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Defending Your 401(k)

Your fiduciary obligations to employees outweigh those to shareholders. Here's how to limit your vulnerability to the slings and arrows of a 401(k) lawsuit.
Russ Banham, CFO Magazine
April 1, 2000

John Eskew won't be caught napping in the woods when the bear arrives.

The CFO of Windermere Real Estate Services Co., a residential real estate brokerage firm based in Seattle, put together a comprehensive fiduciary liability program to reduce the company's — and his own — exposure to lawsuits alleging imprudent management of employee 401(k) retirement savings. "People forget that under ERISA [the Employee Retirement Income Security Act], anyone who has fiduciary authority for employee pensions is personally responsible to the full extent of his or her personal wealth to manage that plan in accordance with the law," says Eskew. "That's a lot of personal responsibility."

When Eskew came to Windermere as CFO in 1997, the company did not have a formal fiduciary management program. Knowing that he'd be on the hook personally for any fiduciary losses, that gave him pause. So Eskew assembled an in-house 401(k) committee that included himself, the CEO, and an employee representative; developed a written investment policy; hired outside investment advisers to select investment options; asked an ERISA attorney to review everything; then instituted a quarterly review process. These efforts were complemented by what Eskew considers the most important component of any fiduciary management program — insurance.

"Nobody thinks about fiduciary liability when the stock market is roaring," says Eskew. "But when it whimpers, employees and retirees look to blame someone, and the plaintiff's bar will see this as the next big payday. Without a fiduciary liability policy, you're risking everything you have ever worked for — your house, your retirement savings, everything."

As a corporate fiduciary, Eskew is not alone in fearing the consequences of a bear market, but he is one of the few doing something about it. While most corporations buy inexpensively priced fiduciary liability insurance (premiums are roughly 5 percent of coverage limits), few have put in place specific programs to manage, reduce, or mitigate such.

But insurance alone may not cover all sins. Cheaper coverage, for one thing, doesn't cover risks that stem from offering company stock as an investment option. Also, you can always be sued for more coverage than you have. And even with the broadest coverage, your company's reputation remains at risk from a nasty lawsuit.

That risk will come home to roost if the stock market decelerates. Currently, more than $1.5 trillion is invested in 401(k) plans representing roughly 40 million individuals, up from $92 billion and 7.5 million participants in 1984. "When your fund is earning so much, you tend not to think much about it," says Ann Longmore, ERISA practice leader at New York-­based insurance broker Willis. "Consequently, there are a lot of violations going undetected, with few if any complaints raised. Companies are not kicking the tires here. If they did, they would be surprised how vulnerable they are."

Alden Bianchi, chairman of the employee benefits practice at Mirick O'Connell, a Worcester, Massachusetts-based law firm, is equally blunt. "The current boom is masking a lot of mistakes," Bianchi says. "Let's not kid ourselves. If you offer a technology stock in your 401(k) options, it will be hard to distinguish [whether] this is a prudent investment or a lottery ticket. Today, you're a hero for offering tech stocks, and employees think they're masters of the universe for selecting these investments. But if we hit a rocky patch in a few years, and baby boomers retire, they'll look for someone to blame for the poor performance of their pension plans. They'll whine and scream and sue their fiduciaries. Count on it."

Assessing ERISA
Ironically, many companies switched from defined benefit plans to defined contribution plans to get a better handle on the risks they confronted under ERISA. By giving employees the option to pick and choose among several investment options in a 401(k) plan, corporate plan sponsors passed on much of their fiduciary risk.

The law's 404(c) regulations, adopted in 1992, reassured most plan sponsors that they were protected from liability as long as they adhered to the guidelines for offering diversified investment options. And as long as they can document that they followed the guidelines, experts say, sponsors should be protected no matter how the options perform. But "you can never fully pass the baton," says Willis's Longmore.

However, documenting the process isn't necessarily easy. "You must show that you undertook whatever steps were necessary to ensure that the investment options you provided were not all three-legged horses when you selected them," says Longmore. "Unfortunately, many companies fail to document the steps they have taken — the reasons why they picked this investment over that one." If sued by disgruntled employees, those companies may find that 404(c) offers no protection.

Too often, in fact, fiduciary issues take second place to other worries. "Employee benefits tend to ride in the caboose," says Bianchi. "Senior management is more concerned with long-term planning, acquisitions, product cycles, and so on, and tend to think of benefits as 'that stuff over there.' "


If sued for an underperforming investment, these companies may be hard-pressed to mount an effective defense. The reason is twofold. For starters, a finance executive handling pension investments is held to a higher legal standard of performance than one handling corporate investments. With the latter, the executive is held to the prudent-person standard. Under ERISA, however, this defense has no weight, because the prudence one must demonstrate in regard to pension investments must be that of an expert.

"It's a much higher standard," confirms Longmore. "Companies fail to realize that there is no higher standard of strict liability than that imposed under ERISA."

In addition, ERISA sets up a basic conflict of interest between shareholders and plan participants, leaving the CFO between a rock and a hard place when it comes to such issues as shifting administrative costs to plan participants and offering company stock as an investment option.

"Ironically, even if you're acting in the good faith of the company, you may not be acting in the best interests of the plan participants," Longmore notes. "There is often an inherent tension. You must manage a pension plan for the benefit of participants and not for the company. These are mutually exclusive."

Consider the two fiduciary liability class-action suits, totaling more than $300 million, against First Union Corp., a Charlotte, North Carolina­-based financial institution. The suits, filed on behalf of some 100,000 current and former First Union 401(k) plan participants, accuse the bank of using their retirement plan to boost corporate profits at their expense. The plaintiffs allege First Union forced employees to invest their money exclusively in its own mutual funds, which have performed poorly in comparison with other mutual funds. "First Union is using its employees' money to increase the size of its funds to make them more attractive to outside investors," says Michael D. Lieder, a partner at law firm Sprenger & Lang Pllc, in Washington, D.C. "They have required employees to shop only at the company store."

First Union's pension plan, with $3 billion in assets, is also its largest client. The lawsuits also claim First Union charged higher fees and expenses to its employees to service the plan than it charges outside clients. (For a closer look at the cases, see our August 1999 article "When Pensions Change Hands.")

Experts say the outcome may serve as a general precedent for all sponsors, not just for financial institutions that also offer their own investment funds to their plan participants and limit choice to just those funds. "Lots of sponsors are paying close attention to this case," says Longmore. "Even if the funds in question compare well with other funds at the time they are offered, thereby meeting the prudent-expert objective, did First Union offer the funds for plan participants' benefit or its own? That's a dicey question the courts must decide."

The first round of skirmishes in the case went decidedly to First Union. In a decision handed down last February 17, a federal district court threw out three of the participants' claims (relating to the proper adoption of the plan, plan termination, and vesting of investment choices). The case is still far from over, however. The court did not throw out the claims about the use of First Union proprietary funds. So the essential fiduciary claims are still in play.

The Law's Teeth
If a fiduciary is sued in an ERISA case and loses, the full extent of his or her wealth is at risk, whereas with corporate investments, an executive has no personal liability. Indeed, it was the government's intent in drafting ERISA to utilize personal liability as the law's teeth.

Just who, then, is on the hook for fiduciary liability — the CEO? the CFO? the board? The scary fact is that anyone who has ever had any discretionary authority with respect to employee pensions is a de facto fiduciary. If a midlevel executive is sent to fill in for a superior at a meeting on the company pension plan and that person is recorded in the minutes providing comment, he or she is exercising fiduciary responsibility. And while insurance companies also offer personal indemnity coverage, experts want it severely limited in scope. "It gives a false sense of security," Longmore says.

Given the number of companies that have merged or been acquired in recent years, and the practice of liquidating the target company's pension plan and investing the proceeds in the acquiring company's plan, a southerly turn in the stock market could prove disastrous for fiduciaries. "If your new pension plan tanks, underperforming the assets in the old plan, acrimonious accusations will fly," Bianchi says. "The plaintiff's bar is sharpening its knives in anticipation."

Still don't believe it? Here's what the law firm that took on the case against First Union has to say. "There are a large number of fiduciaries who have engaged in questionable behavior that plan participants have largely disregarded, simply because of the bull market," says attorney Lieder of Sprenger & Lang. "If and when the market plunges, they will no longer disregard it."

Risk Avoidance
There are two ways to alleviate fiduciary fears — insurance and risk management. The first is a no-brainer. Fiduciary liability insurance is a buyer's market, thanks to few recent lawsuits filed and the overall soft market conditions affecting property/casualty insurance. The main sources of coverage are American International Group (AIG); Lloyd's of London; Reliance Insurance; Travelers Property Casualty; and Chubb Executive Risk. The cost is roughly 5 percent of the coverage limits purchased, unless the company offers its own stock as an investment option. "This potentially creates a conflict of interest that, theoretically, raises the risk of a lawsuit," says Longmore. Premiums then leap to between 10 and 15 percent.


A recent survey by Willis of its large client base reveals that 90 percent routinely buy fiduciary liability insurance. But David Wray, president of the Chicago-based trade association Profit Sharing/401(k) Council, says that many small to midsized firms pass on the insurance. That's a mistake. "It's relatively cheap for what is very broad coverage," Longmore says. Indeed, the only significant exclusion from coverage is deceptive practices, which is required by law to be covered by a fidelity bond anyway.

Some say the best reason to buy the insurance is that it picks up the tab for legal defense costs. Joseph Teklits, associate general counsel at Blue Bell, Pennsylvania-based Unisys Corp., which recently won a protracted fiduciary liability lawsuit, says the company's legal costs were $4 million, paid for by its insurer, AIG.

Companies can buy up to about $100 million in insurance, enough to cover most lawsuits. Unfortunately, many companies fail to get appropriate limits. "They tend to underestimate their own legal fees and the fact that, in a losing lawsuit, they must also cover the plaintiffs' legal fees," Longmore explains. She recommends roughly 5 percent to 15 percent of plan assets (for funds in excess of $1 billion in assets) as a good limit of liability.

Teklits agrees that companies should purchase more coverage. "We had $20 million in primary and excess fiduciary liability insurance, and were sued for $70 million," he says. "While our legal defense costs were $4 million, you can be sure the plaintiffs' legal fees, had we lost, easily would have tripled that. Let me tell you, when you have a couple billion dollars floating around in your pension plan and you've got only $20 million in coverage, that is nothing." He would not reveal how much additional insurance coverage Unisys has, except to say it is significant.

The anticipated upsurge in fiduciary litigation may put an end to the buyer's market for insurance. "Prices are tightening," Longmore says. "We're advising our clients to obtain three-year policies at current prices, and then roll that over each year by adding another year."

Windermere's Eskew bought a three-year policy from Chubb, brokered by New York­-based Marsh. "We'd been hearing that prices were headed up, and wanted to lock in for as long as we could," he says. Other CFOs are likely to follow suit when their current policies expire. "If we can get three years, I'd be interested," says Geoff Hibner, former senior vice president and CFO at The Timberland Co., a Stratham, New Hampshire­-based outdoor footwear, apparel, and accessories maker.

"This is a coverage you cannot afford not to have," he continues. "With some insurance coverages, you make your decision based on the risk-versus-reward calculation. Not in this case. Even if the cost rises because of expectations over additional lawsuits, you do not want to go without this insurance."

As the insurance market tightens, companies that prudently manage their fiduciary risks will be accorded more favorable underwriting treatment, brokers contend. That's a taller order than figuring out how much insurance to buy, but following some basic rules will.

In any case, companies that are carefree about fiduciary liability will pay for their complacency, observers argue. Says Bianchi, "Fiduciary liability is high on the list of income sources for plaintiff attorneys. Those companies that hide behind the stellar stock market as proof of a sound pension philosophy have a bull's-eye painted on their tails. Lawsuits are inevitable, and it ain't going to be pretty."

Longmore agrees, noting that even a single minor complaint from one employee can mushroom into disaster. "ERISA encourages fishing expeditions," she says. "Once an initial allegation is made, plaintiff attorneys can obtain broad-based discovery and find all sorts of things. Even in the best of gardens, you turn over stones and find worms."

In the Dark

A study by Delaware Investments Retirement Financial Services, a Philadelphia-based investment management firm managing more than $50 billion in assets, found that of the 86 percent of employers that outsource their plan's investment management functions, only 35 percent evaluate performance. Moreover, 41 percent do not have a process in place for evaluating their investment managers' adherence to fund objectives, and 29 percent do not produce a written evaluation report. Most frightening, only 43 percent say they are "very comfortable" that they understand the provisions of ERISA. "Many employers are taking unnecessary risks with their lack of formal oversight," says Mary Rudie Barneby, the division's president.

Fiduciary Foibles: How Unisys Managed to Steer Clear of Problems

Recent cases alleging fiduciary liability are few and far between, providing few precedents to learn from. Perhaps the most meaningful case was a long-and-drawn-out class-action lawsuit filed — originally for $208 million — against Unisys Corp. by employee plan participants. In the case, plaintiffs alleged that Unisys, the plan sponsor, breached its fiduciary responsibility by failing to diversify the investments within the plan, making imprudent investments, and inadequately informing participants of the risks.

At issue were three guaranteed investment contracts (GICs) provided by Executive Life Insurance Co., a California insurer that later became insolvent. After a checkered course through the legal system, a Third Circuit Court of Appeals affirmation in favor of Unisys was petitioned to the U.S. Supreme Court, which declined review. "The issue all along was prudence," says Joseph Teklits, associate general counsel at Blue Bell, Pennsylvania-based Unisys.


"We were able to prove that the investment selections we provided were what any other prudent expert would have concluded were sound and appropriate. When we purchased the Executive Life GICs, the company had the highest ratings accorded by A.M. Best and Standard & Poor's. Moreover, we had documentation from an outside consultant who, at the time, was considered the grandfather of GICs — Murray Becker of Johnson & Higgins. In short, we had exercised an expert standard of care in selecting credible investment options. Although Executive Life ran into trouble, the law is not designed to prevent the vicissitudes of the marketplace."

"The Unisys case is a good example of how to do things right," says David Wray, president of the Profit Sharing/401(k) Council of America. "They could prove they had a philosophy for investing, a process for implementing and reviewing those investments, and had retained outside counsel to provide guidance. Most important, they had documented all of the above."

Michael D. Lieder, an attorney with Washington, D.C.-based Sprenger & Lang Pllc, agrees: "The Unisys message is loud and clear: Follow the process and you'll be all right."

Eight 401(k) Commandments: Follow These Basic Steps to Limit Your Fiduciary Liability — or Else

Good 401(k) plan design may not always prevent lawsuits by disgruntled employees, but it will invariably win lower premiums from insurers. Here's an eight-point checklist:

1. Offer plan participants the option of changing their accounts on a daily basis through an 800 number or the Internet. "You don't want a lawsuit from employees saying that you could have given them the ability to switch investments on a daily basis, but didn't," says David Gensler, president of Madison Pension Services Inc., a Purchase, New York-based consulting firm. Otherwise, he says, you may give them cause to complain that "they were stuck in a steamrolling bear market with a rapidly deteriorating stock they couldn't get out of until quarter's end."

2. Don't offer too many investment options. This leads to what's known as "paralysis by analysis." Says Rhonda Prussack, vice president and product manager of fiduciary liability insurance at New York-based insurer American International Group Inc., "A good range is about 6 to 12 investments — more than that and you overwhelm participants with too much information." The plan offered by Windermere Real Estate Services Co., a Seattle-based real estate brokerage firm, offers 18 investment options, from conservative T-bills to an emerging-market tech fund, and the firm would hesitate to offer more, says CFO John Eskew.

3. Offer investment advice only if it's independent. While many plan sponsors have chosen not to offer investment advice to participants, out of fear that it would heighten the sponsors' fiduciary liability, experts say it can do the reverse, provided it comes from an outside investment adviser with no vested interest in your plan. "You want someone with investment expertise to sign off on what you're trying to accomplish," Eskew says. Windermere hired Reliance Consulting & Research, of Bainbridge Island, Washington.

4. Fully document any change in investment advisers. "We recently decided to switch our 401(k) vendor," says Lisa Zappala, senior vice president and CFO of Aspen Technology Inc., a Cambridge, Massachusetts-based software firm. "We appointed a search committee consisting of representatives from finance, HR, and legal, as well as outside consultants. The effort was labor-intensive and time-consuming, but the results were worth it. Does our plan run seamlessly 100 percent of the time? No. But do we have a high level of confidence in it? Absolutely."

5. Craft a carefully worded strategic investment strategy explaining the plan's objectives, and distribute it to participants. Windermere's investment policy is a one-page document that establishes the criteria the firm uses to monitor investments, performance expectations, benchmarks (such as a mutual fund peer review) to guide investment changes, and a quarterly review process. "At least we have something here to show in the event of litigation," Eskew says.

6. Avoid doubletalk. Policy statements that avoid esoteric language "impede zealous attorneys looking for a place to grab onto," says Ann Longmore, ERISA practice leader at New York-based insurance broker Willis. "If recipients can claim they don't understand the technical jargon, you have not made meaningful disclosure to them as required under ERISA."

7. Get an ERISA compliance audit by an attorney or consultant who specializes in the law. "It takes me two hours to read your plan document, so for a stinking 500 bucks you avoid a lot of trouble. And if I make a mistake, you've got my firm's $10 million malpractice insurance policy to call upon," says Alden Bianchi, of Worcester, Massachusetts-based law firm Mirick O'Connell. "That's a lot of malpractice insurance for only $500."

8. Select a group of employees, including plan participants, to be the plan's fiduciaries. "On our 401(k) committee, we have included the manager at one of our real estate offices, whom we feel is more in tune with the retirement goals of our real estate agents," Eskew says.




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