Employers and Executives are Unknowingly Deemed Fiduciaries
Employers have a potential unknown landmine in their midst. Many employers must offer competitive benefits including retirement plans to attract and retain key personnel, yet in the process few grasp the magnitude of the liability they incur.
From a regulatory and compliance perspective when dealing with pension plans (including 401(k)-type plans), owners and key personnel can be designated as fiduciaries to the plan. The expanded definition holds not merely the business accountable but the owners and increasingly key executives who automatically assume all the risks associated with being designated as a fiduciary. Unless a financial advisor has formally assumed the fiduciary role, there is little relief for the owners and increasingly key executives in solving this dilemma.
There is a “right way” to manage a retirement plan defined by ERISA (the Employee Retirement Income Security Act of 1974), the Department of Labor, the Internal Revenue Service and the courts. This right way is called “procedural prudence.” In the world of small to mid-size companies, (loosely defined as those with fewer than 1,000 employees), the message that employers are fiduciaries with corresponding legal obligations to fulfill historically has failed to penetrate.
- Small to mid-size employers, unlike larger employers, tend to shop for retirement plans as if they were any other product or service without being aware of their corresponding fiduciary obligations. Because employers are unlikely to “do it right” without the help of one or more independent advisors, informed employers turn to service providers to help them meet fiduciary obligations and manage fiduciary risks.
- In most instances, the industry model is still a transactional sales model: investment advisors are compensated for moving money NOT for services rendered and employers need to be aware of this in their selection process.
- Owners and executives making decisions regarding employee retirement plans are by definition fiduciaries and personally liable for the management of those plans. The liability extends to include not only investment or plan losses but also the cost of internal fees associated with each investment offered compared to other in-kind investment options.
- While the statutes are largely silent on what constitutes due diligence in this area, case law is not; plan sponsors are expected to confirm the findings of their service providers through independent sources of information. The financial advisor well versed in ERISA and investment issues can serve as that independent source but it is HIGHLY advisable to have this clearly stated in a document which all parties sign and agree to in advance.
- The hiring of an independent advisor does not by itself transfer liability or satisfy the need for verification through an independent source.
The Nature of Fiduciary Duty and Risk
Larger companies virtually never make a decision regarding their qualified retirement plans without consulting professional advisors. The reason is simple: they are unwilling to assume this type of liability. Imagine a corporate executive charged with the responsibility for making decisions regarding a $500 million retirement plan. As a decision-maker, they are de facto a fiduciary, meaning they are personally liable for the prudent management of someone else’s money. How will this executive feel about being personally liable for $500 million?
Look at the following year-2000 case citations from the 10th and 11th federal circuit courts: Hurd v. Ross; Herman v. Schwent; Rhoades v. Casey; Bowles v. Reade. Those names are the names of people, not corporations. Those people are the fiduciaries of their companies’ retirement plans and they were sued as individuals for breaches of fiduciary duty. “Breach” in this context means “error”—these individuals were sued by their companies’ employees for making what the courts determined fit the legal definition of mismanagement of other people’s funds.
When a case is litigated, the owner or executive is the party who is held accountable for paying the damages. Naturally, the plaintiff’s attorneys look to the deepest pockets as well. Consequently, the companies are invariably named in the suits. One point of law is clear to the judge; regardless of the defendants’ attorneys and the retirement plan consultants they call as expert witnesses, fiduciaries are personally responsible for the retirement plans they oversee. The foremost question on the mind of a business owner who sponsors a retirement plan, therefore, should be “How can I best satisfy my legal obligations as a fiduciary?”
The problem for many business owners is that they ask the wrong question. They do not ask, “What do I need to do as a fiduciary?” Instead they say, “I want a retirement plan,” call a broker or agent, and buy whatever that broker or agent is selling. Perhaps they shop, but they let the salespeople control the information that is presented. Often they follow no checklist, consult no specialists, and review no due diligence “how-to” manual. Fiduciary due diligence requires “procedural prudence,” but most plan sponsors follow no set procedure and would not know what such a procedure should include in order for the courts to view it as “prudent.”
In court, it is logical to assume that a plan fiduciary will be asked certain questions:
- Do you have an investment policy statement?
- Can you document the process you followed in reviewing your investment options?
- Can you show the court your records for the past five years showing the fiduciary monitoring you conducted on plan investments and co-fiduciaries?
- How did you choose your current provider? Show your documentation of the process you followed.
- Can you clearly list all of the internal fees associated with each investment in the plan compared to other comparable investments?
These are only a few of the questions and answers you are expected to address. Unfortunately, many plan sponsors can not satisfactorily respond to even these few questions. As ERISA attorney Thomas Hoecker of Snell & Wilmer LLP in Phoenix, Arizona, said at the ALI-ABA “Fiduciary Responsibility Issues Update” in 2001, “Employers basically look at it [selecting vendors] the same way they look at buying car insurance and that’s a problem.”1 Small to mid-size plan sponsors need advice. They need the help of competent consultants or advisors who can bring them a version of large-plan fiduciary consulting suitably adapted to smaller plans.
Problems for the Plan Sponsor in Choosing Advisor Relationships
Hiring an advisor poses a number of difficulties for a plan sponsor. While it is clear that an advisor is crucial to the plan sponsor in carrying out fiduciary obligations assuming they have accepted this title: How can the plan sponsor satisfy the requirement for verification through independent sources when its sole source is its professional advisor? The sponsor is right back where it started; how can it possibly know how to guard the guardian—to monitor the advisor whose very job it is to monitor?
The plan sponsor encounters an additional problem in hiring advisors. “An independent appraisal is not a magic wand that fiduciaries may simply wave over a transaction to ensure that their responsibilities are fulfilled. It is a tool and like all tools, is useful only if used properly.” (In Re Unisys Sav. Plan Litig., 74F.3d 420, 3rd Cir. 1996). Thus an advisor is an absolute necessity for most plan sponsors, yet the mere hiring of a competent advisor does not transfer liability and does not satisfy the need for verification through an independent source.
These two potential pitfalls in hiring an advisor or consultant as the plan sponsor’s source of advice suggest two “tests” for advisor relationships:
- Is there a genuine transfer of fiduciary liability from the plan sponsor to the advisor or other service providers?
- Is information on the plan investments and investment monitoring verified through an independent source?
The Myth of Fiduciary Delegation
There is a myth I hear repeated frequently, mostly by otherwise knowledgeable advisors, that fiduciary responsibility cannot be delegated. This is not true. Sections 405, 406 and 409 include insight into how plan sponsors can delegate responsibilities. The Department of Labor’s regulations under ERISA elaborate on this guidance, as in 29 CFR 2509.75-8. From the date of ERISA’s enactment, it was contemplated that plan sponsors might choose to outsource certain plan services, such as investment selection and management.
The critical fiduciaries in most qualified plans are the plan administrator and trustee. A plan administrator is typically not a function that can be fully delegated, since only an insider can fill such roles as payroll, new-hire processing and terminations. A plan administrator, therefore, is generally an employee of the plan sponsor—often a CFO, human resources specialist or bookkeeper. The administrator typically outsources large parts of the administration to a contract administrator or “third-party administrator” (TPA), who is generally not considered a fiduciary. The TPA processes contributions, generates statements, performs non-discrimination tests and completes the IRS Form 5500 for the plan sponsor’s and plan administrator’s review and signature—actions which the Department of Labor views as “administrative” and not fiduciary functions. In many cases, the only fiduciary function of the administrator is to choose (that is, exercise discretion) and monitor the TPA.
The trustee’s functions may be either partially or fully delegated. When an ERISA investment manager is hired, the manager is responsible for the management of the assets under its control, and the trustee remains liable for the selection and monitoring of the manager.
NOTE: This article should not be construed as a complete manual regarding fiduciary obligations. It is intended to highlight serious issues and risks surrounding fiduciary liability and should be used as a preliminary discussion tool only.