Mitigating fiduciary liability for defined contribution plan investment decisions Vanguard commentary June 2013 Executive summary. In recent years, several high-profile class-action lawsuits have alleged that plan fiduciaries violated their fiduciary duty to prudently select and monitor the investment options offered in their retirement plans. 1 Because employers want to avoid litigation, which could result in personal liability for investment committee members, many plan sponsors are seeking ways to manage the risks associated with serving as an ERISA fiduciary, and, specifically, ways to help mitigate the risks that arise from selecting and monitoring their plan s investment lineup. Author Vanguard Strategic Retirement Consulting Fiduciary investment risk mitigation strategies range from taking a do-ityourself approach to hiring an independent investment management fiduciary to choose and monitor the plan s investments without input from the plan sponsor. While it is common to hire an investment manager for defined benefit pension plans, only recently have defined contribution (DC) plan sponsors considered this approach. 1 For the purposes of this paper, the terms plan sponsor and plan fiduciary are used interchangeably. Connect with Vanguard > vanguard.com
All decisions related to selecting and monitoring plan investments are fiduciary acts, generally subject to ERISA s fiduciary duties. Such acts include the decision to hire a consultant, an investment advisor, or an investment manager, or the decision to oversee the plan investments without the assistance of such professionals. Plan sponsors should carefully consider the advantages and drawbacks of each approach to managing plan investments. While plan sponsors and participants can benefit from a third-party investment professional s expertise and perspective, plan sponsors must understand which fiduciary responsibilities they retain when they hire an outside consultant or advisor. This commentary discusses the different approaches DC plan sponsors can take to avoid or limit potential fiduciary breach claims relating to the investment options they offer in their plans. 2
The role of a fiduciary ERISA fiduciary defined Under ERISA, a person is considered a plan fiduciary if he or she exercises discretionary authority or control over the management of the plan, exercises authority or control over the plan s assets, renders or has the authority to render investment advice for a fee or other compensation, or has any discretionary authority or discretionary responsibility in plan administration. Fiduciary status depends not only on a person s title, but also on a person s actions, regardless of title. This functional definition also looks at who exercises control and discretion rather than just who is officially named a fiduciary or formally acknowledges fiduciary status. But a fiduciary s liability can be limited to certain activities they control. For example, courts would not typically hold an investment advisor or investment manager liable for a fiduciary breach committed by an unrelated investment advisor or manager (unless he or she had knowledge of the breach and failed to take corrective action). Basic ERISA fiduciary duties ERISA fiduciaries have important duties, including acting for the exclusive purpose of providing benefits to participants, defraying reasonable expenses of administering the plan, and diversifying investments to avoid large losses. The task of determining appropriate plan investments commonly falls to the plan s investment committee members, who act as fiduciaries when they select and monitor plan investments. If a third-party fiduciary is hired to oversee or select investments, the hiring decision carries with it fiduciary responsibility to prudently select and monitor that service provider. Differing approaches along a spectrum Because courts may hold plan fiduciaries personally liable for breaches that cause plan losses, plan sponsors should take action to limit their liability. Plan fiduciaries have developed different approaches to fulfilling their responsibilities, reflecting varying levels of investment expertise and comfort in their decision-making ability. Do-it-yourself For many committees, adhering to a well-defined, deliberative, documented process should be an acceptable and manageable approach to risk mitigation. Many plan sponsors use optimal investment design tactics that include a qualified default investment alternative (QDIA) in a tiered investment lineup. The advantages of an index-tiered investment structure include diversification at a low cost and ease of monitoring index investments against their benchmarks. For more information on the benefits of using a tiered approach, see Building blocks of a well-balanced portfolio. 2 Designing the plan and its investment lineup to comply with ERISA Section 404(c) can also mitigate risk. Fiduciaries of a 404(c)-compliant plan face no liability for investment losses incurred by participants that solely result from a participant or beneficiary exercising control over the assets in their account, provided the available investment options are prudent and certain other regulatory requirements are satisfied. Many plan sponsors are comfortable fulfilling their fiduciary responsibilities on their own by holding regular committee meetings, adhering to a wellcrafted investment policy statement, engaging in a deliberative process, and carefully documenting decisions. Vanguard provides guidance to plan sponsors in its print-only publication Best practices for plan fiduciaries. While a do-it-yourself approach can be an effective strategy, committees and plan sponsors should understand that under this approach, there generally are no outside parties with whom to share fiduciary responsibility. Plan sponsors should ensure that they have committee members with sufficient investment knowledge and expertise to make sound and defensible decisions consistent with ERISA s prudent expert standard. If certain members lack the appropriate qualifications, then those individuals should pursue relevant knowledge through training and education programs. 2 Vanguard, May 2010. 3
Ultimately, committees need to demonstrate a disciplined process that details the committee s operation and articulates the goals and objectives for the plan assets. They should also include a process for evaluating manager and fund performance. For more on Vanguard s view on investment committees, see: Investment committees Vanguard s view of best practices. 3 Purchasing fiduciary liability insurance In addition to the prudent approaches already described, plan sponsors can further limit personal financial exposure by purchasing fiduciary liability insurance. Claims commonly covered under a fiduciary liability insurance policy include breach of fiduciary duty, negligence in connection with the administration of the plan, defense costs, settlements, and judgments. These policies do not cover claims of discrimination, fraud, illegal profiting from the plan, and acts before the effective date of the policy. Even with these limitations, it is still a best practice for plan sponsors to purchase this type of protection. Nonetheless, the devil is in the details and terms of the policy need to be carefully reviewed before purchase. Securing fiduciary warranties Some investment providers offer a form of fiduciary warranty or guarantee to plan sponsors. Generally, these products provide some protection against plan losses and litigation costs resulting from or related to a plan s investment offerings. However, these warranties depend on their terms and the warrantor s ability to pay, so some may not offer much protection. For example, some warranties provide that the warrantor is not a fiduciary to the plan. This means the plan sponsor is still responsible for the selection and ongoing monitoring of the plan s investments. Before relying on a warranty, plan fiduciaries should consult with ERISA counsel to identify clearly what protections are actually being offered and the circumstances under which those protections will be provided. Hiring third-party assistance Some plan fiduciaries may decide to hire a third-party investment professional to assist with investment decisions. These third parties include consultants, investment advisors, and investment managers, and each type assumes a different level of fiduciary liability. Regardless of which investment professional is chosen, the investment committee must consider the following as they make their hiring decision: The acts of hiring and monitoring outside experts are fiduciary decisions. The fees paid with plan assets to protect the plan sponsor from liability for the investment selection and monitoring process must be reasonable. The investment professional should not have any potential conflicts of interest that could influence his or her investment recommendations. All decisions related to hiring, monitoring, and, if necessary, replacing the investment professional must be documented. Hiring a consultant Plan fiduciaries sometimes hire a nonfiduciary consultant to help evaluate plan investments. Consultants are independent experts with a broad view of the markets who can bring industry experience to the committee. They can help with investment lineups, service provider searches, and plan design considerations. Consistent with having a prudent fiduciary process, plan committees must follow a deliberative process and document their discussions regarding the consultant s recommendations. 3 Vanguard, 2010. 4
Hiring a consultant helps to mitigate risk because it demonstrates plan sponsors have taken that extra step to contribute to a deliberative process. However, because consultants generally do not have discretionary authority and are not plan fiduciaries, the plan committee retains full fiduciary responsibility for all decisions made even though they employ the consultant for guidance. While sponsors retain the right to follow or disregard the consultant s suggestions, the intentional or inadvertent failure to follow the consultant s recommendations may create additional risk for the sponsor. The consultant s service agreement outlines the extent of the consultant s role and the limits of their liability. Hiring an investment advisor under ERISA section 3(21) Some plan sponsors prefer, or have the negotiating leverage to insist, that the hired consultant serve as a plan fiduciary. In such a case, the consultant acknowledges fiduciary status as an investment advisor as defined in ERISA section 3(21). Under that section, an investment advisor renders investment advice regarding plan assets (or has the authority or responsibility to do so) for a fee or other direct or indirect compensation. 4 Like the nonfiduciary consultant, the investment advisor is an independent expert with industry experience and training to assist with establishing the plan s investment lineup. While this option can be costly, the investment advisor is liable for the investment advice he or she provides. Note, however, that the advisor does not exercise discretion over the investment of the plan s assets; rather, the plan sponsor or investment committee retains the ultimate decision-making power over plan assets. Since the plan sponsor retains discretion, the plan sponsor is not relieved of fiduciary liability for selecting and monitoring the plan s investment options. With this shared responsibility arrangement, a committee might take comfort in knowing that the investment advisor has a fiduciary responsibility to deliver prudent advice consistent with ERISA s fiduciary standards, because the investment advisor shares liability for fiduciary breaches. For some committees, this benefit might outweigh the extra cost of hiring someone who is more than a nonfiduciary consultant. Hiring an investment manager under ERISA section 3(38) Plan sponsors may attempt to further limit their fiduciary investment responsibilities by turning complete control of their investment lineup over to an investment manager, as defined by section 3(38) of ERISA. An investment manager is a hired fiduciary who has the power to manage, acquire, or dispose of any plan asset. Only a registered investment advisor, a bank, or an insurance company qualified to perform services under the laws of more than one state can serve as an investment manager. In addition, the investment manager must acknowledge in writing that they are a fiduciary to the plan. The investment manager becomes the sole decisionmaker for investment selection and monitoring. In other words, the plan sponsor generally has no say in matters concerning plan investments. Input from the plan sponsor may negate the fiduciary protection sought by the sponsor. Under this type of arrangement, the plan committee s liability is limited to selecting and monitoring the investment manager, who generally assumes fiduciary liability only for matters related to the selection and monitoring of plan investments. 4 In October 2010, the Department of Labor issued a proposed regulation that would have broadened the circumstances under which an individual would be considered a fiduciary under ERISA as a result of providing plan-related investment advice for a fee. The proposed rule would have expanded the fiduciary definition to include additional persons serving plans in various capacities that historically have not been considered fiduciary activities, such as consulting on plan investment lineups or providing appraisals for plan assets. In September 2011, the DOL withdrew the proposed regulation and announced that it would repropose the regulation at a later date. 5
While this approach offers the plan sponsor the greatest protection from claims related to poor investment selection and monitoring decisions, it is also the most expensive. In addition, these types of arrangements typically offer the least flexibility. For example, many investment managers will not accept fiduciary responsibility for a brokerage option in the plan s investment lineup, an option included in about 12% of plans. 5 It is important to note that hiring an investment manager does not completely absolve plan sponsors of their fiduciary liability. Most reputable investment managers will readily acknowledge this. For example, the plan sponsor is still responsible for prudently selecting and monitoring the investment manager. In addition, plan sponsors are still responsible for ensuring that fees paid by the plan are reasonable. In recent years, participants alleging that fees paid by their plan were unreasonable have sued several large plan sponsors. A number of these high-profile, excessivefee, class-action lawsuits resulted in multimilliondollar settlements. For more information on the reasonableness requirement, see Determining reasonableness of retirement plan fees. 6 The plan committee also retains sole responsibility for ensuring that the plan is administered in accordance with the terms of the plan document, that the plan document is current with the latest laws and regulations, and that participant contributions and loan repayments are remitted to the plan in a timely fashion. Company stock Instead of giving full control of the investment lineup to a third party, some plan sponsors will hire an independent fiduciary whose only responsibility is to determine the prudence of offering company stock as a plan investment option. Offering company stock is a popular option in large plans: about 40% of Vanguard-recordkept plans with more than 5,000 participants include it in their lineup. 7 Company stock provides participants with the means to establish an ownership position in the company. However, the inclusion of company stock in a plan s investment lineup historically has been one of the greatest sources of litigation in DC plans. Generally, these so-called stock-drop cases allege that company stock was not a prudent investment because the fiduciaries knew, or should have known, about events or circumstances that adversely affected the value of the company stock and took no action to limit or remove it as an option. The risk is highest when the investment committee members are senior officers of the company. There could be a conflict between their obligation as an ERISA fiduciary to always act in the best interest of plan participants and their duties under securities laws limiting their ability to act on inside information, and requiring disclosure of any material information to all shareholders. For these reasons, some plan committees will hire an independent fiduciary to review, evaluate, and, where appropriate, remove company stock as a plan investment option. The service agreement should outline the duties and responsibilities of the independent fiduciary. Given the recent scrutiny of company stock in DC plans, the agreement should include a representation by the independent fiduciary of fiduciary status, identify limitations on plan sponsor responsibility, and explicitly state that the plan sponsor shall not attempt to influence the independent fiduciary. 5 How America Saves, 2013. 6 Vanguard, September 2011. 7 How America Saves, 2013. 6
Final thoughts Being an ERISA fiduciary carries the risk of personal liability for plan losses. During periods of market volatility and given today s legal environment, heightened scrutiny is placed on the fiduciary s approach to the selection and monitoring of the plan s investment lineup. As a result, many plan sponsors are now reexamining their investment decision-making process. While no single approach is best, and the appropriateness of any approach will depend on the facts and circumstances of each plan, all plan sponsors need to prudently deliberate and document their decisions. Regardless of whether a committee hires a consultant, an investment advisor, or an investment manager, they should review agreements periodically to determine if the fees they are paying are reasonable and commensurate with the benefit they are receiving. Committees should monitor the performance of the consultant, investment advisor, or investment manager periodically. It may be prudent to terminate the relationship for cost, underperformance, or ineffectiveness. Finally, it is important to remember the functional nature of ERISA. Even where agreements set limits and boundaries, the committee s actions may dictate fiduciary responsibility. But when used properly, a consultant, investment advisor, or investment manager can be a valuable ally in risk mitigation. Whether plan sponsors do it themselves or hire a third party, the plan sponsor s liability can be mitigated but never completely eliminated. Each plan committee must decide which approach best fits their circumstances and risk tolerance. 7
P.O. Box 2600 Valley Forge, PA 19482-2600 Connect with Vanguard > vanguard.com Vanguard research > Vanguard Center for Retirement Research Vanguard Investment Strategy Group E-mail > research@vanguard.com Vanguard Strategic Retirement Consulting (SRC) is a valuable technical resource that can help both defined contribution and defined benefit plan sponsors optimize their plan design, develop fiduciary best practices, and achieve regulatory compliance. The strategies developed by SRC consultants are grounded in expert analysis of broad-based data and are informed by Vanguard s highly respected research teams, including the Vanguard Center for Retirement Research. All investing is subject to risk, including the possible loss of the money you invest. For institutional use only. Not for distribution to retail investors. 2013 The Vanguard Group, Inc. All rights reserved. MFLDC 062013