Five Steps to Mitigate Your Fiduciary's Risk

Transcription

1 Company Stock in Your 401(k)? Five Steps to Mitigate Your Risk By: Samuel Henson, JD There is no way around it, offering company stock in your 401(k) brings increased risk. You open the door to significant audit risk from the United States Department of Labor (DOL) who, after the collapse of Enron, scrutinizes 401(k) plans heavily invested in company stock. In addition, the post-enron retirement world has seen hundreds of participant lawsuits relating to company stock, most of which fall into situations where the company: Artificially inflated company stock prices due to the Misled participants through deceptive company company s failure to disclose adverse information to communications. plan participants. Should have appointed an independent fiduciary Failed to prevent employees from purchasing because they had conflicted interests. company stock when the company had information indicating they should do so. 7

2 In spite of these risks, employers and employees can both recognize a great deal of benefit from the addition of company stock in their 401(k) s investment portfolio. Employees receive tax and reduced fee benefits of investing through a qualified plan, and employers benefit from the capital generated as well as the deductibility of employer stock contributions. However, the only benefit that matters when deciding to offer company stock, is the benefit of providing a secure retirement for participants. Your decision to offer company stock is governed by ERISA s requirements of: Having undivided loyalty to participants. Essentially you must act solely in the interests of the plan and its participants for the exclusive purpose of serving plan-related goals and cannot consider the goals of the company in the decision to offer the company stock. Acting in a prudent manner. Exercise the care, skill, prudence and diligence of how a knowledgeable fiduciary would have acted under similar circumstances. Here you must consider all of the issues that would be thought significant when making the decision to offer the company stock. Ensuring the plan is diversified. ERISA expressly states the duty of diversification, and the duty of prudence to the extent it would otherwise require diversification from company stock. Following the terms of the plan s documents. Step 1 Design the Plan to Reduce Your Liability If you have made the decision to offer company stock, designing the plan with specific provisions can greatly reduce your liability. First, you should express clearly in the plan documents what the objectives are in offering company stock and make sure provisions pertaining to company stock are consistent across the plan document, the summary plan description, the trust document, the investment policy statement and any participant communications. In addition, you should consider how the company stock investment will be funded. Will it be employee or employer contributions or both? Many plans contain a provision mandating that employer contributions must be made or invested in company stock, which prevents a participant from being able to immediately diversify. This can be significant if participants are being forced into poorly performing company stock. One design option is to shorten (or remove altogether) the timing of a participant s ability to change or move away from company stock to other options. These restrictions have been a source of litigation where companies have declined to the point of insolvency and the plan s rules required continued investment in company stock. To address these cases, the Pension Protection Act of 8

3 2006 (PPA) granted participants the right to diversify their own contributions out of employer stock at any time, while restricting diversification of employer contributions to participants reaching three years of service. At a minimum you must ensure your plan is in compliance with the PPA, but should consider more liberal restrictions. Finally, one of the best design strategies is to discourage participants from overinvesting in the company stock. By imposing restrictions on the amount of company stock that can be held in a plan (for instance 30 percent of a participant s account), you can essentially force diversification and reduce the risk of significant loss if the company stock declines. Step 2 Establish a Good Decision-Making Process The decision to offer company stock is itself a major fiduciary risk. Your fiduciary obligations require you to follow the terms of the plan. By specifying your fiduciary decision making process in the terms of the plan, you create your own fiduciary rule book by which you will be measured. If the plan mandates the inclusion of company stock as an investment option, simply saying you were required to offer the stock will not get you off the hook. If the company stock was inappropriate for the plan because the stock was in a precipitous decline or you were aware of the company s impending collapse, you cannot hide under the plan documents. It is not a fiduciary defense to say that you were only following the plan s terms if things go wrong, but if the terms of the plan specify a sound process, and you adhere to that process, the burden of showing you acted prudently is greatly reduced. Specifically, you need to build the decision to offer company stock into the plan. All participants, fiduciaries, and the plan sponsor should be very clear on how the fiduciary decision to offer company stock occurs. The process begins with determining who is best able to make the decision and then putting the structure in writing via a committee charter, fiduciary acknowledgement, and investment policy statement. By following the process strictly, you can minimize the chance that someone without the authority makes a fiduciary decision, thus, greatly reducing the risk of liability for people making unauthorized fiduciary decisions. Step 3 Separate the Decision From the Company Now that you have a process, you need to appoint the individual decision makers. One of the biggest risk mitigation steps is to spread fiduciary roles to different people. Much of the company stock litigation involves conflicted fiduciaries who made fiduciary decisions while being heavily influenced by the company s interests. Investment in company stock has tremendous benefits to the employer, but none of these benefits can be considered if a fiduciary is acting for the exclusive purpose of the plan and its participants. 9

4 One effective strategy is the appointment of a totally independent fiduciary who will evaluate the company stock, monitor its continued performance and make recommendations to the plan s trustee. The most significant drawback to the appointment of an independent fiduciary is the loss of control and influence over the decision, but this is also the greatest benefit. Independent fiduciaries generally operate under a presumption that the company stock should continue to be offered, and will only change that presumption if there is evidence that the company s financial condition is in clear doubt or collapse is imminent. The independent fiduciary is not conflicted and can make determinations solely on behalf of the participants. The independent fiduciary will perform the diligence, direct the trustee to take appropriate action and thus remove almost all of the liability from the plan sponsor. As with any appointed fiduciary, the plan sponsor always retains liability for the selection and monitoring of the independent fiduciary. Many plans find the cost of an independent fiduciary to be prohibitive, they can be expensive. If an independent fiduciary is not an option, at a minimum, the plan sponsor should consider a dedicated company stock committee of qualified company officials whose only fiduciary role is to evaluate the company stock and provide the recommendation to the trustee. Whatever approach is selected, the need is clear; in order to mitigate your liability, the more involvement of senior officials who have nonpublic financial knowledge, the greater the risk. As a result, consider eliminating the involvement of these individuals in the plan s fiduciary structure or limiting their involvement with the decision to offer company stock. Step 4 Monitoring Company Stock Your plan includes investment options besides company stock, thus you already have a process in place for reviewing the performance and continued prudence of the plan s options. If you choose not to appoint an independent fiduciary, the investment committee will retain the decision making authority as the other investments. The investment committee should review the company stock at the same time using the same evaluation criteria. If the plan has an investment policy statement, it should address the criteria for the company stock as well. In most cases, company stock may be more volatile in performance than a normal investment benchmark because employer stock is a single security. As a result, the investment review must determine if there is evidence indicating a need to stop offering the company stock fund. The investment committee would need to clearly document their consideration of all public information available to the committee at the time of the investment review, and should pay particular attention to: Sudden drops in stock price. Announcements of adverse events affecting the company. 10

5 Recommendations of investment analysts. Decisions made by independent institutional managers regarding the company stock. Evidence about whether corporate insiders are buying or selling the stock. Step 5 Review Participant Communications Any communications to participants must be carefully scrutinized to prevent any misrepresentations about company stock or the company s financial outlook. Companies that overstate the benefits of company stock and fail to advise participants of the risk of not diversifying out of the company stock fund can find themselves in trouble. The company should clearly communicate in either the summary plan description or in a stand alone communication the risks of investing in company stock. The communication should encourage participants to consult professional advisors regarding their allocations and the importance of diversification. Simply relying on the plan s 404(c) language is not enough; there should be dedicated plan provisions dealing with the company stock. Nothing will completely insulate you from the fiduciary risks company stock presents, aside from not offering company stock. There are however, relatively simple and effective strategies you can take to greatly reduce the risk. At the end of the day, none of these steps are effective if you do not carefully document the fiduciary decision making process surrounding company stock and make sure to follow the terms of your plan. For more information please contact your Lockton Retirement Services team. SAMUEL HENSON, J.D. Senior ERISA Counsel Lockton Retirement Services shenson@lockton.com 11