohibited Transactions
There is a long list of specific transactions that should be avoided at all costs by a plan’s fiduciary. Typically, those transactions occur between the plan assets and the fiduciary themself, the plan trustees, legal counsel for the plan, the plan sponsor (the employer), an employee organization (unions), any 10 percent owners of the plan sponsor, any employees, any relative of any previously mentioned at-risk group, or any organizations related to the plan sponsor (like a subsidiary). Transactions between the plan assets and any of these at-risk groups will raise a red flag for the regulators and generate additional scrutiny. Better to avoid that if at all possible. Even if §404(c) is in force, the fiduciary still must be on guard against the prohibited transaction types.
Regulators especially watch for self-dealing, which is any transaction that uses the plan assets that present a benefit for the fiduciary. Common benefits that would create a regulatory alert are any financial kickbacks (payment by someone to the fiduciary to incentivize a certain transaction), any ancillary benefits (paid trips or golf outings), personal financial gain from selling an asset to the plan (perhaps at above market rates), or personal financial gain from buying an asset in the marketplace, which drives up the price in order for the fiduciary to sell a personal holding in the open market (large purchases can impact the market price on stocks with lower trading volume).
Regulators have also compiled a list of prohibited transactions to help a fiduciary know exactly what to stay away from. Any sale, exchange, or leasing of property between the plan assets and an interested party (like the plan sponsor or the relative of an owner) is expressly prohibited. The plan should not lend money or furnish any goods or services to any of the at-risk groups previously described. It is also a big red flag if any more than 10 percent of the plan assets are used to purchase the stock of the plan sponsor. Regulators are trying to guard against the employee seeking to use the plan assets to control a valuable voting block of the outstanding shares of the company. It is very common for small businesses to unintentionally violate the prohibited transactions list. This is usually a mistake and not a willful violation. If a fiduciary has any question about a given transaction, they should seek legal counsel before placing the trade.
There is a very broad series of exemptions to the prohibited transactions list. Without a sequence of exemptions, fiduciaries could not pay for basic needs, like the third-party service providers or external investment managers. There are three categories of exemptions. The first category is called statutory exemptions. Statutory exemptions cover transactions like plan loans, ESOP loans, reasonable compensation to the plan service providers, and a special clause for bank or insurance company employees who want to purchase a proprietary investment that is assembled and sold by their employer (the bank or insurance company). Without these statutory exemptions, you can see how some basic functions of the plan would not be legitimate. The second category of exemptions is called administrative exemptions, and they come specifically from the DOL. The administrative exemptions are too numerous to list, but know that a fiduciary may have access a certain transaction if there is an administrative exemption on file with the DOL. The final type of exemption is called an individual exemption. These individual exemptions are similar to private letter rulings previously discussed ... they only come into play if no other exemption exists for the transaction. A fiduciary can petition the DOL for a one-time exemption if they can prove that the exemption is administratively feasible, in the best interests of the plan’s participants, and ultimately protects the rights of the plan’s participants.
Some common transactions that will always get a regulator salivating are loans from the plan assets to the company, the company’s owners, or relatives of the company’s owners. Another huge red flag is a contribution of anything other than cash. If the company contributes an ownership interest in an income-producing real estate property, not only would the fiduciary need to contend with the potential for unrelated business income tax (UBIT), but they will need to be concerned with valuation issues. This type or transaction should just be avoided. Another common trouble spot is if the plan sponsor uses the plan assets to purchase a property or voting shares of another company and then uses the plan’s ownership for the plan sponsor’s ultimate benefit.
One final exemption exists for investment advisors. Because they provide investment advice to a plan or directly to the plan’s participants, investment advisors are typically deemed to hold a fiduciary status. Recall that fiduciaries are prohibited from self-dealing, and charging a fee to the plan is self-dealing. So, how do they get paid? Investment advisors are permitted to charge fees if certain criteria are met. First, the fees must be static (they cannot vary depending upon the investment options selected). However, they can charge a different level of fees if computer models are involved in the financial advice because computer models (algorithmic trading) are very specialized and very costly. Second, the fees must be specifically authorized by the plan’s fiduciary and monitored by the fiduciary on an on-going basis. Third, the fees must be audited annually to ensure compliance with these other criteria.
Limiting the Fiduciary Liability
Fiduciaries are personally liable for any losses that result from a breach in their fiduciary duty.4 There is also a provision to clawback (take back) any profits that the fiduciary earns illicitly from personal transactions with the plan assets. Fiduciaries are also personally liable for breaches of duty committed by other plan fiduciaries! They could be on the hook if they knowingly participated in illicit activity with a cofiduciary or helped to conceal a violation. This includes deleting e-mails or shredding paperwork. They could also be liable if they failed to put in place the controls to prevent another fiduciaries breach of duty. If the regulators do rule that a transaction was a breach of duty, not only will they go after the fiduciary in question, but they can also charge the party on the other end of the transaction a 15 percent “excise tax” penalty!
If a fiduciary’s role were viewed as an “investment,” one would certainly be fair to say that it is an investment with limited, moderate return potential and unlimited risk. Not really a great deal for the plan fiduciary. But some must fill the role.
With all of these limitations and the risk of regulatory oversight, why would anyone willingly agree to become a plan fiduciary? There is a mechanism to place a cap on the risk taken by the fiduciary. The first step in this risk-limiting process is to document every action taken with respect to the plan. If every action taken is documented and it fits within the limits of the law and the plan document, then there is nothing to fear. It is also important that the various roles of plan administration and investment supervision be specifically allocated to specific people so that, it is clear who makes which decisions. In real estate, there is a phrase that the most important component of a piece of property’s value is location, location, and location. In the world of fiduciary duty, a vital component is delegation, delegation, and delegation. If the fiduciary does not have expertise in an area, then they are obligated to delegate the function to a paid professional who is an expert. The icing on the cake of risk limitation is that either the fiduciary themselves or more likely their employer, can purchase a fiduciary bond, which is an insurance contract that will pay benefits if the fiduciary breaches their duty. This series of protective mechanisms transforms the fiduciary relationship into a moderate return “investment” now with limited risk. With this risk profile, professionals are typically willing to accept the role of a plan’s fiduciary.
Discussion Questions
The CFO of a large company only has discretion over the assets of the employer’s retirement plan. Is this individual a fiduciary?
An attorney, who only recently passed their bar exam (allowing them to become an attorney), for a given employer-sponsored plan is under the impression that they are free of fiduciary obligation for the retirement plan. Are they correct?
You overhear a legitimate plan fiduciary saying that they are able to be a bit more liberal with their judgments because they have no personal consequences if something goes wrong. What would you tell them?
A legitimate fiduciary uses the same brokerage company personally that they use for plan assets. Due to the size of the business relationship, the brokerage company has given the fiduciary a 50 percent reduction on the trading costs for both the plan assets and personal assets. Is this an issue?
Is the prudence of a fiduciary’s investment decisions based on the ultimate investment outcome?
There are many required duties of a fiduciary. However, diversification of the pool of investments is a voluntary duty. Is this understanding correct?
In an attempt to access the reduced responsibilities offered by §404(c), a fiduciary decides to alter their operations to allow each participant to exercise investment authority. Those who do not exercise discretion will automatically be placed in a well-diversified large company mutual fund. They simply make the change and provide a notice to all the participants stating that they “will now have the opportunity to exercise investment discretion. Anyone who does not exercise this discretion will be automatically allocated into XYZ Large Core Mutual Fund.” What issues, if any, do you see in this scenario?
A plan’s fiduciary receives a notification of what they perceive to be a fantastic investment opportunity. It meets all of the requirements for prudence ... it truly is a good investment. This would be an investment in a privately-held business, which is part-owned by the cousin of one of the owners of the plan sponsor. Is there any issue?
A loan from an employer-sponsored retirement plan to an employee is a violation of the prohibited transactions rules. Is this statement correct?
You are an investment advisor working for XYZ Capital Management. You have been hired to educate the participants in ABC Manufacturing’s 401(k) plan. Are you considered to be a fiduciary?
How could the inherent personal liability associated with being a fiduciary be limited or removed?