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Most 401(k) reforms before Congress don't address a critical source of risk: fiduciary duty.
Kris Frieswick, CFO Magazine
June 1, 2002
Thanks to the enormous losses of retirement savings suffered by Enron employees, the 401(k) plan faces its most significant overhaul since its creation in 1980. Dozens of proposals have been made in Congress to amend the Employee Retirement Income Security Act of 1974 (ERISA) as it relates to plan oversight. Some would place caps on the amount of employer stock in plan accounts; others would lift restrictions on employees' ability to divest this stock.
Meanwhile, companies are reexamining the provision and administration of their 401(k) plans — in which 42 million Americans hold assets worth $1.8 trillion — to determine what, if any, risks lie therein. Some companies have concluded that by making a few tweaks, such as allowing employees to diversify out of previously restricted company stock, they're avoiding potential trouble spots. But they may be looking for trouble in the wrong places. Even at Enron, about 89 percent of the company shares held in its 401(k) plans were fully diversifiable when the stock began its free fall, according to the American Benefits Council, a Washington, D.C., lobbying group for Fortune 500 corporations.
A greater risk, say analysts, lies in the interpretation and execution of the most commonly misunderstood words in ERISA: fiduciary duty. "Most of the existing ERISA land mines will remain after approval of [reform legislation]," says James M. Delaplane Jr., vice president, retirement policy, for the council. The demands of being a fiduciary "are based on prudence in a given situation, and it's hard to eliminate risk from this kind of fact-specific determination." Indeed, some observers say that Enron's cardinal sin was not faulty 401(k) plan provisions, but rather its alleged breach of fiduciary duty when its executives encouraged employees to hold on to their Enron stock even as the company was heading into bankruptcy.
Yet, despite its potential for exposing a corporation to massive liability, execution of fiduciary duty remains the single most problematic risk area in company-sponsored plans, say experts.
"Most fiduciary breaches are the result of a lack of prudence," says Jan Steinhour, a benefits attorney with Rothgerber Johnson & Lyons LLP in Denver. "The fiduciaries just don't understand what their responsibilities are." What's more, managers are frequently unaware that they are, in fact, fiduciaries. This misunderstanding leads to most of the violations that can lead to lawsuits, says Steinhour, who adds that most of the problems can easily be prevented.
What's in a Name?
The first thing companies must do to minimize fiduciary risk is identify everyone who has legally defined fiduciary responsibilities, or who is performing the functions of a fiduciary without knowing it. A fiduciary is a functional role that is not based on job title, so a determination of fiduciary status often comes down to a nuanced interpretation of a person's role with regard to the benefit plan and the specific duties he performs in that role.
ERISA states that a person is a plan fiduciary "to the extent that he exercises discretionary control or authority over plan management or authority or control over management or disposition of plan assets, renders investment advice regarding plan assets for a fee, or has discretionary authority or responsibility in plan administration." As such, a person can be a fiduciary whether or not he has been formally named one in the plan document, says Mary Turk-Meena, a principal and employee-benefits specialist with Deloitte & Touche in Charlotte, North Carolina. There are executives and human-resource managers in companies all over the country, she adds, who may have no idea that they are fiduciaries.
Unfortunately, many companies operate under the misconception that by outsourcing plan administration to third-party vendors and a plan trustee, they have off-loaded fiduciary responsibility. Others think that by giving employees a slate of investment options, and letting employees self-direct those investments, they are also off the hook. "Most companies think, 'We've given them these choices, that's all we have to worry about.' That also shows a lack of prudence," says Steinhour.
In fact, ERISA mandates that when no plan administrator is designated in a plan document, the plan sponsor is the plan administrator. In this case, the sponsor cannot insulate itself from ongoing responsibility to another party, such as a third-party administrator, Also, where the sponsor or a committee of plan-sponsor employees appoints the plan trustee or investment manager, responsibility for monitoring the performance of the trustee or investment manager ultimately rests with the sponsor or committee making the appointment, says Turk-Meena.
What's more, plan sponsors often are involved in selecting the funds in which employees may invest. With these selections comes a twofold fiduciary responsibility. First, the individual or group must act according to the "prudent man" standard, defined by ERISA roughly as the actions a prudent man in a similar capacity would take in similar circumstances. Execution of fiduciary duty in this instance is not just a matter of picking good investment options or a worthy manager (although the chances of anyone raising fiduciary issues are slim if investments are doing well). The law requires that fiduciaries have a sound process in place to make the decisions.
"Fiduciary responsibility is assessed based on process," says Turk-Meena. To meet the prudent-man standard, fiduciaries must make themselves reasonably knowledgeable about the options available, investigate a variety of options and compare choices with competing offerings, and keep detailed records showing how the final decision was made.
The Monitoring Requirement
The duties don't end there. Fiduciaries are also responsible for monitoring the performance of the trustee, investment managers, or investments they have chosen to ensure that they meet certain performance thresholds or match the investment policies outlined in plan documents. It's the failure to execute on this requirement that causes problems for many companies. "A lot of companies say, 'If there's a problem, we deal with it,'" says Turk-Meena. "That's a blatant ignoring of fiduciary duty. There is a monitoring requirement as well."
At International Paper Co., fiduciaries closely monitor the performance of the team of investment managers the paper and forest-products company uses to manage the customized investments it provides for its employees through its 401(k) plan. Robert Hunkeler, the company's vice president of investments, receives monthly performance reports from plan custodian State Street Bank, and a quarterly detailed analysis from IP's investment consultant. He reports to the fiduciary review committee twice a year and meets with his investment managers at least once a year. "Our goal is to ensure that our investment managers are meeting targets," says Hunkeler. "That's our first line of defense to protect plan assets."
Typically, nonfiduciary duties associated with a plan include decisions related to the adoption, amendment, and termination of the plan, as well as ministerial administrative duties associated with the plan. (Ministerial duties are those that involve no exercise of discretion, such as compiling reports or financial data regarding the plan.)
At Procter & Gamble Co., the company's three-man benefit policy committee has fiduciary responsibility to set policy and procedures used in administration of the company's 401(k) plan. Tom Mess, P&G director of global business services and employee services, and the plan administrator, is not considered a fiduciary, he says, because his duties are purely ministerial and do not involve any independent decision-making authority. However, some courts have ruled that such a ministerial administrative role can cross the boundary into "discretionary" (and therefore be subject to fiduciary duty).
No wonder, then, that many companies routinely misinterpret the word fiduciary. And the implications of doing so are profound. For example, if the courts eventually determine that former Enron chairman Kenneth Lay was acting in a fiduciary capacity in August 2001 — when he sent two E-mails to employees reassuring them that Enron's business was sound — then the company (or what's left of it) could be on the hook for the amount that the employees lost in their retirement accounts.
Education in Prudence
Once fiduciaries are identified, they must be educated about exactly what their role entails. The general rule is this: fiduciaries are expected to meet the prudent-man standard in the execution of their duties, which must always be conducted for exclusive benefit of participants and beneficiaries. Obeying this rule can be complicated, but companies can take some basic steps that will reduce the likelihood of stepping on ERISA land mines, say experts.
"Get some good education about what ERISA requires you to do" at various functional levels, advises Turk-Meena. "And make sure there are processes in place that are a check and a counterbalance to discretionary authority so it's hard for anyone to act as a renegade." Failure to do so could open up a company or plan fiduciary to allegations of lack of prudence, she adds.
It's not crucial that everyone who is a fiduciary "have a college degree in ERISA," observes Steinhour. "It's OK to appoint someone who doesn't have expertise and background in it, but you must make available to that person the resources and people who can help them. If you don't do that, it's an imprudent appointment."
The most pernicious source of fiduciary confusion is when the fiduciary is also an executive with insider information about the company. Experts say it's a bad idea to appoint a senior executive with inside information as a plan fiduciary. This is because ERISA requires that plan fiduciaries act for the sole benefit of plan participants — a requirement that sometimes runs counter to the best interests of the corporation. Even when such dual roles are avoided, senior executives who are not fiduciaries may slip into that role if they simply act as a fiduciary — as some believe was the case when Lay told employees that Enron's fundamentals were fine.
"If you give plan information at a gathering of plan participants, you become a de facto fiduciary at that point," says Steinhour, "whether you're named one or not."
As more companies face tough times, experts expect to see a flurry of cases alleging that executives who wear two hats, which is allowed by ERISA, are failing to act for the sole benefit of plan participants. Still, employers believe that such conflicts are rare. "The complete conflict of interest [by an executive wearing two hats] is a worst-case scenario," says Roxanne Horning, vice president of employee benefits at news giant Gannett Co., which now allows employees to diversify out of previously restricted company stock issued to match employee contributions.
Such conflicts of interest are particularly apt to occur at small and midsize companies, where a senior executive is also likely to be a plan sponsor or sit on the sponsor board, says Robert Rachal, a defense attorney specializing in ERISA benefits and fiduciary claims with the New Orleans office of Shook, Hardy and Bacon LLC. "Executives get to be successful businessmen because they believe in themselves and they believe they can pull a company out of trouble," he explains. "When companies get into trouble, [wearing two hats] becomes an untenable conflict situation."
When that point comes, one way to limit a potential breach of fiduciary duties is to appoint an independent fiduciary that takes over entire responsibility for the plan, and over which the senior executives with insider knowledge have no control or oversight at all. But the chances of an executive's doing that are often slim. "It's completely counterculture for a senior executive to give up control," says Rachal. So far, courts have based decisions in this area on which "hat" a fiduciary was wearing when he took specific acts.
Even executives at the highest levels of global organizations can accidentally slip up on fiduciary issues and open their companies up to liability. But a sound fiduciary identification and education effort can go a long way to help all potential fiduciaries steer clear of future problems.
Kris Frieswick is a staff writer at CFO.
Under ERISA regulations, a fiduciary is relieved of responsibility and liability for any loss resulting from a participant's self-directed investment decision if the employee can choose from a broad range of investment alternatives (at least three meeting certain verification requirements); give investment instructions to buy or sell with a frequency that is appropriate in light of the market volatility of those investment alternatives; and obtain sufficient information to make informed investment decisions.
Nowhere, however, does ERISA require or even encourage employers to educate their employees about making good decisions. Quite to the contrary, ERISA restrictions on "prohibited transactions," or those transactions that ERISA prohibits between a party-in-interest and the plan, have created an environment in which employers are highly unlikely to provide real investment advice or meaningful education to employees. Instead, investment education often involves a lecture on how important it is to diversify your assets into a variety of asset classes, and to minimize risk as retirement approaches. Period.
This tends to result in employees who are, for better or worse, the ultimate buy-and-hold investors. A study by the Employee Benefit Research Institute shows that even during 2000, when equities showed their biggest declines in years, employees did not shift their plan asset allocation out of underperforming stocks. One reason for this, say experts, is that some employees may still believe that their employer would never provide them with a retirement vehicle that would lose money or put their personal assets at risk. This is clearly a hangover from the days when the vast majority of companies offered defined benefit plans, in which employees were guaranteed a retirement benefit of a specific amount upon retirement, no matter what happened to the company or the market.
"The thinking is that if the company offers these investment options, then they must be OK," says Mary Turk-Meena, a principal and employee-benefits specialist with Deloitte & Touche. "You hear people say that there's no employee loyalty these days, but there's clearly an expectation of leftover paternalism."
That may soon change, however. Some of the proposed legislative changes to ERISA seek to alter the fiduciary liabilities of plan sponsors that arrange for investment advice for their employees. These changes face some of the stiffest opposition of any of the reforms. There is serious concern among some observers that companies would most likely seek this investment guidance from the same third-party investment managers they use for investing plan assets, a situation ripe for conflict of interest — not to mention unintended consequences. For example, "if you're a plan sponsor with significant employee stock in the plan," says Curt Morgan, senior vice president of Pittsburgh-based Mellon HR Solutions, "are you going to be willing to pay a third party to tell your employees to diversify out of your stock?"
As fiduciary-risk mitigation becomes an ever more important focus of corporations, it is likely that the answer to that question will increasingly be yes. —K.F.