Source: http://wagnerlawgroup.com/managed-accounts-the-answer.html
Timestamp: 2017-09-26 05:37:33
Document Index: 346327280

Matched Legal Cases: ['§2550', '§2550', '§2550', '§2550', 'art 2509', '§2550']

The plunging stock market, severe market volatility, and utter devastation of many plan participants' account balances argue forcibly that it is no longer fiduciarily prudent, if ever it was, to leave the vast majority of plan participants to invest their own account balances with little or no substantive investment education or advice. A March 24, 2003 headline in Pension and Investments screams "401(k) education fails as participants time market ­employees buy equities after the market rises, they sell when the market goes down." The article concludes: "Clearlyparticipants need an easy way to let someone else make the decisions for them [it is] predicted that managed accounts, in which participants use independent firms to run their accounts, will become popular."
In the author's opinion, the proliferation of self-direction of defined contribution plans has led to a plethora of legal fiduciary issues, which are discussed below, resulting in so much potential fiduciary liability exposure that the pendulum is swinging "back to the future" of managed accounts, which brings a defined benefit investment methodology to the defined contribution world.
This article first discusses certain elements of the developments of the law concerning investment education, advice and managed accounts. It then analyzes the significant risks to the plan sponsor generally inherent in hiring money managers or entities related to money managers to provide investment advice where the money manager or affiliate receives variable profits (usually through variable investment management fees) from the investment options that are the object of the advice. The article concludes that managed accounts, if structured to comply with standards set forth in the Department of Labor's Advisory Opinion issued to SunAmerica, is the best and least risky alternative for plan sponsors and plan participants.
A. The Prohibited Transaction Issue In General.
A prohibited transaction may arise where participants are invested, in whole or in part, in mutual funds of a company to which the person providing asset allocation services is related.
An adviser who renders "investment advice" (defined below) to plan participants thereby becomes a fiduciary to the plan, which could be problematic if the advice is or could be conflicted. For example, if an investment adviser is a member of a controlled group or affiliated with a mutual fund family providing some or all of a particular plan's investment options, there could be a conflict of interest. The adviser might have a direct or indirect financial incentive to cause the plan to pay greater fees to, or make greater profits for, the fund family, adversely affecting the investment adviser's best judgment. [1] As a result, a violation of the prohibited transaction rules may occur.
The Employee Retirement Income Security Act of 1974, as amended ("ERISA") Section 3(21)(A) defines a "fiduciary" as a person with respect to a plan who (i) exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets, (ii) renders investment advice for a fee or other compensation, direct or indirect, with respect to any monies or other property of such plan, or has any authority or responsibility to do so, or (iii) has any discretionary authority or responsibility in the administration of such a plan.
Department of Labor (the "Department" or "DOL") Reg. Section 2510.3-21(c)(1) describes when a person will be deemed to be rendering investment advice. In general, a person would be considered to be rendering "investment advice" if he:
Renders advice for a fee to the participant [2] on the value of securities or other property, or makes recommendations as to the advisability of investing in, purchasing, or selling securities or other property; and
Renders the advice on a regular basis to the participant or beneficiary, under a mutual agreement, arrangement or understanding (written or otherwise, with the participant or beneficiary) which provides that: (i) the advice will serve as one of the primary bases for the participant's or beneficiary's investment decisions on plan assets, and that (ii) the adviser will render individualized advice based on the particular needs of the participant or beneficiary.
2. Prohibited Transaction Rules.
ERISA imposes various duties, standards and prohibitions upon fiduciaries of employee benefit plans. General standards of conduct are provided for plan fiduciaries in Section 404 of ERISA. In addition, there are specific rules relating to prohibited transactions, in which plan fiduciaries must not engage unless there is an available exemption. Substantial penalties apply to any breach of fiduciary responsibility or other violation of these rules by a fiduciary or party in interest.
Section 406(a) of ERISA prohibits a fiduciary with respect to an employee benefit plan from causing the plan to engage in certain prohibited transactions, including the sale or exchange of property between the plan and a party in interest (Section 406(a)(1)(A)), the furnishing of services between the plan and a party in interest (Section 406(a)(1)(C)) and the transfer to, or use by or for the benefit of, a party in interest of any assets of the plan (Section 406(a)(1)(D)). Section 406(b) of ERISA prohibits a fiduciary from dealing with the assets of a plan in his own interest or for his own account; from acting on behalf of a party whose interests are adverse to a plan in any transaction involving the plan; or from receiving consideration for his own account from a party dealing with the plan in connection with a transaction involving plan assets. [3] Section 408(b)(2) of ERISA, however, provides that "the prohibitions provided in section 406 shall not apply" to the provision of "services" (such as financial services) "necessary for the establishment or operation of the plan, if no more than reasonable compensation is paid therefor." However, the regulations at 29 C.F.R. Section 2550.408b-2(a) state that Section 408(b)(2) of ERISA provides an exemption only from Section 406(a) of ERISA and "does not contain an exemption from acts described in 406(b)."
Under example (1) of 29 C.F.R. Section 2550.408b-2(f), a nondiscretionary investment adviser may propose "to perform for additional fees portfolio evaluation services in addition to" investment management services. The investment adviser may "arrange" and then provide the additional services, if they are approved by an independent fiduciary, so long as that independent fiduciary is "prudent in his selection and retention of [the investment adviser] and other investment advisers of the plan." However, under example (2) of 29 C.F.R. Section 2550.408b-2(f), a nondiscretionary investment adviser ("C"), by recommending the purchase of an insurance contract on which C will receive a commission from the insurance company, engages in an act described in Section 406(b)(1) of ERISA (as well as Sections 406(b)(2) and (3) of ERISA), even though C has fully disclosed the reasons for the recommendation and the fact that it will receive a commission, and even though an independent fiduciary considers the recommendation and approves the transaction.
Since Section 408(b)(2) of ERISA does not exempt transactions under Section 406(b) of ERISA, if an investment advice fiduciary rendering advice with respect to affiliated funds were deemed to be a fiduciary by virtue of the advice it renders, it could be deemed to engage in a prohibited transaction because, in general, the profits or related fees it receives could vary depending upon which investment options a plan participant selects.
C. Class Exemptions. [4]
Class exemptions provide relief from the prohibited transaction restrictions for any transaction meeting the conditions of the exemption. The DOL has recognized that ERISA Sections 406(a) and (b) might prevent an investment adviser that advises mutual funds from also investing assets of the plan in shares of the funds. Thus, the prohibited transaction rules might preclude what would otherwise be beneficial arrangements for plan participants. However, the DOL is sensitive to the abuses and self dealing that may occur if appropriate safeguards are not in place in connection with investment advice.
2. PTCE 77-4 Described.
PTCE 77-4 (42 Fed. Reg. 18732 (4/8/77)) generally permits an investment adviser to an open-end investment company, who is also a fiduciary to a plan, to purchase or sell shares in the investment company on behalf of the plan if the plan pays neither a commission nor an investment management fee with respect to the plan assets invested. The fee for distribution expenses under Rule 12b-1 of the Investment Company Act is treated as a commission. [5] Thus, PTCE 77-4 does not apply to funds bearing such charges.
PTCE 77-4 permits a fiduciary to cause a plan to purchase shares of a mutual fund to which the fiduciary is the adviser, if the following conditions are satisfied:
The plan pays no sales commission.
Redemption fees, if any, are paid only to the mutual fund itself and are adequately disclosed.
The plan pays no investment management, investment advisory or similar fee with respect to plan assets invested in the shares of the mutual fund (although the mutual fund may remit its usual fees to the adviser and other service providers) or, in the alternative, if any investment management fee is paid on plan assets invested in the mutual fund, the advisory fee for the assets invested in the mutual fund and paid to the adviser is determined and credited for the benefit of the plan.
An independent fiduciary with investment authority (e.g., the plan sponsor) has received a current prospectus of the investment company and full and detailed written disclosure of the various fees.
On the basis of the prospectus and disclosures, the independent fiduciary gives approval to the purchases and sales of the investment company shares. Its approval must be set forth in either the plan documents or in an investment management agreement between the plan and the investment adviser, indicated in writing prior to each purchase or sale, or indicated in writing prior to the commencement of a specified purchase or sale program in the shares of the investment company.
The independent fiduciary is notified of any changes in any of the rates and fees in the disclosure information with respect to the advisory fees for the mutual fund, and following notification gives written approval for the continued investment of plan assets in the mutual fund.
3. Why PTCE 77-4 is Likely Inapplicable to Most Investment Advisory and Managed Account Relationships.
Although there is an argument that PTCE 77-4 provides relief from transactions involving investment advice or managed accounts, in the case of defined contribution plans with multiple participants, it is far from clear that PTCE 77-4 provides such relief for several reasons.
First, concerning investment advice, the fifth requirement of the PTCE 77-4 provides that an independent or so-called "second" fiduciary must independently evaluate and affirmatively approve the advice rendered, consistent with the fiduciary obligations imposed under Title I of ERISA. The Department has taken the position that the recipient of investment advice (e.g., the participants) cannot be independent of the person who gives the advice. [6] Thus, the fifth requirement should not be satisfied.
Second, Section 408(a) of ERISA requires, among other things, that the Department determine prior to granting a prohibited transaction exemption that the transaction is protective of the rights of, and in the interest of, participants. The administrative record of PTCE 77-4 demonstrates that no relief for the provision of investment advice was contemplated and neither was relief contemplated for managed accounts in the context of defined contribution plans with multiple participants. [7] Thus, PTCE 77-4 relief is probably unavailable for transactions involving products and services such as investment advice and managed accounts for defined contribution plans with multiple participants that did not exist in 1977, when the exemption was issued. Arguing that the provision of investment advice and managed accounts to such plans is protected under PTCE 77-4, when not specifically contemplated thereby, is to read PTCE 77-4 as a statute (which could imply an invalid delegation of power to the Executive Branch). Furthermore, in Advisory Opinion 2000-15A issued to Stephen M. Saxon (footnote 4), the Department clearly indicates that, even if the words of an exemption appear to cover a particular transaction, that transaction must have been contemplated by the Department if it is to receive exemptive relief.
Third, the regulations under Section 404(c) of ERISA provide that if the conditions of such regulations are satisfied, a plan participant is not a fiduciary with respect to his account. Since it is likely that many of the transactions under the investment advice or managed account programs will comply with Section 404(c) of ERISA, participants who direct such transactions will not be fiduciaries. Therefore, it is not certain that such participants could qualify as "second fiduciaries" for PTCE 77-4 purposes, when they are not specifically defined as such under PTCE 77-4.
Hence, for the aforementioned reasons, it involves some risk to assert that PTCE 77-4 provides relief with respect to the provision of investment advice or managed accounts.
D. Individual Exemptions.
Under ERISA Section 408(a), the DOL may grant relief from the prohibited transaction rules for particular transactions described in detail to the DOL. Factors which must be considered and found to be present by the DOL are whether the exemption is: (i) administratively feasible, (ii) in the interests of the plan and of its participants and beneficiaries, and (iii) protective of the rights of participants and beneficiaries of such plan. [8]
There have been a few Prohibited Transaction Exemptions ("PTEs") of significance in this area, including the following [9]:
Shearson Lehman Brothers (PTE 92-77).
The DOL sanctioned an investment service program whereby Shearson (and affiliates) would provide nonbinding and non-discretionary (i.e., the participants implement the advice themselves) investment advisory services to participating plans and their participants and investment management services to the mutual funds offered through a trust which is a registered mutual fund company formed by Shearson. The DOL permitted Shearson (and affiliates) to receive fees from (i) the plans for the investment advisory services rendered thereto, and (ii) the mutual fund for the investment management services provided to the different investment portfolios thereunder. The exemption requires that (i) the investment advisory services provided by Shearson to a participating plan are limited to non-discretionary recommendations; (ii) the fees received from the various mutual fund portfolios are the same regardless of the distribution of a plan's assets among the portfolios (i.e., a flat fee statement), except a lesser fee could be charged for the money market fund; [10] (iii) no plan will pay a fee or commission by reason of the acquisition or redemption of the shares of the mutual funds; and (iv) the plan sponsors are provided with full disclosure of the affiliate relationship of all the service providers and the fee structure under the program.
vThe DOL sanctioned the acquisition or redemption of units in the TCW life cycle trusts established in connection with participation in the TCW portfolio solutions program by individual account plans and the acquisition or redemption of shares in the TCW Galileo Funds, Inc. by the trusts, in addition to the provision of advice, in connection with the investment by the plans in the trusts under the program. TCW is the holding company for a group of wholly owned subsidiaries that provide a broad range of investment management services. Based on responses to questionnaires, TCW sought to render investment advice to plan participants. Each trust was to invest exclusively, but in varying proportions, in the Galileo funds. The funds' assets were to be managed by TCW Funds Management, Inc.
In general, the conditions under the exemption include:
The terms of each purchase or redemption of the units in the trusts must be at least as favorable to an investing plan as those obtainable in an arm's length transaction with an unrelated party.
Participation of a plan in the program must be expressly authorized in writing by a fiduciary of the plan who is independent of TCW.
The total fees paid to TCW and its affiliates by each plan for the provision of services in connection with its investment in the units of the trusts under the program must be reasonable. In this regard, the total amount paid by a trust to TCW or unaffiliated third persons for services necessary to operate the trusts, and for TCW to provide investment advice, must not exceed 1% per annum of the average daily "net asset value" of the shares of the funds and cash held by such trust.
No plan will pay a fee or commission by reason of the acquisition or redemption of units in the trusts or shares in the funds.
TCW will not receive any fees from the plans whose participants receive recommendations concerning investment in a trust, nor from the trusts in which the plans invest. However, TCW may receive:
fees from the funds which are paid by other investors in the funds;
reimbursements for "direct expenses" in connection with the operation of the program; or
reimbursement for direct expenses which TCW pays to unaffiliated third persons for goods and services provided to the trusts and/or plans under the program.
Any investment advice rendered to the participants by TCW under the program must be based on the responses provided by the participants to worksheet questions which are developed and designed by an independent financial expert and independent behavioral expert. The investment allocation model will also be developed by the independent financial expert. Independence for this purpose means, in general, that not more than 5% of the expert's gross income in any taxable year may be derived from TCW or its affiliates.
Any investment advice given to the participants will be implemented only at the express direction of the participant.
TCW will render investment advice limited to the trusts, a money market fund, a guaranteed investment contract or a similar investment vehicle that may or may not be affiliated with TCW. TCW will receive fees only with respect to investment recommendations for the trusts.
All transactions involving securities owned by the funds will be executed through brokers in which TCW has no interest and who are unrelated to TCW.
E. Advisory Opinion 2001-09A Issued to SunAmerica.
1. Legal Significance of An Advisory Opinion.
As an advisory opinion, Advisory Opinion 2001-09A does not have the same authority as an exemption or regulation published for comment in the Federal Register. Further, as a technical matter, it can only be relied on by the recipient and binds only the Department of Labor only if, and to the extent that, all the material facts and representations and the actual situation conform to those described in the opinion request. [12] However, advisory opinions have been cited by courts when making decisions involving other parties. Further, in the author's view, the SunAmerica Advisory Opinion is well-reasoned, and therefore it is unlikely that a court will disagree with its analysis.
The Advisory Opinion explains how, in the DOL's view, financial service providers can provide independent investment advice without running afoul of the prohibited transaction rules; therefore, financial services providers other than SunAmerica can use the Advisory Opinion to develop similar investment advisory products. This is precisely why a number of large financial institutions have announced they will follow this model. [13] It is the author's view that as advisers realize the munificent and tangible benefits of managed accounts, especially by ameliorating plan sponsor fiduciary exposure (as discussed below), other financial institutions will follow suit.
2. What the SunAmerica Opinion Letter Provides The Creation of Managed Accounts.
SunAmerica applied to the Pension & Welfare Benefits Administration ("PWBA") [14] for an exemption from the prohibited transaction rules of ERISA Section 406 so that it could provide asset allocation services to participants in ERISA plans. SunAmerica intended to offer its investment advisory program to defined contribution plans. Under the program, asset allocation services will be offered to plan participants either through the "discretionary asset allocation service" or the "recommended asset allocation service." Under the discretionary asset allocation service, a specific model asset allocation portfolio will be created automatically for a participant's account. Under the recommended asset allocation service, a specific model asset allocation portfolio will be recommended to a participant, but the participant may choose to disregard the recommendation in whole or in part and invest in a manner that does not conform to the model asset allocation portfolios.
The model asset allocation portfolios will be created using a computer program that applies an investment methodology developed and maintained by a financial expert who is independent of SunAmerica. The financial expert, using its own methodologies, will construct strategic "asset class" level portfolios using generally accepted principles of modern portfolio theory. The model asset allocation portfolio created for a particular participant, therefore, will reflect the application of the methodologies developed by the financial expert, taking into account individual participant data.
The fiduciary responsible for a plan's participation in the SunAmerica program (i.e., a fiduciary independent of SunAmerica) will receive information concerning the program and the role of the financial expert in developing the model asset allocation portfolios. The plan fiduciary will also receive, on an ongoing basis, disclosures concerning the program and any proposed increases in investment advisory or other fees.
The financial expert will be compensated by SunAmerica for its services, but the fees paid for those services cannot exceed 5% [15] of the financial expert's annual gross income, presumably and logically determined on an entity-level, not controlled group basis. Further, the fees paid to the financial expert will not be affected by investments made in accordance with any asset allocation portfolio under the program.
SunAmerica sought a prohibited transaction exemption because, by providing discretionary asset management services and investment advice to participants, it might be acting as a fiduciary with respect to the participating plans. Further, SunAmerica was concerned that implementing a model asset allocation portfolio might result in increased investment advisory fees for SunAmerica or an affiliated entity. Thus, at issue was whether SunAmerica's receipt of the fees from the asset allocation or investment advisory services provided to plan participants under the investment advisory program violated the prohibitions of ERISA Section 406.
The PWBA has stated that providing investment advice for a fee is a fiduciary act. Thus, SunAmerica would be acting as a fiduciary to both the discretionary and nondiscretionary asset allocation services and, as such, would be subject to the fiduciary responsibility provisions of ERISA, including ERISA Sections 404 and 406. To the extent it acts as a fiduciary, SunAmerica would be responsible for the prudent selection and periodic monitoring of its investment advisory services consistent with the requirements of ERISA.
As to the prohibited transaction rules of ERISA Section 406, the PWBA opined that the individual investment decisions or recommendations (and the resulting, asset allocation) provided or implemented under the program would not be the result of SunAmerica's exercise of authority, control, or responsibility for purposes of ERISA Section 406. Thus, there would be no prohibited transaction.
The PWBA based its opinion on the following:
The plan fiduciaries responsible for selecting the SunAmerica investment program would be fully informed about, and would have to approve, the program and types of services provided, including the role of the financial expert;
The investment recommendations provided to, or implemented for, participants would be the result of methodologies developed and maintained by a financial expert who is independent of SunAmerica and any of its affiliates; and
The arrangement between SunAmerica and the financial expert would preserve the financial expert's ability to independently formulate the basis of the asset allocation.
II. Investment Education v. Investment Advice and Managed Accounts
A. The Section 404(c) Regulations.
The ERISA Section 404(c) regulations set forth the conditions that plan fiduciaries must meet to be relieved of liability for the consequences of employees' investment or "control" over their account balances. There are three primary requirements. [16] First, the plan must offer a broad range of investment alternatives, including at least three diversified "core" options with each of those having different risk and return characteristics. [17] Second, employees must be allowed to transfer among these options with a frequency commensurate with the investments' market volatility, but at least as often as quarterly in the case of the core options. [18]Third, employees must have access to sufficient information about each investment option that they can make informed investment decisions.[19]
Although the regulation provides broad relief to employers, its third requirement raises the question of whether providing the necessary information constitutes "investment advice" and thereby renders the information-giver an ERISA fiduciary. The Section 404(c) regulations clearly state that they do not require the employer to provide investment advice to maintain a Section 404(c) plan. [20] Accordingly, it is clear that providing the information necessary to satisfy Section 404(c) does not necessarily make the employer a fiduciary, and DOL officials have taken great pains to reiterate this point publicly.
However, the issue is more than concern over employer liability for providing the minimum information required by Section 404(c). Some employers are concerned about the possible liability for doing more than the required minimum disclosure. Such employers want their employees to become knowledgeable investors who are equipped to ensure the adequacy of their retirement income. The issue for such employers is whether they can provide robust, individualized education that goes beyond the straightforward information requirements of Section 404(c) to employees, but not cross the line to provide investment advice. The author believes it is likely that the provision of particularized, individualized education/recommendations would, if effective, constitute the rendering of investment advice. This conclusion is supported by the following discussion of the Department's definition of investment education.
B. Investment Education Background.
With the growth of participant-directed individual account pension plans, more employees are directing the investment of their pension plan assets and thereby assuming more responsibility for ensuring the adequacy of their retirement income. [21] At the same time, there has been an increasing concern on the part of the Department, employers and others that many participants may not have a sufficient understanding of investment principles and strategies to make their own informed investment decisions. While a number of employers sponsoring participant-directed individual account pension plans have instituted programs intended to educate their employees about investment principles, financial planning and retirement, many employers have not offered programs or have offered only limited programs due to uncertainty regarding the extent to which the provision of investment-related information may be considered the rendering of "investment advice"[22] , resulting in fiduciary responsibility and potential liability in connection with participant-directed investments. Although, as discussed above, Section 404(c) of ERISA and the Department's regulations promulgated thereunder provide limited relief from liability for fiduciaries of pension plans that permit a participant or beneficiary to exercise control over the assets in his individual account, there remains a need for employers and others who provide investment information with respect to pension plan assets to know what standards apply in determining whether an education activity may give rise to fiduciary status.
The crux of the issue is thus simple: If an employer advises a participant on how to invest his pension assets, the employer may take on fiduciary responsibility for the provision of such advice, but would not have such fiduciary responsibility if the employer merely educates the employee so that the employee can make his own investment decisions. In view of the important role that investment education can play in assisting participants and beneficiaries in making informed investment and retirement-related decisions and the uncertainty surrounding the fiduciary implications of providing investment-related information to participants and beneficiaries, specifically where the line is between education and advice, the Department of Labor attempted to clarify, in Interpretive Bulletin 96-1 [23] , the application of ERISA's definition of the term "fiduciary with respect to a plan" [24]to the provision of investment-related information to participants and beneficiaries.
Interpretive Bulletin 96-1 identifies categories of information and materials regarding participant-directed individual account pension plans that do not, in the view of the Department, constitute "investment advice" under the definition of "fiduciary" in ERISA. [25] The Interpretive Bulletin points out, in effect, a series of graduated safe harbors under ERISA for plan sponsors and service providers who provide participants and beneficiaries with four increasingly specific categories of investment information and materials - plan information, general financial and investment information, asset allocation models and interactive investment materials. Thus, the goal of investment education is to provide plan participants with the tools they need to make wise decisions with their plan assets, but not to tell them what to do.
C. Investment Education Defined.
Under the Interpretive Bulletin, the furnishing of the following categories of information and material to a participant or beneficiary in a participant-directed individual account pension plan would not constitute the rendering of "investment advice" - irrespective of who provides the information (e.g., plan sponsor, fiduciary or service provider), the form in which the information or material is provided (e.g., on an individual or group basis, in writing or orally, via video or computer software), or whether an identified category is furnished alone or in combination with other identified categories.
1. Plan Information.
Information or material that informs a participant or beneficiary about the benefits of plan participation, the benefits of increasing plan contributions, the impact of pre-retirement withdrawals on retirement income, the terms of the plan, or the operation of the plan; and
Information described in the Regulations promulgated under Section 404(c) of ERISA [26] on investment alternatives under the plan, such as descriptions of investment objectives, risk and return characteristics, historical return information, and related prospectuses.
2. General Financial and Investment Information.
This material includes information informing a participant or beneficiary about:
general financial and investment concepts (e.g., risk and return, diversification, dollar cost averaging, compounded return, tax-deferred investment);
historic differences in rates of return between different asset classes (e.g., equities, bonds, cash) based on standard market indices;
estimating future retirement income needs;
determining investment time horizons; and
3. Asset Allocation Models.
This category includes information or material (e.g., pie charts, graphs, case studies) that provides a participant or beneficiary with models of asset allocation portfolios of hypothetical individuals with different time horizons and risk profiles, where:
the models are based on generally accepted investment theories that take into account the historic returns of different asset classes (e.g., equities, bonds, cash) over defined periods of time;
all material facts and assumptions on which the models are based (e.g., retirement ages, income levels, financial resources, replacement income ratios, inflation rates, rates of return) are disclosed;
to the extent that an asset allocation model identifies or matches any specific investment alternative available under the plan with a generic asset class identified in the models, all investment alternatives of that generic asset class available under the plan are similarly identified or matched; and
the asset allocation models are accompanied by a statement indicating that, in applying any particular asset allocation model to his individual situation, the participant or beneficiary should consider his other assets, income and investments (e.g., home equity, IRA investments, savings accounts) in addition to his interest in the plan.
4. Interactive Investment Materials.
This category includes questionnaires, worksheets, software, and similar materials that provide a participant or beneficiary the means to estimate future retirement income needs, and the means to assess the impact of different asset allocations on retirement income, where:
the materials are based on generally accepted investment theories that take into account the historic returns of different asset classes (e.g., equities, bonds, cash) over defined periods of time;
there is an objective correlation between the asset allocations generated by the materials and the information and data supplied by the participant or beneficiary;
all material facts and assumptions (e.g., retirement ages, income levels, financial resources, replacement income ratios, inflation rates, rates of return) that may affect a participant's or beneficiary's assessment of the different asset allocations accompany the materials or are specified by the participant or beneficiary;
to the extent that an asset allocation generated by the materials identifies any specific investment alternative available under the plan, all investment alternatives under the plan with similar risk and return characteristics are similarly identified; and
the materials are accompanied by a statement indicating that, in applying any particular asset allocation to his individual situation, the participant or beneficiary should consider his other assets, income and investments (e.g., home equity, IRA investments, savings accounts) in addition to his interest in the plan.
C. Why Investment Advice or Managed Accounts are Preferable to Investment Education.
Plan sponsors often inquire whether their fiduciary exposure would be lessened if they merely hire an entity to "educate" employees. It is the author's contention that the appropriate provision of managed accounts will lessen the fiduciary exposure of plan sponsors for the reasons described below.
1. Definition of Managed Accounts and Distinction From Investment Advice.
When a financial institution renders "investment advice" it merely is recommending to participants how they should invest; the individual himself must proactively provide information and affirmatively elect to implement the advice. This is in sharp contrast to a managed account where the financial institution acts as an investment manager, and actually invests or "manages" the participant's plan assets; the financial institution providing managed accounts might also advise as to appropriate amounts of elective deferrals, as a number of financial institutions have stated they intend to do, and manage other assets in the participant's overall portfolio, such as IRAs and other savings.
2. Selection and Monitoring of Educators, Advisors, and Managers.
The designation of a person to provide either investment educational services, investment advice or managed accounts to plan participants would be an exercise of discretionary authority or control over management of the plan. Thus, persons making the designation would have to act prudently and solely in the interest of the plan participants, both in making the designation and in continuing the designation.[27] Even if a plan sponsor were to attempt to limit his or its fiduciary exposure by providing investment education, the choice of the educator and the monitoring of said educator are, in fact, fiduciary functions. [28]As a practical matter, the liability of a plan sponsor in selecting a fiduciary where conduct is circumscribed by an exemption or advisory opinion should be no greater than the liability a plan sponsor would incur in selecting an educator. Moreover, monitoring the effectiveness of the education rendered is difficult, if not impossible, for most plan sponsors.
3. No Protections.
A plan sponsor is responsible, as a fiduciary, for the selection and oversight of the "educator" but would not have the protective conditions and explicit government review[29] supplied by a prohibited transaction exemption or advisory opinion.
4. State Law Concern.
An educator may be subject to all applicable state law [30] and not ERISA which governs fiduciaries. This may permit an "educator" with a financial interest in what fund a participant selects (such as a sponsor of a mutual fund family) to skew the "education" to lead to the selection of funds which result in higher fees and profits for the "educator" without liability for the "educator" under ERISA. However, such a scenario would enhance the possibility of liability under ERISA for the plan sponsor for either improper selection or inadequate monitoring of the educator. Monitoring would have to include a determination that the "education" does not slip over the line and become "investment advice". If the "education" turns out to be "investment advice", and the educator receives different fees depending on which investment alternative is selected by an employee, the sponsor may find itself having hired a fiduciary on behalf of the plan, rather than merely an educator. If this is the case, and the educator is affiliated with any of the funds in the plan, the fiduciary will probably have engaged in "self dealing" which is prohibited under ERISA.
Moreover, many of the different state laws to which an educator may be subject may well have different standards from ERISA; no plan sponsor will want to monitor the laws of various states. This is a potential source of tension between the interests of the plan sponsor, which is subject to ERISA, and the educator, which is subject to a different legal standard. If an educator is held liable under state law for a violation, the holding may be evidence in a federal court that a plan sponsor has not satisfied ERISA's prudence requirement in selecting and monitoring the "educator". On the other hand, if the "educator" is held not liable under state law (because of less restrictive standards) for something that would be a violation under ERISA, the plan sponsor may still be liable for the imprudent selection or monitoring of the "educator", since the looser state laws may have deprived the plan of a cause of action against the "educator".
Furthermore, persons who act as fiduciaries will not generally be subject to state law, which avoids the uncertainty of jury trials, punitive damages, consequential damages and liquidated damages, all of which can be extraordinarily high. ERISA generally requires that adversely affected parties be made whole, and illegal profits disgorged, but there is no punitive element in such correction.
Finally, the investment advice fiduciary/investment manager and the plan sponsor which generally selects and monitors such fiduciaries are subject to ERISA. Accordingly, their interests are aligned in that if the investment advice fiduciary or investment manager meets its responsibilities under ERISA, it would be very difficult to maintain that the plan sponsor breached its responsibilities under ERISA to prudently select and monitor such fiduciary.
5. Investment Education May Constitute Investment Advice.
Even if a plan sponsor believes the financial service institution is providing investment education, it may in fact be rendering investment advice, thus placing the plan sponsor, as a co-fiduciary,[31] in the worst of all worlds, engaging in a fiduciary role by hiring such person to provide conflicted advice, without protection of an exemption or advisory opinion.
a. The Interpretive Bulletin.
As mentioned above, the Department issued the Interpretive Bulletin which encourages and facilitates the provision of investment education for participants. The Interpretive Bulletin accomplishes this by describing information that will not constitute investment advice. Certain providers (including several large mutual fund companies) have stated that they will provide plan sponsors with various interactive investment materials that will be tailored to render specific, individualized investment recommendations to plan participants. These providers contend that such advice constitutes "investment education", within the meaning of the Interpretive Bulletin. The Interpretive Bulletin specifically provides that interactive investment materials will not result in the provision of investment advice where the information the Interpretive Bulletin describes is "information [which] would not constitute a 'recommendation' within the meaning of 29 CFR 2510.3-21(c)(1)(i) and, accordingly, would not constitute 'investment advice' for purposes of section 3(21)(A)(ii) of ERISA." However, where sophisticated, individually tailored education is provided to generally unsophisticated plan participants, it may be hard to argue that this does not constitute a de facto recommendation as how best to proceed. Therefore, the approach of equating the provision of individualized recommendations with mere "education" raises serious issues, and might best be avoided by the conservative plan sponsor.
b. The Definition of an Investment Advice Fiduciary.[32]
The author postulates that, if one parses the regulatory elements of what constitutes investment advice, it is clear that interactive investment materials, to the extent useful to plan participants, in fact constitute investment advice.
As previously discussed, a person who renders investment advice is a fiduciary under ERISA.[33] In order to be a fiduciary by reason of providing investment advice, a person must meet each of five elements:
Make recommendations as to the advisability of investing in securities or other property. If recommendations are made explicitly, or functionally, this element will be met. As a practical matter, it would be difficult not to meet this requirement if a program attempts to assist financially unsophisticated persons.
Render advice on a regular basis. It is unclear what constitutes a regular basis, other than it seems to require that advice be provided more than once. It is possible that where advice is rendered to unsophisticated persons, such as participants, a lesser frequency may be required.[34] If advice is provided on an ongoing basis via a computer (e.g., over the Internet), and access is unrestricted, it seems a given that, as least with respect to some participants, advice will be rendered on a regular basis.
Provides individualized advice. In order to be optimal, the advice must take into account the individual circumstances of the participant. Virtually all current programs are designed to elicit such information from participants, and presumably take the information into account. Certain investment advisers have argued that they are not rendering "individualized advice" and therefore not providing investment advice if they merely recommend non-specific life cycle funds. This argument could, however, have unintended consequences if one agrees with the proposition that non-specific advice is less good than specific advice from the individual plan participant's point of view. If so, then the Department's opinion in its Information Letter sent to Diana Orantes Ceresi of the SEIU (February 19, 1998) could be problematic. Therein the Department stated that if a plan sponsor determines to offer a product or service to a benefit plan, that decision is a fiduciary function and the quality of the offering must be taken into consideration; logically, offering a less good alternative could therefore have significant and negative fiduciary ramifications.
The advice must be rendered for a fee. Such fees include any fees incident to the transaction, and need not come from the plan. [35] Therefore, if a money manager does not charge a separate fee for the advice, it may nonetheless be deemed to charge a fee because of the fees it charges for managing the funds it may recommend. Furthermore, if a money manager charges a plan sponsor a fee for advice, but not the plan, the money manager might still be to deemed to charge a fee to the plan, albeit indirectly. [36]
The advice must be rendered pursuant to a mutual agreement or understanding that it will serve as one of the primary bases for the participant's investment decisions. This element is often misunderstood as requiring that the understanding be that the advice form the primary basis for a participant's investment decisions(s). The regulation and its preamble are clear that all that is required is that the advice be one of the primary bases for the decision. Financially unsophisticated persons generally do not have easy access to any alternate source for advice concerning how to allocate assets in their accounts. A person who provides advice to such persons should understand that such advice will serve as one of the primary bases for investment decisions, and a participant who follows the advice would probably agree with this understanding, unless the adviser maintains that it intended that its advice be ignored by the participant and its advice program be ineffective. Even if a court believes this assertion, once a participant follows the advice, any subsequent advice that is followed would constitute compelling evidence of a mutual agreement or understanding that the advice in fact serves as one of the primary bases for the participant's investment decisions.
The Department must, in order to grant a prohibited transaction exemption, find that the transaction is in the interest of employees. A transaction that is not prudent would not be in the interest of employees. Therefore, the Department only grants exemptions that incorporate conditions and procedures which the Department believes will insure, to the greatest possible extent, that the transactions that it exempts are prudent. [37]
The Department must also find that the terms of a transaction are protective of the rights of employees. [38] Accordingly, unless the Department is satisfied that the terms of a transaction are favorable to plan participants, it will not issue an exemption. In this connection, it is not unusual for the Department to insist that the terms of a transaction be made more favorable to plan participants than the requester had initially requested before it will propose to issue a prohibited transaction exemption. [39] Similar standards are typically applicable as a practical matter to the issuance of Advisory Opinions, since the Department is not required to issue Advisory Opinions.
The caution of the Department has had a predictable result. Exhaustive computer searches have failed to uncover any case in which a party complying with the conditions of an individual prohibited transaction exemption or advisory opinion was held liable for a breach of its fiduciary responsibilities in connection with transactions which were the subject of the exemption or advisory opinion. Further, the author has been unable to locate a single reported case in which a fiduciary breach was even alleged against such a person.
This is encouraging for any plan sponsor that retains an adviser to provide investment advice or managed accounts to its employees. If all conditions of the exemption or advisory opinion are complied with, then it would take a truly imaginative plaintiff to originate a theory under which the plan sponsor could be held liable for damages for hiring or continuing to retain such a fiduciary.
7. Conflicted Advice Without the Protections of an Exemption or Advisory Opinion.
Conflicted advice refers to the situation where an investment advice fiduciary renders advice to participants concerning funds with which it is affiliated. As discussed in this Article, such conflicted advice raises the spectre of prohibited transactions as a direct result of the conflict of interest inherent in such situation. This section discusses the resulting lose-lose situation for plan sponsors and plan participants where conflicted advice is rendered without the protections of an exemption or advisory opinion.
In a letter from Ann L. Combs, Deputy Assistant Secretary of the Labor, to Jonathon Katz, Secretary of the SEC, dated March 15, 1988, the Department opined that restrictions on redemption rights sought by College Retirement Equities Fund ("CREF") in conjunction with its registration as an investment company, would effectively leave CREF investment advisers and underwriters unregulated by the ERISA fiduciary responsibility provisions, as CREF's underlying investments would not constitute plan assets pursuant to ERISA Section 401(b)(1), applicable to investment companies registered under the Investment Company Act of 1940. In such an unregulated environment, where CREF redemptions were effectively precluded, the Department concluded that plan sponsors investing in CREF as ERISA fiduciaries could not fulfill their ongoing fiduciary responsibilities to effectively monitor plan investments. The legal proposition the "Combs Letter" stands for is that plan sponsors have significant ERISA liability with respect to the decision to invest in financial products if critical protections are lacking.
The Combs Letter therefore creates the underlying analytic basis for Labor Secretary Alexis M. Herman's letter of July 19, 2000 to the Honorable William F. Goodling, Chairman of the Committee on Education and the Workforce of the U.S. House of Representatives, strongly opposing H.R. 4747, the Retirement Security Advice Act of 2000, H.R. 4749, the ERISA Modernization Act, and H.R. 4748, the Comprehensive ERISA Modernization Act of 2000, which substantially included the provisions of both H.R. 4747 and H.R. 4749. These bills would effectively remove investment advisers from the application of the prohibited transaction protections, enabling the provision of conflicted advice with little safeguard from abuse.
The Secretary opined: "The 'Retirement Security Advice Act' would effectively leave retirement plan participants and beneficiaries vulnerable to bad and, in some cases, conflicted investment advice with little or no meaningful recourse if they rely on it. The bill would create a statutory exemption from the prohibited transaction rules for 'fiduciary advisers' who provide investment advice to a plan, or to its participants or beneficiaries. Such advisers would be required to disclose their fee arrangements and interest in any assets they recommend for purchase or sale (along with other required disclosures); in return, they could not be held liable under ERISA's per se prohibitions for the advice they render. Participants harmed by the advice would have to show that the advice was imprudent, a much more difficult task than showing a conflict of interest. This alteration of the rights and remedies that currently govern the provision of investment advice would place the risk of bad investment advice squarely on the participant" and, in the author's opinion, the plan sponsor that arguably imprudently hired such adviser.
With respect to the ERISA Modernization Act, the Secretary opined:
"The changes would weaken or eliminate rules designed to prevent the abuse of benefit plans by persons who profit from their dealing with plan funds. This would shift responsibility from persons who are in the business of offering such products and services and are most knowledgeable about the market to persons who hire and monitor such persons, usually plan sponsors, who typically know far less. We believe that such a shift would lead to abusive arrangements. This would also increase the responsibility of plan sponsors because they would now be dealing with persons who are subject to a less protective regulatory framework. The increased responsibility could discourage plan sponsors, who are sensitive to increased potential liability and regulatory burdens, from establishing and continuing to maintain employee benefit plans." (emphasis added).
Arguably, the only way a plan sponsor could fulfill its fiduciary obligations with respect to selecting and monitoring a conflicted investment adviser would be to have an independent expert review and approve the adviser's algorithms or "black box" used to create the recommended investment allocations. This would likely be cost prohibitive and practicably unworkable to all but the largest and most sophisticated plan sponsors.
If enacted, these or similar bills would have placed extremely significant burdens not only on plan sponsors with increased and significant fiduciary exposure, but on plan participants as well. The inappropriate incentives inherent in conflicted advice may lead to inappropriate investment allocations, resulting in increased risk to plan participants and/or lower investment returns. [40]
III. Investment Advice v. Managed Accounts
It is the author's contention that managed accounts in compliance with the SunAmerica Advisory Opinion are significantly more advantageous than the provision of investment advice. In fact, all parties involved with managed accounts win, as all are better equipped and thus more likely to achieve their desired goals.
A. Plan Participants.
Based on pilot tests, the majority of participants want a professional to manage their retirement money, especially after so many have seen their account balances devastated by the stock market decline. In general, participants want an easy, hassle-free way of having their money managed; the rendering of financial advice, though laudable, has not proven to be the panacea to participant inertia in investment allocation and savings that it was intended and hoped to be. Experts surmise that the reason is that too much is expected of participants in the typical investment advice product (e.g., significant amounts of financial information, implementing the advice, periodic rebalancing, periodic supervision). In sharp contrast, managed accounts, once certain financial information is received, are self-sustaining from the participant's perspective; little is thereafter required as managed accounts by their very design require the absolute minimum input from plan participants. The participants' accounts are professionally managed and periodically rebalanced in accordance with the modern portfolio theory and investment practices and procedures used by traditional defined benefit pension plans.
The effect of such ease of use in managed accounts, especially when combined with recommended or automatic increased elective deferrals, usually from future salary increases so the participants will not miss the money [41] , has a powerful result: increased usage of defined contribution plans and increased retirement savings, with little attrition.[42] In fact, The 401(k) Wire on March 4, 2003 reported the following:
"The [Wachovia Bank] AdviceTrack Program, which is set for launch in the coming months, is modeled after the Tarbox Group's managed-account pilot program implemented in late 1999 and the SunAmerica Advisory Opinion of late 2001AdviceTrackprovides a complete solution for employees by folding in expert portfolio and savings-rate management as discussed in the initial SunAmerica applicationThe new program addresses financial outcomes for retirement based on savings rates and asset allocation. Upon sign-up, the independent financial expert will create a personalized portfolio, which will be monitored, rebalanced and reallocated automatically on an ongoing basis. Participants may also select the key Managed Savings option, which will gradually raise their deferral percentage each year until the employee reaches the program limit. Thereafter, participant inertia prevails and drives better retirement outcomesResults from the Tarbox Group pilot program, which was conducted for an Illinois-based manufacturing company, showed minimal attrition despite the considerable short-term market volatilityIndeed, over 50 percent, or 162, of the 315 eligibles chose the program, and their average deferral percentage increased from 3.5 percent to 13.6 percent over the four years...Also, the opt-out rate for managed savings was extremely low, and, the group's projected results for replacement retirement income increased dramatically."
Simply put, managed accounts constitute an effective mechanism to get participants' inertia to benefit the participants themselves.
The effectiveness of the managed account concept, particularly if combined with managed savings, if widely implemented, will result in dramatically increased retirement income, which can only be viewed positively given the gross inadequacy of the retirement approaches of most people, particularly baby-boomers, and the uncertainty regarding the funding of the Social Security system.
Managed accounts might also assist in ameliorating governmental budgetary issues as baby-boomers retire; by increasing rates of savings in tax-deferred retirement vehicles, managed accounts providers thereby increase the amount of money that will be distributed from such vehicles and therefore subjected to ordinary income tax. This expected phenomenon will increase governmental revenue just when the retirement of the baby-boomers will be challenging the solvency of the social security system.
C. Plan Sponsors.
1. Business Rationale.
Managed accounts support the underlying business rationale for plan sponsors adopting retirement plans: to wit, the attraction and retention of valued employees. To the extent that employees value the managed account approach to retirement savings, they will be more satisfied with their employers, likely increasing retention rates; similarly, attractive retirement programs serve to attract desirable employees.
2. Minimizes Fiduciary Risk.
A prime concern of plan sponsors is the desire to eliminate as much as possible any fiduciary liability they might face. Managed accounts are particularly effective in this regard. In implementing a managed account program, the employer must select and monitor the investment manager. ERISA Section 402 enables a named fiduciary to appoint an investment manager, who must on a timely basis acknowledge its fiduciary status. Thereafter, the named fiduciary, typically the employer, is only fiduciarily responsible for retention and monitoring in a duly diligent manner. This is routine in the defined benefit context and most employers are comfortable with and know how to satisfy these requirements.
Hiring investment managers should also work for defined contribution plans whereby an investment manager may manage participant's accounts, which is, in its essence, what the SunAmerica Advisory Opinion provides. Moreover, even though ERISA Section 404(c) protection should not be needed if the employer complies with the elements of ERISA Section 402 for hiring and retaining investment managers, it may be available if the participant elects to have his money managed in a managed account; if the managed account is automatic (e.g., negative election) there is no Section 404(c) protection, but it should not be needed, since ERISA Section 402 should provide the same protection, limiting fiduciary responsibility to appropriate selection and monitoring.
Finally, the employer's fiduciary exposure is significantly ameliorated by providing a high quality, effective program (measured by increased likelihood of reaching retirement income objectives) to plan participants. [43]
By implementing managed account programs that satisfy the elements of the SunAmerica Advisory Opinion, financial institutions will likely reap significant benefits for several reasons. The institutions will not be relying on a tortured, aggressive reading of the dated PTCE 77-4 for exemptive relief. Further, there will be no need to pursue the difficult, expensive and time-consuming process of applying for a prohibited transaction exemption. Moreover, once plan participants become accustomed to managed accounts, it is likely that they will want non-plan assets so managed, as well as rollovers from qualified plans. Thus, those financial institutions offering managed accounts should experience significantly increased rates of asset gathering and retention. Finally, the interests of the financial institutions and the plan sponsors are perfectly aligned under a managed account program; the managed account program is an uncontroversial way of providing participants with what they want and need, while reducing plan sponsor's fiduciary liability; this is in stark contrast to the provision of conflicted investment advice which, even if it does not rise to the level of a prohibited transaction, puts severe fiduciary pressure on the plan sponsor (see discussion of Combs Letter in Section II.C.7 above).
E. Monitoring Effectiveness.
The plan sponsor has a fiduciary obligation to monitor the effectiveness of its retirement programs. A managed account program, by definition, will be 100% effective i.e., individual circumstances will be taken into account when determining appropriate asset allocation, accounts will be actively managed, and rebalancing will occur automatically. By contrast, once advice is rendered with respect to the appropriate life cycle fund or other investment option, the participant must implement the advice and periodically rebalance his portfolio. The extent to which each participant's actions are consistent with the advice or recommendations will be difficult and costly for the plan sponsor to monitor, and advice will, in any event, likely not achieve 100% effectiveness, as the requirement of participant proactivity would likely inhibit such result. [44]
IV. Life Cycle Funds v. Managed Accounts.
The plan sponsor is interested in one issue above all others: how to minimize fiduciary exposure. It is the author's opinion that life cycle funds raise fiduciary issues that are not present with respect to managed accounts.
Life cycle funds are often "funds of funds", i.e., a combination of mutual funds contained within another mutual fund in which participants are advised to invest depending primarily on their life stage (i.e., age). Such funds may be provided on a managed or discretionary basis, or in the alternative, advice may be rendered in connection with such funds.
A. Self dealing Issues.
If the financial service provider, which is affiliated with the life cycle mutual fund family, creates the algorithm for asset allocation applicable to individual plan participants, then the issue of self dealing arises, as the financial service provider may have an incentive to skew the advice to those life cycle funds where the group's profits, fees or margins are the greatest. Although this conflict of interest does not give rise to a prohibited transaction because mutual funds themselves are not plan assets [45], this puts pressure and significant fiduciary responsibility for monitoring [46] on the plan sponsor for hiring someone who could have an incentive to render conflicted advice or management.
By contrast, the managed account programs have no self dealing element, and thus, no heightened fiduciary responsibility for the plan sponsor.
B. Quality of Process.
Since asset allocation is so critical to returns, the advice rendered should be as particularized to the individual as possible. Managed accounts are clearly tailored to most salient aspects of the participant's circumstances (e.g., age, risk tolerance, retirement goals, savings rate, assets/liabilities outside of the plan), whereas advisers for life cycle funds generally place most if not all emphasis on one factor: age. Hence, arguably, the life cycle alternative is a lesser quality choice than managed funds. In accordance with the Department's information letter to Diane Orantes Ceresi, discussed above, the plan sponsor, as fiduciary, should document and explain why it would choose a service of lesser quality or effectiveness. All other things being equal, this documentation element clearly places a high burden on a plan sponsor who chooses a life cycle option over a managed account program.
C. Quality of Algorithms.
Managed account providers seeking to comply with the SunAmerica Advisory Opinion must hire independent experts to create the algorithms or "black box" for asset allocation purposes, while investment advisers with respect to life cycle funds cannot fall within the ambit of the Advisory Opinion and therefore usually do not hire such independent financial experts. This places heightened burdens on the plan sponsors. The financial service providers for life cycle funds who create the algorithms would not be liable as ERISA fiduciaries for the appropriateness of the algorithms and would not be subject to the prohibited transaction protections. This could result in skewing of algorithms, in a manner which would be prohibited by ERISA, but with no ERISA cause of action against the financial service provider [47]. However, the plan sponsor could be liable under ERISA for hiring an entity that provided potentially conflicted advice. The plan sponsor's exposure would be increased since the conflict is not regulated under ERISA.
D. Disclosure Issues.
As a general fiduciary principle, plan sponsors should disclose to participants issues participants should take into consideration regarding investment advice. Thus, for example, if the investment adviser with respect to life cycle funds does not take into account individual circumstances that could be relevant to appropriate asset allocation for that individual, such as outside savings or any circumstance which is particular to the individual unusual for the life cycle fund's target group, the plan sponsor may have a duty to disclose this information. Again, life cycle funds place a burden on plan sponsors that managed accounts simply do not.
The development of the law and financial products in the area of investment education, advice and managed accounts has been set forth in detail in this Article to acquaint the reader with the complex statutory and regulatory framework plan sponsors, participants and financial institutions operate within. There are many pitfalls that can severely adversely impact: (i) participants, with lowered savings and greater risk, (ii) plan sponsors with significant fiduciary exposure, and (iii) financial institutions caught between providing education when participants want to be told what to do and the prohibited transaction rules and standards concerning conflicted advice.
The best solution to date to these oftentimes competing and contradicting needs and desires is the managed account system including managed savings. This system, by effectively aligning all parties' interests, accomplishes the following objectives: (i) increased participant retirement income, (ii) reduced employer fiduciary exposure, and (iii) increased satisfaction with the financial institutions that provide the managed accounts and the logical consequences thereof, heightened demand for the use of such managed accounts and increased flow of retirement and non-retirement assets into managed account arrangements.
It is important to note that the funds used to purchase mutual fund shares, as well as the shares themselves, typically constitute plan assets. Therefore the fiduciary rules, including the prohibited transaction rules, are applicable to transactions involving such mutual fund shares and the assets used to purchase the same.
However, the underlying assets of the mutual funds do not constitute plan assets; accordingly, transactions that occur within the mutual fund, which would otherwise constitute prohibited self dealing, do not constitute prohibited transactions, absent a plan or arrangement to circumvent ERISA's protections.
Support for this point may be found in the legislative history of ERISA which states:
"Since [ERISA] prohibits both direct and indirect transactions, it is expected that where a mutual fund, e.g., acquires property from a party-in-interest as part of the arrangement under which the plan invests or retains its investment in the mutual fund, this is to be a prohibited transaction." (3 U.S. Cong. & Adm. News 1974, p. 5089).
The original regulation was not clear that it applied to participants, but Interpretive Bulletin 96-1, see footnote 23, so clarified.
Internal Revenue Code Section 4975 contains parallel provisions which similarly prohibit transactions between plans and "disqualified persons."
Significant portions of Sections I.C. and I.D. of this Article are derived from an outline by I. Lee Falk of Morgan, Lewis & Bockius, entitled "Asset Allocation Programs Prohibited Transaction Implications".
See DOL Advisory Opinion 93-13A at n. 4 (4/27/93).
See 29 C.F.R. Section 2550.408b-2(f), Example 2, discussed above, and Advisory Opinion 84-04A to Rogers, Casey & Barksdale (January 4, 1984) and Advisory Opinion 96-15A to Scudder Trust Company, footnote 3 (August 7, 1996). It should be noted that 29 CFR 2550.408b-2(f), Example 2 provides that the recipient of investment advice cannot be independent of the person providing investment advice, and since this regulation was issued in the same time frame as PTCE 77-4 by the same office, it is clear the Department did not intend that PTCE 77-4 be applicable to investment advice.
Also, although the Department, in an Advisory Opinion issued to Pro Administrators, Inc. on May 21, 1980, stated that a participant could, in certain circumstances, be an independent fiduciary under Class Exemption 77-9, this Advisory Opinion is inapplicable to Class Exemption 77-4.
This is evidenced by the fact that relief is available under PTCE 77-4 if the reviewing fiduciary considers only the fees and not the basis for the investment allocation. One reason for this limitation must be that the reviewing fiduciary could have an understanding of the appropriate asset allocation for the individual involved. Absent the possibility of such an understanding, the findings required by ERISA Section 408(a) could not have been made, since asset allocation is essentially determinative of investment return. Of course, such knowledge of the individual situation of multiple persons in a defined contribution plan is simply not possible, but could be in the IRA context.
Under DOL Reg. Section 2570.31, an individual exemption applies only to the specific parties in interest named or otherwise defined in the exemption. While an individual exemption cannot be relied on by other parties for an exemption from ERISA's prohibited transaction rules, the exemptions nonetheless provide guidance with respect to the positions of the DOL on the similar issues discussed therein.
The following PTEs are also relevant but not discussed herein: PTE 96-59, 61 FR 40000 (July 31, 1996) (Paine Webber Incorporated); and PTE 93-59, 58 FR 47290 (Sept. 8, 1993) (Prudential Mutual Fund Management, Inc.); PTE 97-12, Wells Fargo Bank.
Interestingly, this could create an incentive for Shearson to recommend more conservative funds, other than money market funds, where the costs of maintenance, and therefore profits for flat fees, may be greatest.
The author drafted and submitted to the DOL the application for this prohibited transaction exemption on behalf of TCW Group, Inc.
See ERISA Procedure 76-1.
See "Wachovia Turns to Managed Accounts" The 401(k) Wire, March 4, 2003. Wachovia has announced it will institute a combination of managed accounts with managed savings (i.e., it will advise participants how much to electively defer); both greatly increase a participant's likelihood of reaching his retirement goals in a way that no other broadly applicable program has done. Informing participants how much they should electively defer is a fiduciary function, which is arguably covered by the reasoning of Advisory Opinion which arguably could permit an institution to provide this advice using third party algorithms. Likewise, Merrill Lynch plans to launch a managed account program based on the SunAmerica Advisory Opinion (see "Merrill to Follow SunAmerica Model," The 401(k) Wire, October 9, 2002), as, of course, does SunAmerica.
The PWBA has since changed its name to Employee Benefits Security Administration.
This "5% rule", in this context, was originated in the TCW prohibited transaction exemption discussed above.
An in-depth discussion of Section 404(c) of ERISA is beyond the scope of this Article.
Labor Regulation §2550.404c-1(b)(1)(ii).
Labor Regulation §2550.404c-1(b)(2)(i)(A).
Labor Regulation §2550.404c-1(b)(2)(i)(B).
Labor Regulation §2550.404c-1(c)(4).
Under Section 3(2) of ERISA, the term "pension plan" encompasses any plan, fund or program established or maintained by an employer or employee organization, or by both, to the extent that by its express terms or as a result of surrounding circumstances, it provides retirement income to employees or results in a deferral of income by employees for periods extending to the termination of covered employment or beyond. For purposes of Title I of ERISA, an employer-sponsored individual retirement account ("IRA") is considered to be an individual account pension plan. See 29 CFR 2510.3-2(d).
Section 3(21)(A)(ii) of ERISA; 29 U.S.C. 1104(c); and at 29 CFR 2550.404c-1.
29 CFR Part 2509, 61 Fed. Reg. 29586 (June 6, 1996).
Section 3(21)(A)(ii) and the corresponding regulation at 29 CFR 2510.3-21(c)(1).
Labor Reg §2550.404(c)-1(b)(2)(i).
See 29 C.F.R. 2509.96-1(e). This Section also notes that hiring a person as an investment adviser may result in co-fiduciary liability under Section 405 of ERISA if the fiduciary which hires such an adviser fails to carry out such designation in a manner consistent with the general fiduciary responsibility provisions of ERISA.
See Preamble to Interpretive Bulletin 96-1, referenced in footnote 23 above.
The Department must find, on the record, that an individual exemption is in the interests of employees before it grants an exemption.
See Coyne v. Selman, 98 F.3d 1457 (4th Cir. 1996), Curtis v. Nevada Bonding, 53 F.3d 1023, 1027 (9th Cir. 1995) and Dukes v. U.S. Healthcare, Inc., 57 F.3d 350, 355 (3rd Cir. 1995), cert. denied 116 S.Ct. 564 (U.S. 1995). In contrast, most state laws would not be applicable to investment advice fiduciaries or managed account providers. In this regard, Section 514 of ERISA generally preempts all state laws, except for those which relate to banking, insurance, securities, and generally applicable criminal law.
See ERISA Section 405 regarding co-fiduciary liability rules.
Portions of this section were derived from an outline entitled "Investment Advice/Investment Education" submitted by Roberta Casper Watson of Trenam, Scharf, Barkin, Frye, O'Neill & Mullis.
The elements of investment advice are listed in 29 C.F.R. Section 2510.3-21(c)(1).
See Thomas, Head & Greisen Employees Trust v. Buster 18 EBC 1293 (9th Cir. 1994).
See footnote 3 of Interpretive Bulletin 96-1 at 29 C.F.R. Section 2509.96-1.
Interpretive Bulletin 75-2, 29 CFR Section 2509.75-2, prohibits the avoidance of ERISA liability through indirect transactions, such as transactions between plan sponsors and parties in interest, if such transactions would otherwise constitute prohibited transactions between plans and parties in interest.
This result could indicate a divergence of interests between plan sponsors and financial service providers. Another example of such divergence can be found with respect to so-called "Deemed IRAs". Deemed IRAs were created by the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") which, by enacting Code Section 408(q) permits qualified plans to maintain IRAs thereunder, could also pose significant fiduciary concerns for plan sponsors. EGTRRA, as amended by the Job Creation and Worker Assistance Act of 2002, expressly amended ERISA to provide that Deemed IRAs are subject only to the following Title I provisions: (i) the exclusive benefit rule, (ii) general fiduciary and co-fiduciary rules, including the application of ERISA Section 404(c), and (iii) ERISA's enforcement requirements, including its claims procedures. These provisions apply in the same manner as they would apply to a simplified employee pension ("SEP") under Code Section 408(k) (ERISA Section 4(c)). Importantly, the following ERISA rules do not apply: (i) reporting and disclosure provisions (e.g., no separate summary plan description requirement/Form 5500s), and (ii) ERISA Section 409 concerning monetary liability for fiduciary breach. The prohibited transaction provisions under ERISA also do not apply, but the parallel provisions under the Code do apply (ERISA Section 406 and Code Section 4975(e), (g)(2)). IRA reporting and disclosure requirements will apply to Deemed IRAs (Code Section 408(i) Reg. Section 1.408-5, Reg. Section 1.408-6, Reg. Section 1.408-7, and Reg. Section 1.408A-7).
As a result of the inapplicably of Title I of ERISA's reporting and disclosure rules, along with rules regarding fiduciary liability for breaches, it could be argued that Congress intended that more general, less predictable (and potentially costly and punitive) fiduciary rules regarding reporting and disclosure, and more especially, the equitable remedying of fiduciary breaches, apply to plan sponsors (See, Gerosa v. Savasta & Co., 2nd Circ., No. 02-9005, 5/19/03). In other words, perhaps the "carve out" of certain sections of ERISA Title I for Deemed IRAs invites the judiciary to apply the general fiduciary obligations and requirements of ERISA expansively, to the likely detriment of the plan sponsor community.
"Save More Tomorrow: Using Behavioral Economics to Increase Employee Savings", Richard H. Thaler and Shlomo Benartzi, August 2001.
The managed savings/managed account approach recognizes that there are critical elements in addition to asset allocation that should be addressed in connection with an effective retirement program. Such elements include the appropriate amount to save or spend. While a discussion of the extent to which the prohibited transaction provisions of ERISA are applicable to managed savings is beyond the scope of this article, the Combs Letter, discussed above, would be applicable. The Combs Letter instructs the regulated community that retaining a person with a conflict of interest to provide critical services increases a plan sponsor's risk if the prohibited transaction protections are not present. Therefore, plan sponsors should carefully consider whether to hire a person with a conflict of interest. Similarly, the plan sponsor should consider corporate structure and accountability. If the entity providing the services to a plan has no assets, such service provider is effectively not accountable. This is particularly important in situations where the service provider renders services which could have a dramatic effect on retirement income. In cases such as this, the quality of the services should be paramount to the plan sponsor that desires to minimize its risks. A plan sponsor's exposure could be increased if it retains a service provider, that otherwise has substantial assets, to provide critical services through an entity with little or no assets. A plan sponsor could ameliorate its exposure under such circumstances by hiring a competent third party to review the quality of services provided.
See the Department's February 19, 1998 Information Letter to Diane Orantes Ceresi of the SEIU.
44 In fact, The New York Times on May 18 ran an article concerning Financial Engines' provision of investment advice, which provides in relevant part: "Financial Engines, the research company based in Palo Alto, Calif., told 80 percent of the people who enrolled in its online advice service that they should start saving more for retirement, but only 20 percent said they actually did so, according to recent finding by the companyFinancial Engines found that 55 percent of participants had investments with an inappropriate level of risk. Of these, the company said, 93 percent had taken on too much risk as they tried to increase their investment returns, while 7 percent had invested too conservatively. Only 35 percent [of the participants who actually accessed the site]who were told that the risk level of their investments was inappropriate said that they accepted the recommendation, according to Financial Engines." (emphasis added) No information was provided to verify whether or the extent to which the participants "accepted" the recommendation.
See Combs Letter discussed in Section II.C.7 above.
There could be applicable state law causes of action.