| Denali FM: In-depth analysis and discussion of current fiduciary issues |
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| Managing ERISA Risk - A Series |
| Risk Management in 401k Plans The concept of risk management is often not applied to the management of defined contribution plans. That is unfortunate for plan participants and plan fiduciaries alike. Plan participants lose because the failure of Plan fiduciaries to consider and apply risk management principles will negatively impact investment returns over time. Plan fiduciaries lose because without documentation showing that they considered the application of risk management principles they will have failed to live up to the standard of care implied by ERISA’s Prudent Man rule. That failure generates personal liability for plan fiduciaries and for those members of the Board of Directors who serve as appointing fiduciaries. The Fiduciary’s Risk Management Dilemma – This isn’t a part-time job. Too many 401(k) plan fiduciaries believe that their plan management functions are relatively static. This view is naïve and illustrates a fundamental flaw in understanding the responsibility of an ERISA fiduciary. The very language of ERISA’s Prudent Man Rule stipulates that fiduciary conduct is to be evaluated in the context of “the circumstances then prevailing”. In general, courts have broadly interpreted this language to mean that an ERISA fiduciary’s conduct has to reflect what a Prudent Expert would do in the particular set of circumstances that prevailed at the time a fiduciary chose the course of action. This Prudent Expert standard of care implies, and the courts have upheld, that fiduciary conduct will not strictly be judged with 20/20 hindsight. How poorly the investment results turn out may stimulate an inquiry into fiduciary management, but poor results alone will not stimulate a breach of duty judgment. Under the current framework of the law, a fiduciary will be judged on the basis of applying prudent processes to plan management and documenting those activities. Many retirement plan fiduciaries have not digested the implications of this standard of care. If it is the failure to use and document the use of prudent processes in plan management that creates liability for plan fiduciaries, then what constitutes prudent processes? Basically the standard of care required implies that the fiduciary should either know the principles involved in the institutional investment management of long-term Trust assets OR should hire an expert who does. Therefore, if you have no training in the arena of institutional investment management and you are a fiduciary, your belief that something is prudent doesn’t mean that you have met the standard required by the law. The key elements of care required are exercising prudent processes and having knowledge. ERISA is one area of law in which ignorance is not only no excuse, it actually creates the personal liability fiduciaries want to avoid. Managing Risk in a Changed Investment Environment As a fiduciary, you are expected to know what a Prudent Expert would know as prevailing investment conditions change. In the past couple of years, investment conditions have dramatically changed. We have moved from a decreasing interest rate environment to widespread expectations of an increasing interest rate environment. We have moved from a strong US currency and low cost of working capital to a weak currency and a higher cost of capital. What implications do these changes hold for your management of the 401(k) plan? If you have not considered these questions, your plan management processes are rightfully suspect for their lack of prudence. The failure to apply risk management principles to the management of a defined contribution (DC) plan is very much a breach of fiduciary duty as it would be if the same conduct applied to a defined benefit (DB) plan. There is no allowance for 401(k) fiduciaries to manage a plan using lower fiduciary standards than fiduciaries of defined benefit plans. There is no safe harbor in ERISA for not paying attention to your statutory duties. There is no recognition that if you and your colleagues are well meaning people, you will be shielded from personal liability. As the scrutiny of retirement plan management increases, you cannot expect federal courts to be sympathetic to your sense of being well-meaning while your conduct illustrated a lack of responsible oversight to the standard required by law. Make a mistake on managing a DB plan and the financial liability for the mistake falls to the shoulders of the Plan Sponsor. Make a mistake on managing a DC plan and your plan participants will experience the consequences. Whether their unhappiness results in a class action lawsuit or condemnation of a corporate culture in which management failed to exercise its fiduciary duties, the company and plan participants both lose. Once such an unraveling of the company culture takes place, it is a long time before the esprit de corps of your human capital recovers. When your human capital gets discouraged and dispirited your shareholders lose as well. After all, it is your human capital that deals with customers and generates the business that creates values for shareholders. Risk Management Involves Awareness and Tough Questions. As a practical matter, few Plan Sponsors have personnel on staff who are skilled and experienced in the institutional investment management of long-term Trust assets. Few have risk management personnel experienced at questioning the assumptions built into various plan management practices. Because internal risk management resources aren’t readily available, many plan fiduciaries seek to acquire information and advice regarding plan management issues from external sources. However, most of those external sources do not have a fiduciary duty to the plan participants. This is the foundation for much dysfunctional Plan Sponsor behavior. The advice Plan Sponsors are offered from most external resources often reflects various influences that do not honor a fiduciary perspective in whole or in part. Whether it is a vendor who counsels a Plan Sponsor for the purpose of promoting its own interests, an ERISA attorney whose advice is based on defending corporate behavior or an “independent” consultant who wants to secure or protect other non-plan consulting engagements, external resources have intentions that are in conflict with core ERISA fiduciary principles. A structure of plan management which makes use of such advice and such advisors makes the task of fulfilling an ERISA fiduciary duty more difficult. Each of these scenarios is a common impediment to instituting a best fiduciary practices standard of care. Indeed, they are not just common; they are prolific. They will remain in place until a governance process is adopted which shines a bright light on to the business relationship the various parties-in-interest who touch the plan have to the Plan Sponsor or the plan. Risk Management 101: Self-Interest and Self-Assessment. The fundamental risk management function a 401(k) fiduciary must fulfill is to determine the self-interest of all parties who provide services to the plan. That self-interest may be economic but not necessarily so. Everyone who works in the retirement plan industry has self-interest in working with a retirement plan. That statement is neither a surprise nor a reason for concern. We all have an interest in maintaining our jobs, our careers our companies, our reputations and our cash flow. However, when that self-interest has not been identified, the fiduciary can not make an assessment of it. The fiduciary cannot fulfill his or her duty to determine that the vendor’s business relationship with the plan has not done harm to the plan participant’s best interests. Without assessing the impact of vendor self-interest on the plan your role as guardian and your duty of loyalty to the Trust beneficiaries will not have been honored. How many of your vendors acknowledge their fiduciary status to the Plan? Have you ever examined that issue? Is there even an agreement between the plan’s fiduciaries and the various plan vendors as to what generates fiduciary status? Have you ever examined that issue? There are three interesting consequences and implications to consider from such close examination of vendor self-interest. One of these consequences is evident when one applies principles from the field of emotional intelligence to the activity. More on this topic in the next article. For the purposes of this article, there are two implications that are important to note. First, if you are not working with any vendor who claims fiduciary status, then who, if anyone, represents the best interests of the plan participants? Given that Plan Sponsor personnel are conflicted by their duty of loyalty to the company as well as their duty of loyalty to the Trust participants, who in the plan management process is unconflicted with the plan participants? Indeed, is there anyone who speaks with a single voice on behalf of plan participants? Secondly, by disclaiming fiduciary status to your Plan, an investment vendor in effect declares their belief that they are legally entitled to represent their self-interest first and foremost when doing business with the Plan. Note that their belief system is not relevant to the issue of whether they have liability for any element of their conduct. Liability is not an issue for you or them to determine. If and when you are ever engaged in litigation a judge will decide who is liable for their actions (or lack of action as the case may be). This distinction is so important it is worth repeating. The declaration of a vendor’s non-fiduciary status is tantamount to telling you that they are allowed to embed their self-interest into their products and services and that it is up to you to figure out what that self interest is, whether it is tolerable, whether it is reasonable and whether it does harm to the plan participants. Risk Management 102: Identification and Control of Conflicted Voices Many Plan Sponsors use their vendors to get advice regarding plan management. They typically don’t have to pay for such advice and therefore it is often the first (and sometimes the last) phone call made. While the vendor may have the knowledge of a Prudent Expert, if that vendor is not a fiduciary and is conflicted by their self-interest in the delivery of their products or services, whose interests will their advice champion? Unless you have implemented a process to identify your vendor’s self-interest, you cannot begin to determine how that self-interest impacts the framing of the information you receive. Given that they know more about their business than you do, vendors can and do “spin” investment information in such a way as to cast it in the most favorable light possible. That light is engineered to direct you down a path they want you to walk. That spin can and often does interfere with your commitment to serve the best interests of your plan participants. Here is an example that illustrates the point about vendor self-interest. For many years bundled 401(k) vendors have received push back from customers regarding vendor flexibility in offering an open investment architecture. Whereas they once offered customers only their own funds, in the last 10 years the marketplace has demanded more flexibility. Plan Sponsors and plan participants wanted choice. From that demand record keeping off-set subsidy payments were born. These subsidies skewed the recommendations made by vendors who collected significant marketing dollars for serving as distributors of investment funds created by other money managers. Some of this demand for open investment architecture has recently been muted by the marketing prowess of bundled vendors who are now hard at work selling “lifestyle” funds to their 401(k) customers. Lifestyle funds typically come in a series that represent a mix of equities and fixed income allocations which are rebalanced each year into a slightly larger fixed income allocation. The funds in the series differ in their initial allocations based on the number of years left until the participant expects to retire. The funds are marketed to Plan Sponsors on the basis that the automatic nature of the asset allocation shift makes portfolio management easier on plan participants. They promote the theory that anything which makes portfolio management easier for plan participants is a good thing. Though we do not disagree with the general premise, “lifestyle” funds have certain fundamental flaws. Anyone involved in the institutional investment management industry knows and understands that as of Q1 of 2005, the expected rate of return from investing in a domestic intermediate fixed-income portfolio over the coming five years is zero. The rising interest rate environment is expected to impact an intermediate fixed income portfolio such that the total return over the next five year period is expected to be nothing. This estimate is based on forecasting models that result from the use of standard tools in the institutional investment management business. This estimate has substantial credibility among a multitude of Prudent Experts. Given that “lifestyle” funds, promoted by bundled vendors generally include an intermediate domestic fixed income component, and given that Prudent Experts expect that portion of the portfolio to produce high volatility but no total return for the coming five year period of time - what is the basis on which a fiduciary would adopt such a series of funds? Further, on what basis would such funds be used as a plan’s default options? Query: If the fixed income component of the “lifestyle” funds were a stable value fund that earned 450-500 basis points (net) each year, wouldn’t that make more sense for plan participants? Why didn’t your vendor offer you that? Less risk – more reward. From a fiduciary perspective, there is nothing wrong with that picture. Would you be surprised to find out that your vendor earned more from fixed income management than from stable value fund management? |
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