Employer Fiduciary Responsibilities

ERISA & RETIREMENT PLANS

Unfortunately, many employers are not fully aware of the responsibilities shouldered under the Employee Retirement and Income Securities Act (ERISA), landmark employee benefit legislation originally passed in 1974 and subsequently amended by regulation.

ERISA was enacted to protect the interests of participants in employee benefit plans from abuses and discriminatory practices that evolved throughout the 1950’s and 1960’s. The magnitude and complexity of ERISA has led to a widespread lack of understanding of its basic principles and a commensurate lack of understanding of the liabilities under it. Moreover, a high level of apathy has developed among fiduciaries who seek comfort in claiming they are “covered” by strictly worded plan documents.

Employers need to be aware of responsibilities they have as fiduciaries and the penalties that could be imposed for non-compliance with ERISA. This document provides a framework that allows employers to develop a system of compliance, properly fulfilling their fiduciary obligations with implementation and maintenance of the ERISA standards.


INTRODUCTION TO ERISA

Anyone who is a trustee, sponsor or otherwise exercises any authority or control over any type of employee benefit plan is a “fiduciary.” A fiduciary who does not act according to the precepts of ERISA is not only subjected to personal liability but could subject a plan to loss of its tax-free status.

Standard employee plans include profit sharing, pension and 401(k)s. However, any plan maintained for employees is covered by ERISA, including stock bonus plans, insurance plans (life, health and disability) and even vacation and scholarship funds.


BASIC PRINCIPLES OF ERISA

ERISA outlines five broad areas that set the standards of fiduciary conduct in administering a plan. In essence, anyone who exercises any authority over management, administration, disposition of assets or renders advice will be held as a fiduciary that includes specific standards of responsibility.

· Responsibility of fiduciaries

The fiduciary’s duties must be discharged solely in the interest of plan participants and their beneficiaries.


· Transaction restrictions

Reasonable expenses may be paid if the fiduciary’s duties are discharged for the exclusive purpose of providing benefits to participants and their beneficiaries. Transactions for the benefit of any other entity are prohibited.


· Investment objectives

The benefit plan must be formalized in writing and must have written investment objectives. Fiduciaries must discharge their duties according to these plan documents and may rely on professional assistance to meet this obligation.


· Standard of competence

The Prudent Expert Rule defines the standard of competence to which a fiduciary will be held responsible with respect to plan investment decisions. ERISA states that a fiduciary must discharge duties “with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character with like aims.”

In other words, fiduciaries can be held to the same level of skill as that of a professional money manager in making investment decisions. It is important to remember that pension dollars belong to employees and beneficiaries, not the sponsoring company. Hence, ERISA holds fiduciaries to as high an investment standard as possible - that of a professional expert.


· Diversification

A fiduciary must diversify the investments of a plan to minimize the risk of large losses unless it is clearly not prudent to do so. It is also important to diversify among many types of investments, not just individual stock or bond issues.


FIDUCIARY RESPONSIBILITY

The scope of fiduciary responsibility is much wider than generally recognized, mainly because the definition of “fiduciary” is very broad. To be thought of as a fiduciary, there must be an element of authority or control over the plan, including plan management, administration or disposition of assets. To the extent that investment representatives, consultants and/or advisors influence or maintain discretionary authority over plan management or investments, they are also fiduciaries.

“Named” fiduciaries are those listed in the plan documents as having responsibility for plan management. Obviously, the trustees, plan officers and plan directors fall under this definition, but so do the individuals delegated duties by the named fiduciaries. Other persons or firms, such as corporate officers, directors and shareholders and advisors, also may exert enough control to be deemed fiduciaries.

Investment advisors and investment representatives are fiduciaries if they provide advice on the value and advisability of owning investments and have the discretionary authority to purchase or sell investments with plan assets. It is important to note that if trustees or named fiduciaries properly select and appoint a qualified money manager, they will NOT have a co-fiduciary responsibility for acts and omissions of the advisor, unless they knowingly participate or try to conceal any such acts or omissions.

It is extremely important for all plan fiduciaries to understand the graveness of their responsibilities and the potential penalties. Fiduciaries can be held personally liable for breach of violation of these responsibilities, even to the extent of having to restore lost profits to the plan.


THE WRITTEN PLAN AND INVESTMENT OBJECTIVES

All employee benefit plans must establish and maintain a plan in writing. This is the only way a fiduciary can meet obligations and legally defend future actions. When the objectives and purposes of the plan are specified, it provides standards against which the fiduciary’s conduct will be judged.

The Investment Policy Statement is the foundation upon which investment goals, manager evaluation and monitoring will be based. It must be clear and specific enough to be a working document. Broad-based generalities will not serve as investment objectives. Being specific is the key to providing a proper working investment plan. “Long-term appreciation” is a nebulous goal. A better standard would be “average growth of inflation plus 6% over three years.” Qualitative aspects also are important; therefore, at a minimum, the following items should be covered when designing an investment policy statement:

· Nominal return benchmarks (the “real” rate of return)
· Definition of “risk”
· Risk tolerance
· Time period for review and evaluation
· Allowable investments and quality standards
· Liquidity requirements
· Policy asset allocation
· Procedure for selecting and dismissing money managers
· Cash flow of the plan (both in and out)
· Company finances that affect contributions

The plan document does not have to be overly complex as long as the objectives are specific enough to meet plan needs and goals. Some very comprehensive Investment Policy Statements have been contained within three pages. Written objectives are as integral a part to a three-person pension plan as they are to massive plans such as General Motors. Fiduciaries in both cases will be held to standards defined by ERISA as well as by plan documents.


DIVERSIFICATION OF PLAN ASSETS

It is an investment axiom that diversification is the key to reaching long-term goals, yet this area is one often violated by pension plans. Many benefit plans have too many eggs in one basket in an effort to seek maximum return or perhaps because of plain apathy on the part of the fiduciary. While ERISA does not specify recommended percentages among asset classes, diversification is one of the most prudent actions a fiduciary can take to protect the long-term health of the plan. The following should be considered when evaluating diversification of the plan’s portfolio:

· The amount of plan assets
· Type of investments (stock, bonds, real estate, etc.)
· Projected portfolio returns vs. funding objectives
· Volatility of investment returns
· Liquidity and future cash flows
· Maturity dates and retiree pension distributions
· Economic conditions that would affect the company
· Economic conditions affecting the plan investments
· Company and industry conditions
· Geographic distribution of assets

There is not a specific minimum or maximum for each asset class. ERISA states that a fiduciary should not invest an unreasonably large part of the funding in any one investment type. Interestingly, ERISA explicitly states a plan invested solely in bank CD’s meets the diversification requirements.

A corollary to this is whether the fiduciary has considered enough comparable investments to ensure that the best alternative was chosen for the plan. This may involve a formal search for a money manager or a schedule of bond maturities at various dates and/or qualities that correspond to future benefit payments. The fiduciary should be confident that enough alternatives have been reviewed to make the most suitable choice for the plan given inflation, comparable yields, risk vs. return, etc.

Choosing a local money manager just for convenience will not suffice. A broader menu of choices that fit the plan’s goals should be reviewed and a rationale given for choosing (or not choosing) certain investments.


AN EVALUATION OF RISK VS. RETURN

The concept of risk vs. return is pervasive in the investment business, and nowhere is it weighed more heavily than in the management of employee benefit plans. Specifically, the fiduciary must “minimize the risk of large losses, unless it is clearly not prudent to do so.” This would be a rare phenomenon indeed, and the Department of Labor has yet to review a case where it was not prudent to minimize losses.

This responsibility applies to the entire portfolio, not every single investment. Thus, one stock that turns out to be disastrous should not present a problem. The key is whether the risk of the individual investment and its impact on the total portfolio are appropriate for the plan and its objectives.

ERISA specifies four criteria to use in evaluating the risk and return characteristics of investment alternatives:

1. In terms of liquidity, diversification, return and safety, the individual investment should be appropriate to the total portfolio.

2. Once the asset class is selected (stock, bond, etc.), the fiduciary is required to find the prevailing rate of return of that market given the appropriate levels of risk. In other words, the choice must be made in the context of overall risks; and the investment choice should represent the “fair” return, not necessarily the “highest.”

3. A fiduciary faced with investments of equal risk should not choose the one with the lower returns if a higher return is available.

4. In order to evaluate alternatives, some objective standards must be set forth against which to measure them. This is a two-step process. First, the funding and investment policies must be determined and put in writing. Second, the most suitable investments or qualified investment manager must be selected.


THE INVESTMENT PROFESSIONAL

It is obvious from the foregoing discussion that the typical fiduciary will be unable to meet many of ERISA’s requirements without professional assistance. The Prudent Expert Rule alone is a sobering mandate, but the writing of investment objectives and funds monitoring are also key areas where the investment representative can provide invaluable input.

ERISA encourages fiduciaries to use financial professionals, especially money managers. The Department of Labor agrees that most fiduciaries do not possess the necessary skills to discharge their duties adequately. Therefore, working with a consultant and money manager is often the only prudent course of action.

While the fiduciary has the exclusive authority to manage plan assets, that authority can be delegated to a professional if the plan provides so in writing. Moreover, only a named fiduciary can delegate responsibility for management of plan assets.

The delegation of plan asset management provides two specific benefits to the plan and fiduciary. First, it fulfills the obligation under the Prudent Expert Rule. Second, the trustee is not liable as a co-fiduciary for any acts or omissions of the investment manager.

However, the fiduciary (trustee) must maintain an oversight obligation; therefore, adequate monitoring, evaluating and reporting procedures must be in place to fulfill this responsibility. The fiduciary should recognize that suitable money managers:

1. Must be registered with the SEC under the Investment Adviser Act of 1940 (unless exempt, as would be most banks and insurance companies).

2. Must acknowledge their fiduciary status in writing. Any professional providing advice must do so pursuant to a written agreement and an oral (preferably written) understanding of the plan.

A local financial services firm may qualify as a money manager. However, in some cases the local representative may be appropriate to handle liaison and assist with selection of a money manager who would work with the local representative.

Moreover, the financial consultant must be well prepared to provide service in three areas of money manager selection:

· Research

Hopefully, the investment representative will have access to a variety of firms and will evaluate historical performance, philosophies and other information of firms with different areas of expertise (small-cap, international, balanced, etc.). Even more desirable is a stable list of managers that the investment representative knows well so that the evaluation process does not degenerate into a “horse race,” choosing merely among the top five-year returns. Qualitative knowledge should be well developed because that provides a true understanding of how a manager works and could carry the greatest weight in determining whether the plan-manager relationship is amiable or contentious.


· Selection

Far too often customers are drawn to the manager with the highest performance figures, thereby overlooking many important qualitative issues. Manager selection should be based on more comprehensive criteria such as risk vs. return, total years of investment experience vs. dollars under management, staff size, level of communication, etc. A “score card” listing these traits may help introduce more objectivity into the process and make it easier for your customers to understand the difference.


· Monitoring

An effective monitoring process should be in place before selection is made. Monitoring criteria should be consistent with plan investment objectives, while allowing enough flexibility so the manager can practice their specialty. Five years would be a preferable amount of time to prove themselves. This can seem “too long” to many customers, but it underlines the importance of the selection process. It is imperative that the customer understands and feels comfortable with the advisor’s philosophy; otherwise, the customer will never have the patience to allow the manager’s discipline to produce the desired results.

Markets move at different rates and are driven by different themes (e.g., value vs. growth). An investment advisor’s greatest value may be in not letting the customer’s myopia or impatience cloud the expectations that were agreed upon in the beginning.


MONITORING AND EVALUATION

It is with monitoring and evaluation that an investment representative/consultant adds greatest value for clients. While most fiduciaries might not have difficulty deriving the plan’s cash-on-cash return, they are usually unqualified to pass judgment on such returns relative to other plans or managers and whether the return continues to be fair in light of the risk parameters.

It is critical to bear in mind that the fiduciary’s responsibilities are ongoing, and liability exists even when professionals (e.g., money managers) are hired, should they subsequently breach their fiduciary duties or fail to meet plan goals. In other words, delegation alone will not protect a fiduciary; a system of delegation and oversight will. The following minimum standards should be considered when designing a monitoring process:

1. What are the benchmarks or indices against which the manager will be judged?

2. Time frame and frequency of review

3. Real vs. nominal return

4. Return benchmarks vs. risk benchmarks (what if the manager’s returns are sub-par but risk elements are superior?)

5. Manager performance relative to peers

6. Degree of personal attention desired

7. Qualitative aspects such as change of philosophy or personnel turnover (sometimes these fundamental changes can be positive improvements)

The process of monitoring should mirror the plan’s funding and investment objectives. It is senseless to set a benchmark of the S&P 500 Index + 2% when the investment objective specifies 50% minimum equity exposure. This would compare a fully invested stock portfolio with a constrained balanced portfolio. The investment advisor can help ensure internal consistency within total plan management.

Plan fiduciaries must be prepared to look into the past to evaluate the current state of management. Most managers need at least three years, preferably five years, to prove themselves. Investment advisors should be able to point this out objectively.

Objectivity of purpose and service is essential to develop longer-term relationships necessary to succeed as an investment representative. Thus, being able to evaluate past performance, service and plan policies is as important as the ability to facilitate future changes.


LIABILITIES AND PENALTIES

Any fiduciary that breaches ERISA’s fiduciary obligation can be held personally liable for losses caused by the breach of duty. As discussed earlier, the definition of a fiduciary is broad; and the responsibilities are not mitigated by simply delegating fiduciary duties.

Moreover, fiduciaries may be personally liable if they know or should have known of a breach by another fiduciary. Pleading ignorance, bad communications or inexperience will not be adequate legal defenses. Delegation to prudent experts and oversight of them are the only defenses upon which a fiduciary can rely.

Penalties may be imposed for up to six years after the fiduciary violation or three years after the party bringing suit had knowledge of the breach. A willful violation carries personal criminal penalties of up to $5,000 ($100,000 for corporations) and up to one year in prison.

Civil actions can be initiated by plan participants, beneficiaries, other fiduciaries and the Department of Labor. Losses to the plan as well as profits made from the improper use of plan assets must be restored. Failure to disclose information to plan participants can result in a daily penalty of $100. The Department of Labor can also remove the fiduciary and take control over plan assets.

Bonding of the fiduciary is recommended to provide some protection against plan losses resulting from dishonest or negligent activities.


CORPORATE GOVERNANCE AND PROXY VOTING

Corporate governance covers proxy voting, shareholder rights and the role the plan takes as “part owner” of a public corporation. The major issue in management is the voting of stock held by the plan that can sometimes be rife with conflicts of interest. The best way to eliminate conflicts is to ensure that the fiduciary with voting responsibility is totally independent of the plan sponsor.

Fiduciaries have a legal obligation to evaluate carefully all sides of governance issues that affect the value of plan assets and shareholder rights. Stock should be voted in the best interest of plan participants, and a system of voting oversight and policies is the best way to ensure compliance with ERISA.


PROHIBITED TRANSACTIONS

ERISA’s prohibited transaction rules state that a fiduciary may not deal with plan assets in his own interest or act in a manner adversely affecting plan participants. Note that this includes transactions with money managers and service providers. Examples of prohibited transactions between the plan and parties-in-interest include:

· Sale, lease or exchange of property
· Lending of money
· Transferring or use of any plan assets
· Acquiring assets used by the employer
(In excess of 10% of plan assets including real estate)
· Self-dealing by fiduciary
· Personal compensation paid to any fiduciary by party-in-interest

Many institutions offer “bundled services” to employee benefit plans such as custodial services, asset management and plan administration. Bundled services do not constitute a prohibited transaction if the plan is paying “necessary and reasonable” costs for such services.

However, the advantages of each separate service must be evident when compared to unbundled alternatives in the marketplace.

The most common area where a conflict may arise is the directed brokerage and soft dollar payments. While not in and of itself a violation, directed brokerage concerns revolve around two issues:

1. Is the brokerage cost reasonable in light of the services provided?

2. Has the manager fulfilled his fiduciary obligation to obtain the best execution for the transaction?

Best execution is not necessarily the lowest price but must be considered along with the quality of execution. The ability of a firm to execute transactions where others may be unable should be part of the evaluation of total costs of execution.


SUMMARY

The protection of employee benefit plan participants under ERISA is forthright, but the Department of Labor has realized that rules without compliance are rendered meaningless. Additionally, the Pension Benefit Guarantee Corporation (PBGC) is running a significant deficit. This government agency, analogous to the Federal Savings and Loan Insurance Corporation (FSLIC), can no longer be supported by taxpayer dollars. Pressure is being increasingly applied on private pensions to meet ERISA’s rules in order to minimize the U.S. government’s liability in this area.

Increasing surveillance and audits of small and medium-sized plans are inevitable since it has been estimated that approximately 80% of small plans (under $3 million) are currently in violation of ERISA regulations. The role of the investment advisor will emerge in the near future, and an extensive understanding of ERISA is going to be key to long-term success in this area.


HOW TO AVOID PERSONAL PENSION LIABILITY

If you have any function with an employee benefit retirement, profit sharing, 401(k), saving, health or other type of plan, you probably are a FIDUCIARY as dictated by the Pension Reform Act of 1974 (ERISA). Being a fiduciary means that you can be personally liable for wrongful acts, knowing or unknowing, direct or indirect, that happen to the Plan upon which you are a fiduciary.

Do not take this liability lightly: court records show many cases where a fiduciary became personally liable, perhaps for acts for which the fiduciary was unaware or in areas he or she did not know were within the scope of responsibility.

Not knowing these responsibilities is no defense, and the cost of legal defense will probably be a personal expense - not be paid by either the Plan or the company. However, this liability can be relatively easy to avoid by following the prudent steps outlined below. There are five general standards of conduct set down by ERISA. A fiduciary’s duty with respect to the plan must be discharged:

1. Solely in the interest of participants, beneficiaries and the test is the individual plan participant, not the employee, union member or potential borrower. The fiduciary’s duties must be carried out solely to provide secure retirement income for all individual plan participants. Plan participants have a right to monitor the activities of the fiduciary and the investments. The fiduciary has a duty of full disclosure that means more than just telling them the cost of the plan.

2. For exclusive purpose of providing benefits to participants and their beneficiaries and defraying reasonable administrative expenses. Transactions for benefit of trustee, party-in-interest or other fiduciaries are prohibited transactions.

3. Must be discharged in accordance with plan documents and instruments governing the plan. The plan must be in writing and should contain written investment objectives. The beneficiaries are dependent on proper determination of the fund’s investment objectives consistent with exclusive purpose and solely in interest tests. Further, the trustees have the right to rely on professionals to assist them, and the trustees have the right to pay them fair compensation.

4. Fiduciary’s duties must be discharged “with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.”

This is the Prudent Expert rule. With respect to investments, the actions of a fiduciary require the competence of an experienced person such as a professional investment manager.

5. A fiduciary must diversify the investments of a plan to minimize the risk of large losses unless under the circumstances, it is clearly prudent not to do so.


BANK INVESTMENTS

ERISA requires that bank investment alternatives be analyzed according to four criteria. Investment alternatives must be analyzed to determine:

1. Is it an appropriate investment in terms of its liquidity, diversification, return, security and other relevant economic factors in terms of the total portfolio?

2. Once the asset class of the investment is determined, the fiduciary is obligated to seek the prevailing rate of return in a particular market consistent with the specific determined appropriate level of risk.

3. A prudent fiduciary, while investing other people’s money when faced with alternative investments that involve equal degrees of risk, does not accept a lower rate of return when a higher one prevails.

4. Therefore, finally, there must be an objective standard for measuring the prudence of the investments judged solely based on their economic value to the plan.


PLAN MONITORING

The Department of Labor says that monitoring the prudence of the investment is a two-step process:

1. Funding and investment policies have to be determined and set down in written investment objectives.

2. The right managers to do the investing must be found.

The Department of Labor strongly urges fiduciary/trustee plans to improve the odds of providing better results by selecting managers; but, they maintain, there is no single “best” process for manager selection. Equally as devastating as personal liability is the fact that imprudent investments can cause a plan to lose its tax-exempt status. To summarize, ERISA requires:

1. That plans have written investment objectives.

2. That selection of investment alternatives is made with the care and standards of a prudent expert.

3. That risk/return appropriateness of investments be weighed and measured with regard to appropriateness of the plan.

4. That economic, industrial and market considerations dictate asset allocation.

5. That investment manager selection is made with the same prudent expert standards.

6. That continual reporting and evaluation be available to the plan participants.


THE KEY TO AVOIDING PERSONAL PENSION LIABILITY

A fiduciary who delegates responsibility for management and control of plan assets to any person other than an investment manager as defined by ERISA remains liable for that person’s acts and omissions. However, if done properly, much of the fiduciary’s liability can be avoided if a professional investment manager is appointed. Depending on the authority granted to the advisor, the plan trustees may share the responsibility for plan asset investment.

If a proper investment manager is prudently selected in accordance with a written investment policy and then is prudently monitored, the trustees will not have any liability for investment decisions if the management and control of plan assets has been properly delegated. The trustee is not liable as a co-fiduciary for any acts or omissions of the investment manager.

A trustee of a plan whose assets are directed by an investment manager will not be responsible for the manager’s investment choices unless the trustee knowingly takes parts or conceals a breach of fiduciary responsibility by the manager. Further, the trustee will retain “oversight” responsibility for the acts of the manager and must have a reporting, monitoring and evaluation procedure in place.


THREE SIMPLE STEPS TO AVOID LIABILITY

1. Use a qualified professional consultant to help you select a suitable investment.

2. See that all plan documents, especially investment objectives and guidelines, are set out in writing.

3. Employ a qualified money manager and monitor the results with information provided to you by your consultant.