1 ERISA Fiduciary Responsibilities A Primer for Plan Sponsors Abigail B. Pancoast Senior Counsel, Lincoln Financial Group The information contained in this article is intended to provide general information, does not constitute tax or legal advice, and does not purport to be complete or cover every situation. Please consult with your own independent legal and tax advisor(s) for more information about your specific situation. This material was prepared to support the promotion and marketing of retirement products. Lincoln Financial Group affiliates, their distributors, and their respective employees, representatives, and/or other insurance agents do not provide tax, accounting, or legal advice. Any tax statements contained herein were not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties. Please consult your own independent advisor as to any tax, accounting, or legal statements made herein. Who is an ERISA Fiduciary? Before discussing specific fiduciary duties, it is useful to consider who is an ERISA fiduciary. Under ERISA, a plan fiduciary is person or entity who: 1 Exercises discretionary authority over plan management, Exercises any authority or control over plan assets, Has discretionary authority over plan administration, or Gives investment advice to the plan or a plan participant for a fee. ERISA requires that the plan have at least one fiduciary (either a person or an entity) named in the plan document or through a process described in the plan document (the named fiduciary ). 2 The named fiduciary must have the authority to control and manage the operation of the plan. The plan can identify the named fiduciary as one or more committees made up of employees of the employer sponsoring the plan. Alternatively (and more commonly in the case of small employers), the plan could provide that the named fiduciary is simply the employer itself. Often, the named fiduciary will not have the time or expertise necessary to properly carry out its responsibilities. To address this, ERISA permits named fiduciaries to delegate most fiduciary functions to other service providers. 3 As discussed further below, this does not absolve the named fiduciary from responsibility for the delegated functions because the named fiduciary is still responsible for the prudent selection of the service provider and ongoing oversight of the service provider s actions. In addition to named fiduciaries and their delegates, there may be individuals or entities that are fiduciaries because they perform fiduciary functions even though they are not named as such ( functional fiduciaries ). This is because formal appointment is not required for fiduciary status; rather, fiduciary status is determined based on what the person or entity actually does with respect to the plan. 4 Thus, for example, a person or entity who manages the investment of plan assets, makes discretionary decisions regarding the operation of the plan, or gives investment advice for a fee to the plan or plan participants would be an ERISA fiduciary whether or not designated as such. 1 ERISA 3(21)(A). 2 ERISA 402(a)(1). 3 ERISA 405(c).
2 With the exception of named fiduciaries, ERISA fiduciaries generally are only fiduciaries with respect to the specific functions they are performing. For example, the person who is a fiduciary by virtue of managing plan assets would only be a fiduciary with respect to the assets managed and only in its capacity as an investment manager. It would not be a fiduciary with respect to the plan as a whole and would not have fiduciary duties other than those related to the investment management of the assets for which it is responsible. The Significance of Being a Fiduciary Basic Standards of Conduct Fiduciary status is important because it carries with it high standards for conduct and potential personal liability if these standards are not met. These standards of conduct require a fiduciary to: 7 Act solely in the interest of plan participants and beneficiaries with the exclusive purpose of providing benefits to them and paying reasonable plan expenses (the duty of loyalty ), Act with the care, skill, prudence, and diligence of a prudent person who is familiar with retirement plan matters (i.e., act as a prudent expert ), and Diversify plan investments to avoid large losses. Duty of Loyalty. The duty of loyalty is a command to avoid conflicts of interest and self-dealing. It means that fiduciary decisions must be made without favoring the interests of the fiduciary or any other third party over the interests of participants and beneficiaries. However, plan fiduciaries are not prohibited from taking actions that incidentally benefit the employer as long as the duty of loyalty standard is otherwise met. 6 This duty also forms the basis for some of ERISA s prohibited transaction rules that forbid a fiduciary from engaging in transactions with plan assets in a manner that would benefit the fiduciary. This duty also places an affirmative obligation on plan fiduciaries to pay only reasonable expenses from the plan. Duty of Prudence. According to the U.S. Department of Labor (DOL), the duty of prudence is one of a fiduciary s most central responsibilities under ERISA. 7 This rule forms the basis for the courts and the DOL s emphasis on procedural prudence. Procedural prudence means that a fiduciary that follows a careful and thorough process in making a fiduciary decision should not generally be liable for violating the prudence requirement even if the decision results in a loss to the plan. Procedural prudence is particularly important in the context of investment decisions because investment decisions can so often have poor outcomes that are not anticipated. In order to be prudent, the decision-making process must involve sufficient investigation and due diligence to allow the fiduciary to make an informed evaluation and decision. Because of the focus on process, documenting decisions and the basis for them is critical for the fiduciary to be able to defend those decisions if they are ever challenged. Another important aspect of the prudence requirement is the requirement that the fiduciary act as a prudent expert in carrying out its duties. This means that either the fiduciary must be knowledgeable and expert in all aspects of plan administration 4 This is made clear in the definition of an ERISA fiduciary, which describes fiduciary status in terms of actions, not titles or appointments. 5 ERISA 404(a). 6 Lockheed v. Spink, 116 S. Ct (1996). 7 DOL Publication, Meeting Your Fiduciary Responsibilities, available at
3 or rely on outside experts. 8 Since plan fiduciaries usually do not have the expertise necessary to administer a plan, they must rely on outside providers to meet the prudent expert requirement. However, the plan fiduciary still retains some responsibility for the actions of these service providers and continues to be responsible for the decisions it makes when relying on expert advice. 9 Therefore, engaging in a procedurally prudent process when selecting these experts, and once selected, monitoring their performance, is critical. Duty to Diversify. In some sense, the duty to diversify investments is a subset of the duty of prudence. The fact that it is listed as a separate duty gives emphasis to the critical importance of the investment functions of ERISA fiduciaries. Proper investment diversification requires consideration of factors such as the purpose of the plan and the type of plan, the amount of plan assets, plan demographics, and general economic conditions. In the context of a participantdirected 401(k) plan, diversification means having a diversified investment menu for participants to choose from. In general, the duty to diversify prohibits the investment of a substantial portion of plan assets in a single investment or a single type of investment. However, there are exceptions, for example, for plans designed to invest primarily in employer stock. In addition, a plan may invest large amounts in insurance/ annuity contracts, provided the insurance company s assets are adequately diversified or in pooled investments or mutual funds where the pooled funds or mutual funds are themselves adequately diversified. 10 Finally, plan fiduciaries can be relieved of the diversification requirement where participants elect to direct the investment of their accounts. 11 Here, however, the plan must offer a broad range of investment alternatives for the participant to choose from, so that participants can diversify their investments if they so choose. 12 Fiduciary Functions and Application of ERISA Standards What emerges from the basic definition of who is an ERISA fiduciary and the standards of conduct applicable to ERISA fiduciaries is that fiduciary functions can be divided into two broad categories: (1) plan asset investment management and (2) noninvestment-related plan management, i.e., general plan administration. These two general functions encompass a wide variety of activities, each of which may have its own set of considerations and issues. The following discusses several of the most important activities that a fiduciary is responsible for in each of these categories and how to ensure that they are carried out in accordance with ERISA s requirements. Plan Investment Management Of all of the functions that a plan fiduciary undertakes, plan investment management probably receives the most attention. This attention is deserved; proper investment management is critical for a plan to have sufficient assets to fund the benefits that participants expect and plan for in their retirement. A failure to properly manage plan assets can lead to unjustified investment losses and/or insufficient 8 See ERISA 402(c)(2), which provides that a plan may provide that a fiduciary may employ one or more persons to render advice with regard to any responsibility such fiduciary has under the plan. 9 See, e.g., Donovan v. Cunningham et al., 716 f2d 1455 (5th Cir. 1983) (holding that fiduciaries need not become experts in valuation of closely held stock but are entitled to rely on expertise of others; however, fiduciaries are responsible for insuring that information upon which the expert s opinion is based is complete and up to date); Donavan v. Mazzonla, 716 F 2d 1226 (9th Cir. 1983) (reliance on counsel s advice, without more, cannot be a complete defense to an imprudence charge). 10 HR Conf. Rep. No (House Conference Report to ERISA) at ERISA 404(c)(1). 12 DOL Reg c-1(b)(1)(ii).
4 investment returns. An ERISA fiduciary s investment management function includes selecting the investment vehicles in which plan assets will be invested and designating the allocation of plan assets among the various investments. In the case of a plan in which participants are permitted to direct the investment of their individual accounts, this function means selecting the investment options that will be available for participants to choose from. The three fiduciary duties discussed above, the duties of loyalty, prudence, and the duty to diversify, all apply to the investment management function. The duty of loyalty dictates that decisions relating to the investment of plan assets must be made free of conflicts of interest. Thus, for example, a fiduciary investing plan assets in companies that the fiduciary has a substantial ownership interest in or hiring a relative as an investment advisor would generally be a breach of this duty. 13 The duties of prudence and the duty to diversify require prudent selection of plan investments that are adequately diversified, and/or the selection of service providers to assist with this function. Of all of these duties, the prudence requirement gets the most attention because fiduciaries can never be sure at the outset that an investment decision will be a good one. Without the benefit of hindsight, the best insurance against potential liability for investment decisions that turn out poorly is to be able to demonstrate procedural prudence in making those decisions in the first place. The Importance of Procedural Prudence. DOL regulations provide that when making investment decisions, the duty of prudence requires the fiduciary to give appropriate consideration to the facts and circumstances that the fiduciary knows or should know are relevant to a particular investment or investment strategy, including the role that the investment (or strategy) will play in the plan s portfolio, and the fiduciary must act in accordance with the conclusions that were reached after that appropriate consideration has been undertaken. 14 Consideration of facts and circumstances that the fiduciary should know about means that it is insufficient to consider only readily available information about the merits of the investment if additional information can be found through thorough investigation and due diligence. Appropriate consideration includes a determination by the fiduciary that a particular investment or investment strategy is reasonably designed to further the purposes of the plan, taking into consideration the risk of loss and the opportunity for gain associated with the investment. 15 Consideration should also be given to (1) the diversification of the overall investment portfolio, (2) the liquidity of the investment relative to the liquidity needs of the plan, and (3) the projected investment return in relation to the objectives of the plan. 16 If the fiduciary can demonstrate that a decision-making process was followed that incorporated these considerations, most courts would find that the decision was prudent even if the investment turns out to have performed poorly. For example, in Donovan v. Cunningham, 17 the court said that the test of prudence is one of conduct, not the performance of the investment. The focus of the inquiry is how the fiduciary acted in his selection of the investment and not whether his 13 See, e.g., Lowen v. Tower Asset Management, 829 F. 2d 1209 (2d Cir. 1987) (investment advisory firm invested significant portion of plan assets in companies in which advisory firm members had substantial equity interests); International Brotherhood of Painters v. Duval, 925 F. Supp. 815 (D.D.C. 1996) (fund s financial consultant was trustee s family member). 14 DOL Reg a-(1)(b)(1). 15 DOL Reg a-(1)(b)(2). 16 Id F2d 1455 (5th Cir. 1983).
5 investments succeeded or failed. This is an illustration of a court s application of the procedural prudence concept. In other words, the decision-making process is more important than the outcome: if the fiduciary engages in procedurally prudent process, the investment decision will generally be respected no matter the actual investment outcome. 18 More recently, courts have also weighed in on the prudence requirements applicable to 401(k) plan fiduciaries when selecting investment options to make available to participants. At issue in these cases is not just investment performance of the fund options but also whether the fees associated with the funds are excessive (of course these two issues are related since fund-level fees can reduce potential investment return). In general, the courts have held that the prudence analysis is the same; that is, the focus has been whether the process for selecting investment options was prudent, not on the performance of the funds selected or the level of fees charged. For example, in Kanawi v. Bechtel Corp., 19 the court held that even though some of the funds available in Bechtel s 401(k) plan underperformed their benchmarks, because the plan fiduciaries regularly reviewed the performance of the funds and considered alternatives, they did not breach their fiduciary duties in the selection of funds for the plan because test of prudence is one of conduct and not performance and [i]t is easy to opine in retrospect that the Plan s managers should have made different decisions, but such 20/20 hindsight musings are not sufficient to maintain a cause of action alleging a breach of fiduciary duty. Similarly, in Taylor v. United Technologies Corp., 20 the court held that because the plan fiduciaries process for selecting investment options gave appropriate consideration to the fees and expenses charged by the mutual fund managers, the participants claims that the selection of those investment options was imprudent failed. It is important to note that some courts have attempted to distinguish between procedural and substantive prudence. Substantive prudence looks at the results of the decision-making process in addition to the process itself. For example, in Braden v. Wal-Mart Stores, Inc., 21 the court indicated that a fiduciary s investment option selection process could be found deficient if the fiduciary could have selected equivalent funds that were less expensive. In contrast to traditional procedural prudence analysis, this focuses on the results of the fund selection process (i.e., the funds that were actually selected), rather than limiting the evaluation to the appropriateness of the process itself. As a practical matter, however, engaging in a procedurally prudent process is still the best defense against potential challenges to fiduciary decision-making because it is much more likely that such a process will yield a substantively prudent result. Adopting an Investment Policy Statement. So how does a fiduciary implement a procedurally prudent process for making investment decisions? One of the best ways to do this is to create a written process for making these decisions and then documenting that this process was followed. In the context of investment decisions, the way to do this is by adopting an investment policy statement. An investment policy statement is a set of guidelines for fiduciaries to follow when 18 For an example of what happens when a prudent process is not followed, see De Costa v. Rodrigues, 46 EBC 2594 (9th Cir. 2009) (plan administrator who failed to undertake any due diligence or make even minimal inquiries into the plan s investment that he authorized breached his fiduciary duties) F. Supp. 2d 1213 (N.D. Cal. 2008).
6 making investment decisions, such as investment objectives and strategy (e.g., growth, capital preservation, balanced), target asset allocation mix, performance benchmarks, fees/expenses, and liquidity targets. In the case of a plan in which participants direct the investment of their individual accounts, the investment policy statement would include such items as the types of funds that should be included in the investment fund lineup, the minimum criteria for fund option inclusion, performance benchmarks for each fund option, and the process for evaluating and replacing existing fund options if necessary. Having an investment policy statement and documenting that it was followed in making investment decisions not only provides legal protection to fiduciaries in the event a decision is challenged, it increases the likelihood that sound investment decisions will be made, thereby reducing the chance of challenges in the first place. 22 Hiring Outside Service Providers. Another important way fiduciaries can ensure prudent investment decisions is to seek the assistance of experts. Because proper investment management requires a high level of specialized expertise that employers and other fiduciaries don t usually have, the prudent expert requirement discussed above effectively mandates that most plan fiduciaries obtain the advice of outside experts or delegate this function to outside experts rather than doing it on their own. As with the hiring of any plan service provider, hiring an outside investment expert is itself a fiduciary function subject to ERISA s duties of loyalty and prudence. In the case of the duty of loyalty, this means ensuring that the outside experts are free of conflicts of interest. Thus, for example, the expert should either be independent of the investment product providers for the plan (e.g., mutual funds or insurance companies) or the compensation arrangements should be structured so the expert s advice or management functions cannot affect the amount of its and its affiliates compensation. 23 In addition, the fiduciary must pay only reasonable expenses from the plan. Therefore, to the extent that an investment service provider s fees will be paid from plan assets, the fiduciary must carefully evaluate them to determine that they are reasonable. This generally involves comparing the fee estimates of multiple potential service providers and understanding what services are included in those fee estimates. 24 As with the making of investment decisions, the duty of prudence requires the fiduciary to obtain and evaluate relevant information about potential service providers and act accordingly. Relevant factors to consider might include items such as: professional qualifications and experience, fee structure, business practices, affiliations, financial condition, and liability insurance coverage. 25 It also means ensuring that the service arrangement terms are reasonable. For example, ERISA generally requires that service agreements be terminable on short notice and without penalty. 26 In addition, the service provider will want to ensure that the fiduciary and the service provider have the same understanding of the scope of services to be provided. To ensure 22 Not only are investment policy statements useful for creating a defense record in the event a fiduciary is sued over an investment decision, the investment policy and documentation that was followed is helpful in the event of a DOL audit of the plan. 23 In addition to a possible breach of fiduciary duty by a hiring fiduciary and the investment expert (who may also be a fiduciary as discussed further below), receipt by a fiduciary of additional compensation as a result of investment advice or management function is a prohibited transaction under ERISA and the Internal Revenue Code, subject to excise taxes and other penalties. See DOL Reg b-2(e)(1). 24 See DOL Publication, Meeting Your Fiduciary Responsibilities, available at html. See also the discussion above relating to recent litigation involving 401(k) plan investment-level fees. 25 Id. 26 DOL Reg b-2(c).
7 these issues are adequately covered and to provide a record of the arrangement, agreements should be in writing. Once a provider is selected, the duty of prudence also requires monitoring the service provider s performance, reading the reports they provide, reviewing actual fees charged, periodic review of policies and practices, and following up on problems that come to the fiduciary s attention. 27 To ensure that all appropriate due diligence is performed and all relevant factors are considered, the fiduciary should establish a written process for service provider selection and monitoring (similar to the investment policy statement for investment decisions) and document that this process was followed for each service provider retained. If the decision is ever challenged, the fiduciary will be much more likely to prevail if it is able to point to the process and a record that the process is followed. In addition, such a process helps ensure that the same criteria are applied in evaluating similar service providers so that the fiduciary can properly compare them. 28 Investment Service Provider Hiring Considerations. In addition to the general fiduciary considerations discussed above, below are some important factors for a fiduciary to consider when making outside investment expert hiring decisions. 1. Investment advice or investment management? A plan fiduciary seeking investment expertise can obtain essentially two levels of service. If the plan fiduciary retains the investment management duty but seeks expert advice, the investment advisor will not manage (i.e., direct the purchase, sale, etc. of) plan assets but rather simply provide advice, which the fiduciary may or may not follow in performing the separate management role. Alternatively, the fiduciary might delegate the entire investment management function out to an expert, in which case the investment manager would have actual authority to direct investment transactions. If the fiduciary delegates this function to an investment manager who (1) is an investment advisor registered under the Investment Advisors Act of 1940, a bank or an insurance company, and (2) acknowledges in writing that it is an ERISA fiduciary with respect to the plan (a socalled ERISA Section 3(38) investment manager ), the fiduciary generally will not be liable for the investment decisions of the investment manager. 29 However, the appointing fiduciary will remain responsible for the proper selection of the investment manager and for monitoring the manager s performance to determine whether its continued engagement by the plan is appropriate. One circumstance in which a fiduciary might want to hire an investment manager is if the plan has an automatic enrollment feature or otherwise has a need for a default investment option for participants who fail to give affirmative investment directions with respect to their individual accounts. Under ERISA, a fiduciary generally will not be responsible for losses that result from investment in a qualified default investment alternative (QDIA), provided the participant was first given the opportunity to direct the investment of his account and he failed to do so and certain other 27 EBSA Publication, Meeting Your Fiduciary Responsibilities, available at 28 In this regard, the DOL suggests that, when evaluating potential service providers, fiduciaries should ask each one for the same information and subject each one to the same requirements for consideration. See DOL Publication, Meeting Your Fiduciary Responsibilities, available at 29 See ERISA 3(38) (defining an investment manager) and ERISA 405(c)(2) (providing that the named fiduciary will not be liable for the acts of a designated fiduciary but will remain responsible for the selection and oversight of the designated fiduciary).
8 requirements are met. 30 A QDIA must generally be managed by either an ERISA Section 3(38) investment manager or a registered investment company (i.e., be a mutual fund). 31 Therefore, if the plan fiduciary wants to use an investment option other than a registered mutual fund as the plan s QDIA, an investment manager is generally necessary. 2. Are the services for the plan or participants? If the plan is one in which participants direct the investment of their individual accounts, the plan fiduciary may wish to make available to participants an investment expert to advise and/or manage their accounts if they so elect. Given the increasingly complex nature of retirement investing and the fact that most plan participants do not have the time or expertise (or interest, for that matter) to manage this on their own, many employers find this service to be an essential feature of their retirement programs. If this is done, the plan may be receiving two tiers of investment management and/or advice services one for the plan fiduciary and one for the participants. For many plan fiduciaries who are not themselves investment experts, retaining both levels of service will be important to ensure proper fund lineup selection and monitoring at the plan level and to offer a resource to participants who need help investing their plan accounts. Some plans will make available investment education to participants instead of investment advice or management services. Investment education is information about retirement investing in general, rather than investment recommendations that are tailored to an individual participant. Under DOL guidance, such information is not considered investment advice and therefore the provider of the education will not be considered an ERISA fiduciary based on providing that information. 32 Investment education can include tools such as asset allocation models that are generated based on information provided by the participant. Such models must be based on generally accepted investment theories and meet several other requirements, mostly aimed at making clear that the models are not directed at any particular individual (i.e., are not individualized investment advice). The DOL has made clear that the selection of a provider of investment education is a fiduciary function. Therefore, as with any other service provider, the fiduciary will be responsible for the proper selection and oversight of an investment education provider. 3. The investment advisor/manager is also an ERISA fiduciary but Whether an investment service provider is providing advice or management services, the service provider will generally be considered to be an ERISA fiduciary. The provider of advice is an ERISA fiduciary because it is providing investment advice for a fee or other compensation. The provider of management services is an ERISA fiduciary because of its authority and control over plan assets. While these service providers are fiduciaries and therefore can themselves be held liable for their breaches of fiduciary duty, it is very important to keep in mind that, under ERISA, their fiduciary status does not remove the responsibility of the fiduciary who hires them. For example, as noted above, most courts have held that a fiduciary will not be insulated from liability merely by relying on the advice of experts. 33 Therefore, relying on the investment advice of an investment expert will not 30 ERISA 404(c)(5). 31 See DOL Reg c-5. Alternatively, the QDIA can be managed by the employer or the plan s named fiduciary. However, for reasons previously discussed, this is often not a viable option. 33 See, e.g., Donovan v. Cunningham et al., 716 F2d 1455 (5th Cir. 1983).
9 necessarily relieve the fiduciary of potential liability even though the investment expert providing the advice is also a fiduciary. The only way that a fiduciary can relieve itself of potential liability for plan investment decisions is to hire an ERISA Section 3(38) investment manager as described above. While using outside investment expertise in any form makes liability less likely by helping the fiduciary make better decisions, and the investment expert can also be held liable for its own actions, it is important to understand the limits of the hiring fiduciary s protection from liability when it hires investment experts. 4. Investment diversification considerations. When selecting an investment provider, it may be important to consider whether the provider s product offerings can allow the plan s investment portfolio to be adequately diversified. This generally is more of a concern for plans in which participants direct the investment of their individual accounts. These plans often want to be able to work with a single provider to offer the plan s investment options. Therefore, the fiduciary should ensure that the provider offers access to a fund lineup that will allow a participant to diversify his or her account sufficiently to avoid large investment losses. In addition, many plan fiduciaries will want to take advantage of the fiduciary liability safe harbor found in ERISA Section 404(c). ERISA Section 404(c) generally provides that the plan fiduciary will not be liable for losses resulting from individual participant investment decisions so long as the participant can choose from among a broad range of investment options and certain other requirements are met. 34 A fiduciary who wants to use this fiduciary safe harbor will want to make sure that the investment provider s product offering includes a sufficiently broad range of investment options. In general, this means that the product offering must: (1) have at least three investment alternatives, (2) each with unique risk and return characteristics that (3) in the aggregate allow the participant to create a personally appropriate investment portfolio that (4) minimizes risk through diversification. 35 Non-Investment Plan Management and Administration As previously noted, ERISA fiduciaries include individuals or entities who exercise discretionary authority over plan management and administration. Noninvestment- related plan management and administration includes functions such as: maintaining a written plan document, maintaining the plan s funding vehicle via a trust or insurance contract, recordkeeping of plan financial activity, Form 5500 reporting to the DOL, providing certain information to plan participants (e.g., summary plan descriptions, benefit statements, etc.), and maintaining operational compliance with applicable legal requirements (e.g., plan coverage and nondiscrimination requirements, minimum distribution requirements, etc.). Hiring Outside Service Providers. Some of these activities (e.g., recordkeeping, preparing Form 5500, coverage, and nondiscrimination testing) do not involve the exercise of discretion or authority and thus are not necessarily in themselves fiduciary functions. However, determining who will perform these activities and ensuring that they are done properly are 34 DOL Reg c-1(b)(1). 35 DOL Reg c-1(b)(3).
10 fiduciary functions subject to ERISA s fiduciary standards. 36 Many of these activities require specialized professional expertise, systems, or other physical capabilities that plan fiduciaries don t have. In some cases, the plan fiduciary might be able to perform the activity but does not have the time or it is simply more costeffective to outsource it. In these cases, fiduciaries must obtain service providers to assist them with these functions. In hiring providers to perform these services, the duties of loyalty and prudence apply in the same manner as when hiring investment service providers. Thus, for example, the duty of loyalty would generally prohibit the hiring of a firm that the fiduciary has an ownership interest in, such that the fiduciary gains a personal financial benefit from the service relationship. Likewise, the duty of prudence involves the same procedural prudence considerations discussed above when selecting and monitoring noninvestment service providers. Non-Investment Service Provider Hiring Considerations. Some examples of important plan administration activities that often require the assistance of an outside service provider are below, along with a discussion of some of the specific considerations that should be given in the hiring of service providers to perform these activities. 1. Plan Document Preparation. ERISA requires that a plan be established and maintained pursuant to a written instrument. 37 This means not only establishing the written document at the inception of the plan, but also reviewing it and updating it periodically to ensure continued compliance with applicable law and consistency with plan operations. 38 Because retirement plans are subject to so many legal requirements and these requirements are always changing, maintaining the plan document requires substantial legal and technical expertise. For this reason, many employers hire attorneys or consultants to help them draft and maintain their plan documents. In addition, many service providers have developed standardized prototype plan documents that individual employers can adopt for a relatively nominal charge, thereby avoiding the expense of writing an individually designed plan document. The service provider sponsoring the standardized document, then, generally has the responsibility to update the document for changes in the law. Some important factors to consider in retaining a document preparer include the following: Should an attorney/consultant or the sponsor of a prototype document be used? If the plan has unusual or complex terms, it may not be possible to use a prototype document. In that case, it may make sense to retain an attorney or other expert to draft an individually designed document even though this will generally cost more than using a prototype document. On the other hand, if the plan has simple and/or commonly used terms, the less expensive prototype option may make more sense. If an attorney is used, the fiduciary should ensure that he or she is licensed to practice law and is expert in the necessary areas of the law (e.g., ERISA and the relevant tax-qualification rules of the Internal Revenue Code). 36 See DOL Publication, Meeting Your Fiduciary Responsibilities, available at html. 37 ERISA 402(a)(1). Initial establishment of the plan document may not be a fiduciary/plan administration function. However, keeping the document updated and current often is the responsibility of the plan fiduciary. 38 In addition to the duties of loyalty and prudence and the duty to diversify, ERISA requires fiduciaries to comply with the terms of the written plan documents, but only to the extent that the documents are consistent with the requirements of ERISA. ERISA 404(a)(1)(D). Thus, it is important to keep the document compliant with applicable law and plan operations so that the ERISA fiduciary can meet this requirement.
11 If a prototype document is used, the fiduciary should ensure that it has a current favorable opinion letter from the IRS and that the document provider commits to keeping that letter current by updating the document for future changes in the law. Often the person providing document services will also prepare certain required participant disclosure documents that are based on the plan terms, such as the summary plan description. The same considerations for determining whether a service provider is qualified to provide document services should be applied here. If a prototype document provider is used, it may make sense to ask to see a sample of these disclosure documents. As part of the plan fiduciary s ongoing monitoring and oversight duties, all documents should be reviewed for accuracy. 2. The Form 5500 Audit. An ERISA-covered plan is required to file an annual report on Form 5500 with the DOL that includes detailed information about the plan and its operation. If the plan is a large plan (generally a plan with at least 100 participants), the plan is required to file audited financial statements with the Form 5500 each year. The audit must be performed by a licensed independent qualified public accountant. Some important considerations when retaining an auditor include the following: 39 ERISA requires that the auditor be licensed or certified as a public accountant by a state regulatory authority. The fiduciary must therefore ensure that the auditor has a current license/certification. ERISA requires that the auditor be independent. This means that the auditor should not have any financial interest in the plan or the plan sponsor that would affect its ability to render an unbiased opinion about the financial condition of the plan. The auditor should have experience in auditing employee benefit plans in particular. Employee benefit plan audits require the auditor to consider factors that are unique to employee benefit plans (that might not be required for audits generally). Examples of factors that auditors need to consider are (1) the timeliness of plan contributions, (2) whether benefit payments are made in accordance with plan terms, (3) whether there are any issues that might affect the plan s qualified status, and (4) whether there are any potential prohibited transactions. The need for specialized experience with employee benefit plan audits may justify any extra cost that may be incurred in retaining an auditor with this experience. 3. Recordkeeping. The administration of a defined contribution plan such as a 401(k) plan requires the separate accounting of financial activity in individual participant accounts. 40 In today s plan administration environment, this requires the allocation and crediting of contributions and earnings, the processing of distributions and other transactions, and the reconciliation of these transactions all on a daily basis. Most employers and other fiduciaries do not have the physical or systems capability to perform these functions. Some important considerations when retaining a recordkeeper include the following: Can the recordkeeper track individual account financial activity on a daily basis? So-called daily valuation is not a legal requirement, but it is now generally what 39 DOL Publication, Selecting An Auditor For Your Employee Benefit Plan available at 40 In the case of a defined benefit plan, the participant s accrued benefit payable at retirement is tracked instead of an individual account. The tracking of individual accounts or accrued benefits is necessary, for example, for the dissemination of required participant benefit statements and the proper distribution of participant benefits when participants become entitled to payment. It s also necessary to perform various compliance functions, such as keeping contributions/benefits within maximum limits, top-heavy testing, and nondiscrimination testing.
12 plan sponsors and participants expect. Will the recordkeeper also perform certain compliance tests necessary for the operation of a retirement plan and will it assist with the preparation of the Form 5500? Many compliance tests required to maintain a plan s tax-favored status, such as topheavy testing, nondiscrimination testing, and testing for compliance with contribution limits, rely on the financial activity tracking functions of the recordkeeper. These tests, as well as the valuation and reconciliation of plan assets and financial activity are also necessary for the completion of the Form Therefore, the record-keeper will often perform these functions as part of its recordkeeping services. If the recordkeeper will perform these services, the plan fiduciary must evaluate the recordkeeper s qualifications in these areas. Will the recordkeeper assist with participant enrollment in the plan? Section 401(k) plans and plans that provide for participant investment direction generally require participants to be able to actively enroll in the plan by making a salary deferral election and/or directing the investment of their accounts among the available investment options. Since employers are generally not equipped to perform this function, it is usually important that the recordkeeper or some other service provider be able to do this. Will the recordkeeper assist with the administrative requirements for plan distributions? Distributions from tax-qualified retirement plans must generally be preceded by a notice to the receiving participant informing him or her of the applicable distribution and rollover options and the tax consequences of these options. In addition, some plans require special notices to be provided to participants who are married at the time of distribution. Once distribution occurs, it is required to be reported to the participant and the Internal Revenue Service on a Form 1099R. If the recordkeeper will perform or facilitate these functions, the fiduciary will need to evaluate the recordkeeper s or other service provider s qualifications and capabilities with respect to these functions. Conclusion Administration of an ERISA-covered plan is an extremely complex endeavor that must be performed by fiduciaries in accordance with one of the highest standards of care existing in the law. 41 But with the right process and the help of qualified service providers, even fiduciaries with the most limited time and little or no plan administration expertise should be able to meet ERISA s exacting requirements. 41 Edmonds v. Hughes Aircraft Co., 145 F 3d 1324 (4th Cir. 1998).
14 Not a deposit Not FDIC-insured Not insured by any federal government agency Not guaranteed by any bank or savings association May go down in value 2010 Lincoln National Corporation Lincoln Financial Distributors, Inc., a broker/dealer, is the wholesale distribution organization of Lincoln Financial Group. Lincoln Financial Group is the marketing name for Lincoln National Corporation and its affiliates. LCN EM-GEN EM-FID-WPR001_Z01 XXX 3/10 Z01 Order code: EM-FID-WPR001
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