Prudent Investing and ERISA: Fees and the Fiduciary Duty of Care

Transcription

1 y Prudent Investing and ERISA: Fees and the Fiduciary Duty of Care by Melanie L. Fein Fein Law Office Washington, DC MAY 2015

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3 1 June 2, 2015 Prudent Investing and ERISA: Fees and the Fiduciary Duty of Care by Melanie L. Fein CONTENTS I. INTRODUCTION...3 II. COST AS AN ELEMENT OF PRUDENT INVESTING...4 A. The Duty of Care...4 B. Uniform Prudent Investor Act...6 C. Uniform Trust Code...8 D. Trustee Compensation...9 E. Third-Party Expenses...12 F. Costs Associated with Mutual Fund Investing...13 III. THE DUTY OF CARE UNDER ERISA...17 A. Derived from Trust Law...17 B. Prudent Man Duty of Care...17 C. Duty With Respect to Fees...18 D. No Duty to Select Least Cost Investment...19 E. A Diversity of Fee Arrangements...20 F. Disclosure of Fees and Compensation Disclosures to Participant-Directed Plans Disclosures by Plan Service Providers DOL Fiduciary Duty Proposal...23 IV. RECENT ERISA LITIGATION...24 V. CONCLUSION...24 VI. APPENDIX SELECTED ERISA CASES...25

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5 3 I. INTRODUCTION The growth and popularity of 401(k) plans and similar retirement plans has increased the demand for investments for such plans. The financial marketplace has responded with a multiplicity of investment products and services. These products and services are offered with a variety of fee arrangements varying widely in amount and method of calculation. Information concerning investment fees and costs is widely available and has enhanced the ability of plan participants and administrators to make informed assessments as to which investment choices are best suited to a plan s needs and objectives. Disclosure of fee arrangements has helped ensure that plan participants are informed as to what fees they are paying, for what services, and to whom. Standardization of some disclosures has made cost comparisons and investment decisions seemingly easier. The increased availability of cost information, however, has led to misconceptions by some plan participants that the least cost investment alternative is the best investment and that plan fiduciaries have a duty to select only low cost investments. This view is inconsistent with well-established trust law principles and investment theory, and has been rejected by the Department of Labor ( DOL ) as a requirement of ERISA. The DOL has adopted regulations requiring ERISA fiduciaries to make detailed disclosures concerning fees and compensation in order to assist them in complying with ERISA s standard of care with respect to fees, but the DOL has not imposed a duty that fiduciaries select the least cost investment alternative. Some plan participants nevertheless have filed class action lawsuits alleging that plan fiduciaries breached their duty of care by failing to select or make available the least cost, or lower cost, investment alternatives. These lawsuits reflect a distorted view of the fiduciary duty of care to the extent they seek to make cost the operative factor in the selection of investments. This view, in its extreme form, excludes or minimizes other important considerations and could result in a narrowing of investment alternatives for plan partipants. Such a reaction to the threat of lawsuits is inconsistent with the fiduciary standard of care.

6 Prudent Investing and ERISA: Fees and the Fiduciary Duty of Care ERISA derives its fiduciary standards from trust law principles. It thus is instructive to consider the duties of an ERISA fiduciary in light of trust law, which is the result of decades of evolution based on judicial application of the law, economic analysis, academic study, and uniform codifications by the states. With this purpose, this paper addresses the treatment of investment costs including fees and compensation under the duty of care as embedded in the Uniform Prudent Investor Act and other statements and codifications of the law of trusts. This paper shows that, under well-established trust law principles, cost is only one of an array of prudent investing factors a fiduciary must consider under the fiduciary duty of care. This paper then discusses the duty of care under ERISA and shows that ERISA applies a similar duty of care. The duty of care under both trust law and ERISA rejects least cost as the governing standard. The appendix hereto describes some of the class action lawsuits that have sought to hold ERISA fiduciaries accountable for a variety of fee arrangements alleged to be excessive or otherwise inconsistent with ERISA. 1 II. COST AS AN ELEMENT OF PRUDENT INVESTING The duty of care under trust law requires a trustee to consider cost as an element of the prudent fiduciary investment process. However, nothing in the trust law duty of care requires a trustee to select the least cost investment alternative for trust accounts and placing cost above other factors would be contrary to the duty of care. A. The Duty of Care The duty to invest trust assets prudently is a core part of the fiduciary duty of care. The duty is applied in the context of an investment portfolio as a whole and includes the duty to incur only costs that are reasonable and appropriate. The duty of care also includes a duty to diversify investments. The Restatement of Trusts (Third) articulates the duty of care as follows: 1 BBecause some of these lawsuits have been settled, it is not known whether the plaintiffs or defendants would have prevailed and the precedential value of these cases in interpreting the ERISA duty of care thus is limited. This paper does not address the duty of loyalty under trust law or ERISA, or the prohibited transaction provisions of ERISA. Nor does this paper address who is a fiduciary under ERISA. The DOL has proposed a rule defining the term fiduciary. See DOL, Definition of the Term Fiduciary ; Conflict of Interest Rule Retirement Investment Advice, 80 Federal Register (April 20, 2015) ). Further, this paper does not address the duty to monitor investments as a component of the duty of prudence.

7 5 The trustee has a duty to the beneficiaries to invest and manage the funds of the trust as a prudent investor would, in light of the purposes, terms, distribution requirements, and other circumstances of the trust. (a) This standard requires the exercise of reasonable care, skill, and caution, and is to be applied to investments not in isolation but in the context of the trust portfolio as a part of an overall investment strategy, which should incorporate risk and return objectives reasonably suitable to the trust. (b) In making and implementing investment decisions, the trustee has a duty to diversify the investments of the trust unless, under the circumstances, it is prudent not to do so. (c) In addition, the trustee must: (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 This articulation of the duty of care gives a trustee flexibility to invest trust assets in investments with different degrees of risk as part of an overall investment strategy for a given trust account. This portfolio standard of care reflects the principles of modern portfolio theory which recognize a relationship between the level of risk of an investment and the amount of expected return. By applying the standard of care on a portfolio basis rather than on an investment-by investment-basis, trust law enables the trustee to structure a portfolio of trust investments with varying degrees of risk in order to achieve risk and return objectives reasonably suited to the particular trust. As pertains to cost, the portfolio standard of care necessarily assumes that varying degrees of investment cost will be incurred. Riskier investments typically have higher fees than less risky investments, with higher risk/reward ratios. The portfolio standard of care thus does not require a trustee to invest in the least cost investment available. Rather, it treats cost as one of many 2 Restatement of Trusts (Third) 90.

8 Prudent Investing and ERISA: Fees and the Fiduciary Duty of Care factors to be considered in an overall investment strategy incorporating risk and return objectives reasonably suitable to the trust. B. Uniform Prudent Investor Act The trust law duty of prudent investing is codified in the Uniform Prudent Investor Act ( UPIA ), which was approved for enactment in all the states by the National Conference of Commissioners on Uniform State Laws in Nearly all of the states have adopted the UPIA or a variation thereof. The UPIA codifies the portfolio standard of care articulated by the Restatement of Trusts (Third) based on a variety of factors, none of which include cost: (a) A trustee shall invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill, and caution. (b) A trustee s investment and management decisions respecting individual assets must be evaluated not in isolation but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust. (c) Among circumstances that a trustee shall consider in investing and managing trust assets are such of the following as are relevant to the trust or its beneficiaries: (1) general economic conditions; (2) the possible effect of inflation or deflation; (3) the expected tax consequences of investment decisions or strategies; (4) the role that each investment or course of action plays within the overall trust portfolio, which may include financial assets, interests in closely held enterprises, tangible and intangible personal property, and real property; (5) the expected total return from income and the appreciation of capital; (6) other resources of the beneficiaries; (7) needs for liquidity, regularity of income, and preservation or appreciation of capital; and (8) an asset s special relationship or special value, if any,

9 7 to the purposes of the trust or to one or more of the beneficiaries. (d) A trustee shall make a reasonable effort to verify facts relevant to the investment and management of trust assets. (e) A trustee may invest in any kind of property or type of investment consistent with the standards of this [Act]. (f) A trustee who has special skills or expertise, or is named trustee in reliance upon the trustee s representation that the trustee has special skills or expertise, has a duty to use those special skills or expertise. 3 Although cost is not a specified factor in the UPIA s principal standard of care, the UPIA does not ignore cost, but treats it separately. In accordance with the Restatement, the UPIA states that a trustee may only incur costs that are appropriate and reasonable : In investing and managing trust assets, a trustee may only incur costs that are appropriate and reasonable in relation to the assets, the purposes of the trust, and the skills of the trustee. 4 The official comment to the UPIA states: Wasting beneficiaries money is imprudent. In devising and implementing strategies for the investment and management of trust assets, trustees are obliged to minimize costs. 5 The UPIA affords a trustee wide latitude to delegate investment functions to third parties, provided the trustee exercises care, skill, and caution in doing so. 6 In this regard, the trustee also is subject to the duty to minimize costs: Costs. The duty to minimize costs that is articulated in Section 7 of this Act applies to delegation as well as to other aspects of fiduciary investing. In deciding whether to delegate, the trustee must balance the projected benefits against the likely costs. Similarly, in deciding how to delegate, the trustee must take costs into account. The trustee must be alert to protect the beneficiary from double dipping. If, for example, the trustee s regular compensation schedule presupposes that the trustee will conduct the investment management function, 3 UPIA 2. 4 UPIA 7. 5 UPIA 7 comment. 6 UPIA 9.

10 Prudent Investing and ERISA: Fees and the Fiduciary Duty of Care it should ordinarily follow that the trustee will lower its fee when delegating the investment function to an outside manager. 7 C. Uniform Trust Code The Uniform Trust Code 8 was drafted in coordination with the writing of the Restatement of Trusts (Third) and the UPIA and more broadly codifies trust law. Like the Restatement and Uniform Prudent Investor Act, the Uniform Trust Code provides that a trustee may incur only reasonable costs in administering a trust: COSTS OF ADMINISTRATION. In administering a trust, the trustee may incur only costs that are reasonable in relation to the trust property, the purposes of the trust, and the skills of the trustee. 9 This duty applies with respect to the delegation of functions to third parties in addition to the trustee s own activities on behalf of a trust: The duty not to incur unreasonable costs applies when a trustee decides whether and how to delegate to agents, as well as to other aspects of trust administration. In deciding whether and how to delegate, the trustee must be alert to balancing projected benefits against the likely costs. To protect the beneficiary against excessive costs, the trustee should also be alert to adjusting compensation for functions which the trustee has delegated to others. The obligation to incur only necessary or appropriate costs of administration has long been part of the law of trusts. 10 The Uniform Trust Code recognizes that a trustee is entitled to be reimbursed for expenses incurred in administering a trust: REIMBURSEMENT OF EXPENSES. (a) A trustee is entitled to be reimbursed out of the trust property, with interest as appropriate, for: (1) expenses that were properly incurred in the administration of the trust; and (2) to the extent necessary to prevent unjust 7 UPIA 9 comment. 8 The Code is the first national codification of the law of trusts and is intended to mitigate the fragmentation of state trust law by providing States with precise, comprehensive, and easily accessible guidance on trust law questions. The Uniform Trust Code was approved by the National Conference of Commissioners on Uniform State Laws in 2000 and recommended for enactment in all the States. It was most recently revised in Approximately 25 states have adopted the Uniform Trust Code or variations thereof as of Uniform Trust Code Id., comment.

11 9 enrichment of the trust, expenses that were not properly incurred in the administration of the trust The Uniform Trust Code does not restate the duty of care for trust investing but incorporates the Uniform Prudent Investor Act. 12 D. Trustee Compensation A significant part of the cost incurred in the administration of a trust is the trustee s own compensation. The Restatement of Trusts (Third) explicitly recognizes that a trustee is entitled to reasonable compensation for its services: (1) A trustee is entitled to reasonable compensation out of the trust estate for services as trustee, unless the terms of the trust provide otherwise or the trustee agrees to forgo compensation. 13 In determining the reasonableness of a trustee s compensation, relevant factors include the trustee s experience, skill, and facilities, local custom, the time devoted to trust duties, amount and character of the trust property, degree of difficulty and responsibility, degree of risk assumed, and the nature and costs of services rendered by others, and the quality of the trustee s performance. 14 The Restatement also recognizes that a trustee it entitled to reimbursement for expenses properly incurred in the administration of the trust: (2) A trustee is entitled to indemnity out of the trust estate for expenses properly incurred in the administration of the trust. 15 With respect to costs for services provided by others, the Restatement states that the amount of the trustee s compensation is relevant in considering whether a trust should be charged with such costs: The amount of compensation received by a trustee is relevant in determining whether certain costs of others services are reimbursable.... This is particularly so of costs of hiring advisors, agents, and others to render services expected or normally to be performed by the trustee. Conversely, even proper expenses of this type may affect what is reasonable compensation for the trustee Uniform Trust Code See Uniform Trust Code, article Restatement of Trusts (Third) 38, Trustee s Compensation and Indemnification. 14 Id., comments a and c(1). 15 Restatement of Trusts (Third) Id. comment c(1).

12 Prudent Investing and ERISA: Fees and the Fiduciary Duty of Care As an illustration of this principle, the Restatement of Trusts (Third) includes the following example: A trustee claims reimbursement for a fee paid to an investment advisor. The fee itself is reasonable. Reimbursement will ordinarily be allowed if the trustee is serving without compensation. If, however, the trustee receives normal compensation, especially a full statutory or settler-prescribed fee, reimbursement will depend on the nature and purposes of the consultation and how the advisor s employment relates to the responsibilities reasonably expected of the particular trustee or to those that are customary for trustees in the relevant community. 17 The Restatement also acknowledges that the terms of the trust agreement may govern a trustee s compensation, but may be adjusted: When the terms of a trust provide that the trustee is to receive certain compensation or no compensation, the trustee s right to compensation is ordinarily governed by that provision.... If the amount of compensation provided by the terms of the trust is or becomes unreasonably high or unreasonably low, the court may allow a smaller or larger compensation, or may allow the trustee to resign. 18 A trustee s compensation also may be increased or decreased by agreement between the trustee and beneficiaries. 19 Some state statutes prescribe formulas for determining the amount of a trustee s compensation and usually provide that trustee fees are to be based on specified percentages of principal or income and principal of the trust. 20 A trustee that acts both as trustee and as executor generally is entitled to such compensation as is reasonable in view of all the duties performed. 21 If there are two or more trustees for a trust, the reasonable compensation for multiple trustees may be higher than for a single trustee because the normal duty of each trustee to participate in all aspects of administration... can be expected not only to result in some duplication of effort but also to contribute to the quality of administration Id. 18 Id. comment e. 19 Id. comment f. 20 Id. comment c. 21 Id. comment h. 22 Id. comment i.

13 11 The Uniform Trust Code, like the Restatement, recognizes that a trustee generally is entitled to reasonable compensation under the circumstances absent terms in the trust agreement specifying trustee compensation: COMPENSATION OF TRUSTEE. (a) If the terms of a trust do not specify the trustee s compensation, a trustee is entitled to compensation that is reasonable under the circumstances. 23 Even if the trust agreement specifies the amount of trustee compensation, the Uniform Trust Code provides for adjustment by a court if the trustee s duties are substantially different from those contemplated when the trust was created or if the specified compensation is unreasonably low or high. 24 The comments to the Uniform Trust Code require close examination of the trustee s services and responsibilities in establishing the amount of compensation, and a downward adjustment of fees may be required if the trustee has delegated investment authority to outside managers: In setting compensation, the services actually performed and responsibilities assumed by the trustee should be closely examined. A downward adjustment of fees may be appropriate if a trustee has delegated significant duties to agents, such as the delegation of investment authority to outside managers. [ ] On the other hand, a trustee with special skills, such as those of a real estate agent, may be entitled to extra compensation for performing services that would ordinarily be delegated. 25 The Uniform Trust Code also addresses compensation when there is more than one trustee for a trust: Because trustee... includes not only an individual trustee but also cotrustees, each trustee, including a cotrustee, is entitled to reasonable compensation under the circumstances. The fact that a trust has more than one trustee does not mean that the trustees together are entitled to more compensation than had either acted alone. Nor does the appointment of more than one trustee mean that the trustees are eligible to receive the compensation in equal shares. The total amount of the compensation to be paid and how it will be divided depend on the totality of the circumstances. Factors to be considered include the settlor s reasons for naming more than one trustee and the 23 Uniform Trust Code Id. 25 Id. comment a (citations omitted).

14 Prudent Investing and ERISA: Fees and the Fiduciary Duty of Care level of responsibility assumed and exact services performed by each trustee. Often the fees of cotrustees will be in the aggregate higher than the fees for a single trustee because of the duty of each trustee to participate in administration and not delegate to a cotrustee duties the settlor expected the trustees to perform jointly. [ ] The trust may benefit in such cases from the enhanced quality of decision-making resulting from the collective deliberations of the trustees. 26 E. Third-Party Expenses The Restatement of Trusts (Third) recognizes that a trustee is not required to perform directly all of the investment functions for a trust: The trustee is not required personally to perform all aspects of the trust s investment activities, even if the trustee is a professional or institutional fiduciary with competence and experience in financial matters. 27 Correspondingly, the Restatement recognizes that a trustee may properly incur and pay reasonable expenses of third parties in the administration of a trust: A trustee can properly incur and pay expenses that are reasonable in amount and appropriate to the purposes and circumstances of the trust and to the experience, skills, responsibilities, and other circumstances of the trustee. 28 In this regard, the Restatement states that the trustee has an implicit duty to be cost-conscious: Implicit in a trustee s fiduciary duties is a duty to be cost-conscious. See generally 77 on the duty to act with prudence Id. comment a (citations omitted). 27 Restatement of Trusts (Third) 80 comment f(1) ( The qualities and qualifications for which trustees are properly selected for fiduciary roles, and the scope and complexity of the investment programs of some trusts, are so diverse that prescriptions for prudent behavior in the delegation of investment functions cannot be expressed in simple or precise legal rules. With professional advice as needed, the trustee personally must at least define the trust s investment objectives. In addition, the trustee must personally either formulate or approve the trust s investment strategies and programs. Admittedly, even these limited generalizations are necessarily and desirably couched in terms that are less than self-defining. In other matters, the trustee must exercise reasonable care, skill, and caution in determining what investment responsibilities to delegate. Then, fiduciary prudence must be exercised as well in selecting an agent and establishing the terms of the delegation, and also in supervising or reviewing the agent s performance and compliance with the terms of the delegation, all in a manner appropriate to the circumstances and conditions of the delegation and competence of both agent and trustee. ). 28 Restatement of Trusts (Third) Id. comment a.

15 13 In discussing what expenses are proper and reasonable, the Restatement recognizes that a trustee is not limited to incurring expenses that are necessary or essential: What expenses are proper and reasonable? A trustee is not limited to incurring expenses that are necessary or essential, but may incur expenses that, in the exercise of fiduciary judgment... are reasonable and appropriate in carrying out the purposes of the trust, serving the interests of the beneficiaries, and generally performing the functions and responsibilities of the trusteeship.... Although a trustee is expressly or impliedly authorized or required to incur a particular type of expense, the trustee has a duty to exercise such care and skill as a person of ordinary prudence would exercise in incurring the expense. 30 The Restatement explicitly recognizes that a trustee may properly incur reasonable expenses in employing lawyers, brokers, or other agents or advisors when appropriate to the sound administration of the trust. 31 However, such expenses may not be proper if the expenses are for services that duplicate those services for which the trustee is compensated and expected to perform: [A] trustee cannot properly incur expenses for another to perform functions the trustee is compensated and thus expected to perform personally. Thus, the method of fixing a trustee s compensation and the amount of that compensation, are relevant in determining whether certain costs of other s services are payable or reimbursable from the trust estate. Even proper expenses of this type, that is, expenses that are neither unreasonable nor impermissible, may affect what is appropriate compensation for a trustee under a typical reasonable compensation standard. 32 Accordingly, a trustee must consider the totality of fees and expenses in addition to its own compensation in considering what costs are appropriate and reasonable charges for its trust accounts. F. Costs Associated with Mutual Fund Investing The Restatement of Trusts (Third) recognizes that, in most of the States, statutes have been enacted allowing trustees to invest trust assets in securities of mutual funds for which the trustee or an affiliate provides services for 30 Id. comment b. 31 Id. comment c. 32 Id. (citations omitted).

16 Prudent Investing and ERISA: Fees and the Fiduciary Duty of Care compensation. 33 The Restatement notes that [t]hese statutes require the trustee to satisfy certain requirements set out in the statute concerning information the trustee must report to beneficiaries about the rate of compensation and the method by which the compensation was determined. The Restatement emphasizes that such a statute does not relieve the trustee of its normal duty to exercise prudence....nor does it dispense with the trustee s fundamental duty to act in the interest of the beneficiaries, its duty of impartiality, or the other fiduciary duties of trusteeship. In particular, the Restatement cautions: [T]he trustee cannot properly confine its investments to the proprietary mutual fund offerings if this would impair the trustee s ability to manage both uncompensated and compensated risk through proper diversification and through asset allocation appropriate to the particular trust... ; and the trustee must be sufficiently aware of overall costs associated with other mutual fund alternatives to enable the trustee to fulfill its important responsibility to be cost conscious in managing the trust s investment program.... Furthermore, the use of proprietary mutual funds for a trust s investment program must not result in the trustee receiving more than the reasonable overall compensation... appropriate to its services to the trust, taking account of the trustee s mutual fund duties and compensation. 34 The Uniform Prudent Investor Act echoes the Restatement and emphasizes the need for careful cost comparisons : The Restatement of Trusts 3d says: Concerns over compensation and other charges are not an obstacle to a reasonable course of action using mutual funds and other pooling arrangements, but they do require special attention by a trustee.... [I]t is important for trustees to make careful cost comparisons, particularly among similar products of a specific type being considered for a trust portfolio. 35 The Uniform Trust Code, in provisions concerning the duty of loyalty, articulates additional standards concerning costs incurred by a trustee when investing fiduciary assets in mutual funds: (f) An investment by a trustee in securities of an investment company or investment trust to which the trustee, or its affiliate, provides services in a capacity other than as trustee is not presumed to be affected by a conflict between personal and fiduciary interests 33 Restatement 78, comment c(8). 34 Id. 35 UPIA 7 comments.

17 15 if the investment otherwise complies with the prudent investor rule of [Article] 9. In addition to its compensation for acting as trustee, the trustee may be compensated by the investment company or investment trust for providing those services out of fees charged to the trust. If the trustee receives compensation from the investment company or investment trust for providing investment advisory or investment management services, the trustee must at least annually notify the persons entitled under Section 813 to receive a copy of the trustee s annual report of the rate and method by which that compensation was determined. 36 The comments to the Code explain that subsection (f) is intended to allow trustees to receive fees for providing mutual fund services but notes that there has been litigation challenging such fees in some cases: This exception applies even though the mutual fund company pays the financial-service institution trustee a fee for providing investment advice and other services, such as custody, transfer agent, and distribution, that would otherwise be provided by agents of the fund. Mutual funds offer several advantages for fiduciary investing. By comparison with common trust funds, mutual fund shares may be distributed in-kind when trust interests terminate, avoiding liquidation and the associated recognition of gain for tax purposes. Mutual funds commonly offer daily pricing, which gives trustees and beneficiaries better information about performance. Because mutual funds can combine fiduciary and nonfiduciary accounts, they can achieve larger size, which can enhance diversification and produce economies of scale that can lower investment costs. Mutual fund investment also has a number of potential disadvantages. It adds another layer of expense to the trust, and it causes the trustee to lose control over the nature and timing of transactions in the fund. Trustee investment in mutual funds sponsored by the trustee, its affiliate, or from which the trustee receives extra fees has given rise to litigation implicating the trustee s duty of loyalty, the duty to invest with prudence, and the right to receive only reasonable compensation. Because financial institution trustees ordinarily provide advisory services to and receive compensation from the very funds in which they invest trust assets, the contention is made that investing the assets of individual trusts in these funds is imprudent and motivated by the effort to generate additional fee income. Because the financial institution trustee often will also charge its 36 Uniform Trust Code 802(f).

18 Prudent Investing and ERISA: Fees and the Fiduciary Duty of Care regular fee for administering the trust, the contention is made that the financial institution trustee s total compensation, both direct and indirect, is excessive. Subsection (f) attempts to retain the advantages of mutual funds while at the same time making clear that such investments are subject to traditional fiduciary responsibilities. Nearly all of the States have enacted statutes authorizing trustees to invest in funds from which the trustee might derive additional compensation. Portions of subsection (f) are based on these statutes. Subsection (f) makes clear that such dual investment-fee arrangements are not automatically presumed to involve a conflict between the trustee s personal and fiduciary interests, but subsection (f) does not otherwise waive or lessen a trustee s fiduciary obligations. The trustee, in deciding whether to invest in a mutual fund, must not place its own interests ahead of those of the beneficiaries. The investment decision must also comply with the enacting jurisdiction s prudent investor rule. To obtain the protection afforded by subsection (f), the trustee must disclose at least annually to the beneficiaries entitled to receive a copy of the trustee s annual report the rate and method by which the additional compensation was determined. Furthermore, the selection of a mutual fund, and the resulting delegation of certain of the trustee s functions, may be taken into account under Section 708 in setting the trustee s regular compensation. See also Uniform Prudent Investor Act Sections 7 and 9 and Comments; Restatement (Third) of Trusts: Prudent Investor Rule Section 227 cmt. m (1992).

19 17 III. THE DUTY OF CARE UNDER ERISA A. Derived from Trust Law The fiduciary duties of an ERISA fiduciary are embedded in the statutory language of ERISA and, as the U.S. Supreme Court has recently confirmed, are derived from trust law: We have often noted that an ERISA fiduciary s duty is derived from the common law of trusts. Central States, Southeast & Southwest Areas Pension Fund v. Central Transport, Inc., 472 U. S. 559, 570 (1985). In determining the contours of an ERISA fiduciary s duty, courts often must look to the law of trusts. We are aware of no reason why the Ninth Circuit should not do so here. 37 Consistent with the court rulings, the DOL has interpreted ERISA as applying trust law standards: ERISA safeguards plan participants by imposing trust law standards of care and undivided loyalty on plan fiduciaries.one of the chief ways in which ERISA protects employee benefit plans is by requiring that plan fiduciaries comply with fundamental obligations rooted in the law of trusts. 38 B. Prudent Man Duty of Care In accordance with trust law, ERISA articulates a duty of care similar to that in the Restatement of Trusts (Third) and the Uniform Prudent Investor Act, discussed above, including a duty to incur only reasonable costs. As with the duty of care under trust law, ERISA imposes no duty on a fiduciary to select the least cost investment for 401(k) or similar retirement plan accounts. The ERISA duty of care is referred to as the prudent man standard under which an ERISA fiduciary must act solely in the interest of participants and beneficiaries and with 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 like 37 Tibble v. Edison International, 575 U.S. (May 18, 2015). See also Eddy v. Colonial Life Ins. Co., 919 F.2d 747, 750 (D.C. Cir. 1990), quoting Cent. States, Se. & Sw. Areas Pension Fund v. Cent. Transp., Inc., 472 U.S. 559, 570 (1985) ( the duties of an ERISA fiduciary are not limited by that statute s express provisions but instead include duties derived from common law trust principles. [R]ather than explicitly enumerat[e] all of the... duties [of ERISA fiduciaries], Congress invoked the common law of trusts to define the general scope of their... responsibility. ). 38 DOL, Definition of the Term Fiduciary ; Conflict of Interest Rule Retirement Investment Advice, 80 Federal Register (April 20, 2015).

20 Prudent Investing and ERISA: Fees and the Fiduciary Duty of Care character and with like aim. 39 The ERISA duty of care also requires a fiduciary to diversify plan investments so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so. 40 C. Duty With Respect to Fees The DOL has described the duty of care as requiring a plan fiduciary to understand and evaluate plan fees and expenses as part of the duty of care in the selection and monitoring of investments and investment options for ERISA plan accounts. The duty pertains to initial investments and requires monitoring on an ongoing basis: Plan fees and expenses are important considerations for all types of retirement plans. As a plan fiduciary, you have an obligation under ERISA to prudently select and monitor plan investments, investment options made available to the plan s participants and beneficiaries, and the persons providing services to your plan. Understanding and evaluating plan fees and expenses associated with plan investments, investment options, and services are an important part of a fiduciary s responsibility. This responsibility is ongoing. After careful evaluation during the initial selection, you will want to monitor plan fees and expenses to determine whether they continue to be reasonable in light of the services provided. There has been a dramatic increase in the number of investment options, as well as level and types of services, offered to and by plans in which participants have individual accounts. In determining the number of investment options and the level and type of services for your plan, it is important to understand the fees and expenses for the services you decide to offer. The cumulative effect of fees and expenses on retirement savings can be substantial. When plans allow participants to direct their investments, fiduciaries need to take steps to regularly make participants aware of their rights and responsibilities under the plan related to directing their investments. This includes providing plan and investment related information, including information about fees and expenses, that participants need to make informed decisions about the management of their individual accounts. Participants must receive 39 ERISA 404(a)(1)(B). 40 ERISA 404(a)(1)(C).

21 19 the information before they can first direct their investments in the plan and annually thereafter. 41 The DOL s description of the duty to consider fees and expenses is generally consistent with the trust law principles discussed above. 42 D. No Duty to Select Least Cost Investment As in the case of trust law, ERISA s duty of care does not require an ERISA fiduciary to select the least cost investment for plan accounts. The DOL has rejected the idea that the least cost investment is necessarily in the best interests of plan beneficiaries. An ERISA fiduciary is not required to select the least cost investment but one with fees that are reasonable. In describing the duties of an ERISA fiduciary with respect to investment fees, the DOL has recognized that fees are only one of several relevant factors in deciding on plan investments: Fees are just one of several factors fiduciaries need to consider in deciding on service providers and plan investments. When the fees for services are paid out of plan assets, fiduciaries will want to understand the fees and expenses charged and the services provided. While the law does not specify a permissible level of fees, it does require that fees charged to a plan be reasonable. After careful evaluation during the initial selection, the plan s fees and expenses should be monitored to determine whether they continue to be reasonable. 43 The DOL s articulation of a fiduciary s duty to ensure that fees charged to an ERISA plan are reasonable is consistent with the trust law fiduciary principles discussed above. The DOL expects fiduciaries, when conducting due diligence on investment service providers, to discern which services relate to which fees and to compare the services to be provided with the total cost for each provider: In comparing estimates from prospective service providers, ask which services are covered for the estimated fees and which are not. Some providers offer a number of services for one fee, sometimes referred to as a bundled services arrangement. Others charge separately for 41 DOL publication entitled Understanding Retirement Plan Fees and Expenses, undrstndgrtrmnt.html, April 8, The U.S. Supreme Court in Tibble v. Edison International, 575 U.S. (May 18, 2015), recently affirmed that ERISA imposes the trust law duty to monitor. The Court did not, however, discuss the scope of the duty but remanded the case for the lower court to determine whether the duty to monitor had been met or breached. 43 DOL publication entitled Meeting Your Fiduciary Responsibilities, fiduciaryresponsibility.html, April 8, 2015.

22 Prudent Investing and ERISA: Fees and the Fiduciary Duty of Care individual services. Compare all services to be provided with the total cost for each provider. Consider whether the estimate includes services you did not specify or want. Remember, all services have costs. 44 With respect to mutual fund fees, such as shareholder servicing or administrative fees, the DOL expects plan fiduciaries to review information concerning such fees in making investment selections: Some service providers may receive additional fees from investment vehicles, such as mutual funds, that may be offered under an employer s plan. For example, mutual funds often charge fees to pay brokers and other salespersons for promoting the fund and providing other services. There also may be sales and other related charges for investments offered by a service provider. The information provided by service providers noted above should include a description of all compensation related to the services to be provided that the service providers expect to receive directly from the plan as well as the compensation they expect to receive from other sources. 45 E. A Diversity of Fee Arrangements The DOL has recognized that the diversity of investment options and services available to plan participants has resulted in a diversity of associated fee arrangements. The DOL has emphasized to plan fiduciaries and participants the importance of understanding such arrangements in view of the substantial effect of fees and expenses on long-term investment returns: There has been a dramatic increase in the number of investment options, as well as level and types of services, offered to and by plans in which participants have individual accounts. In determining the number of investment options and the level and type of services for your plan, it is important to understand the fees and expenses for the services you decide to offer. The cumulative effect of fees and expenses on retirement savings can be substantial DOL guidance describes a variety of different types of fees and fee arrangements that plan accounts may incur including administration fees, investment fees, individual service fees, sales loads and commissions, mutual fund management fees, account maintenance fees, redemption fees, 12b-1 fees, 44 Id. 45 Id. 46 See DOL publication entitled Understanding Retirement Plan Fees and Expenses, undrstndgrtrmnt.html, visited April 8, 2015.

23 21 and various combinations of fees. 47 The DOL does not prescribe any particular amount of fees that are reasonable for a plan fiduciary to incur on behalf of a plan account but cautions plan fiduciaries to be aware of the impact of fees and expenses on investment returns. F. Disclosure of Fees and Compensation To assist ERISA fiduciaries in complying with the standard of care with respect to fees, the DOL has adopted regulations requiring detailed disclosures of fees and costs associated with plan investments. 1. Disclosures to Participant-Directed Plans With respect to participant-directed individual account plans, the DOL has adopted regulations requiring plan administrators to disclose fee and expense information to plan participants and beneficiaries of such plans. 48 The DOL s rule, adopted in 2010, is intended to ensure that all participants and beneficiaries in such plans have the information they need to make informed decisions about the management of their individual accounts and the investment of their retirement savings. The rule provides that, when a plan allocates investment responsibilities to participants or beneficiaries, the plan administrator must take steps to ensure that such participants and beneficiaries, on a regular and periodic basis, are made aware of their rights and responsibilities with respect to the investment of assets held in, or contributed to, their accounts and are provided sufficient information regarding the plan and the plan s investment options, including fee and expense information, to make informed decisions with regard to the management of their individual accounts. General plan-related information must be provided, including a list of the plan s investment options and a description of any brokerage windows or similar arrangement that enable a plan participant to select investments beyond those designated by the plan. An explanation of fees and expenses for general plan administrative services must be provided, including fees and expenses for legal, accounting and recordkeeping services. A description must be provided of any individual fees and expenses that may be charged to the account of an individual 47 DOL publication entitled Understanding Retirement Plan Fees and Expenses, undrstndgrtrmnt.html, visited April 8, See also DOL publication entitled A Look at 401(k) Plan Fees, gov/ebsa/publications/401k_employee.html, visited April 8, See 29 C.F.R a-5; 75 Federal Register (2010). The DOL acted through the Employee Benefits Security Administration ( EBSA ), which is a department of the DOL.

24 Prudent Investing and ERISA: Fees and the Fiduciary Duty of Care participant or beneficiary based on the actions taken by that person, such as for plan loans, investment advice, brokerage windows, commissions, front-or backend loads or sales charges, redemption fees, transfer fees and similar expenses. Participants must receive quarterly statements showing the dollar amount of plan-related fees and expenses, whether administrative or individual, that are actually charged to or deducted from their individual accounts, along with a description of the services for which the charge or deduction was made. In addition, investment-related disclosures are required, including information about each investment option under the plan. Such information must include performance data, benchmark information, and fee and expense information. Total annual operating expenses must be provided for each investment option, which must be expressed as both a percentage of assets and as a dollar amount for each $1,000 invested, along with any shareholder-servicing fees. The disclosures must also include an explanation that, in addition to the disclosed administrative fees and expenses, some of the plan s administrative expenses may be paid from the total annual operating expenses of one or more of the plan s investment alternatives such as, for example, through revenuesharing arrangements, Rule 12b-1 fees, or subtransfer agent fees. 2. Disclosures by Plan Service Providers The DOL has interpreted ERISA to require plan fiduciaries, when selecting and monitoring service providers, to ensure that fees charged are reasonable and that service providers receive only reasonable compensation. In order to assist plan fiduciaries in this duty, the DOL s rules require covered service providers to provide fiduciaries with information to enable them to assess the reasonableness of total compensation, both direct and indirect, received by the service provider, its affiliates, and subcontractors. 49 The rules apply to service providers who expect at least $1,000 in compensation for services from a plan, including investment advisers, brokers, record keepers, custodians, accountants, and others. Indirect compensation is compensation received from any source other than the plan sponsor, the service provider, an affiliate, or subcontractor. The DOL s rules require a service provider who receives indirect compensation to also describe the arrangement by which such compensation is paid, including the source of the compensation and the services to which the compensation relates. 49 DOL Rule 408(b)(2), 29 C.F.R b-2; 75 Fed. Reg (July 17, 2010).

25 23 In addition, a service provider must describe any compensation that will be paid among the covered service provider, an affiliate, or a subcontractor, in connection with services provided if the compensation is based on a transaction basis (such as commissions, soft dollars, or finder s fees) or is charged directly against a plan s investment and reflected in the net value of the investment (such as 12b-1 fees). The description must identify the services for which such compensation will be paid and identify the payers and recipients of the compensation. If recordkeeping services are provided to a plan, the disclosures must describe all direct and indirect compensation that the service provider, an affiliate, or a subcontractor reasonably expects to receive in connection with such services. If no explicit compensation is provided for recordkeeping services, a reasonable and good faith estimate of the cost to the plan of such services must be provided, including an explanation of the methodology and assumptions used to prepare the estimate and a detailed explanation of the recordkeeping services that will be provided to the plan. The estimate must take into account the rates that the covered service provider, an affiliate, or a subcontractor would charge to, or be paid by, third parties, or the prevailing market rates charged, for similar recordkeeping services for a similar plan with a similar number of covered participants and beneficiaries. 3. DOL Fiduciary Duty Proposal The DOL recently issued a proposed rule to define who is a fiduciary under ERISA. 50 The proposed rule does not impose on fiduciaries any duty to seek the least cost investment for plan accounts but rather allows existing fee and compensation arrangements to continue, provided they are consistent with the fiduciary duty to put the client s best interest first. In issuing the proposed rule, the DOL stated: [The proposal] allows firms to continue to set their own compensation practices so long as they, among other things, commit to putting their client s best interest first and disclose any conflicts that may prevent them from doing so. Common forms of compensation, such as commissions, revenue sharing and 12b-1 fees, are permitted under this exemption, whether paid by the client or a third party such as a mutual fund. * * * * The Department is not proposing to prohibit common compensation practices, such as commissions and revenue sharing. Instead, the 50 DOL, Definition of the Term Fiduciary ; Conflict of Interest Rule Retirement Investment Advice, 80 Federal Register (April 20, 2015).