Fiduciary Insights

The Misperception of Fiduciary Risk and Active Management in DC Plans: A Legal Perspective

Highlights

In the complex and litigation-prone world defined contribution plans occupy, it is important to underline what the real focal points for fiduciaries should be. Here are five guiding principles under ERISA that can aid fiduciaries in selecting and monitoring investment options and assessing active strategies within their plan lineups:

It’s about the process.

In order to satisfy ERISA prudence standards, a fiduciary needs to make informed decisions. This means that fiduciaries should have a good decision-making process that they consistently follow.


Fiduciaries should focus on the value-for-cost proposition.

Plan fiduciaries are not required to scour the market for the cheapest possible investment options. Rather, fiduciaries should focus on the value-for-cost proposition. This means that fiduciaries have latitude to consider what different investment strategies provide to plan participants, and not just cost.


There is no one-size-fits-all approach to investment menus.

Making good decisions about investment menus requires a fiduciary to understand the available alternatives and know their audience.


Range of choice and strategies can be appropriate.

In choosing investment strategies, plan fiduciaries should consider the particular attributes of their plans and may appropriately offer plan participants an array of choices across multiple investment styles and strategies.


Fear-based decisions fall short of prudence.

While litigation may be top of mind, it has no place in fiduciary decision-making. Instead, a well-rounded assessment of investments strategies and options that focuses on participant outcomes and plan objectives should supersede all other factors.

The fiduciary standards and guiding principles highlighted above, and discussed later in more detail, do not mandate any particular investment lineup and do not favor the use of either actively or passively managed strategies.

Introduction

Plan sponsors today have unprecedented options available to them when making investment selection decisions for their plans. Among those options is a wide array of actively managed investment strategies. These strategies provide participants a diversity of choice and the opportunity to benefit from excess returns above a benchmark, which can have a significant impact on portfolio value over longer time horizons due to the power of compounding. At the same time, plan sponsors face increasingly complex fiduciary requirements, as well as pressure to provide an optimal plan experience for participants at a reasonable cost. Making investment selection decisions under these conditions can prove challenging.

This white paper aims to help fiduciaries navigate the waters of plan investment selection and monitoring processes by:
 

  • Decoding the legal standards that apply to fiduciaries who are responsible for choosing investment options for their plans.
  • Identifying some guiding principles drawn from legal authorities that may assist fiduciaries assessing investment strategies such as active and passive as part of a plan lineup.
  • Emphasizing the importance of process as the most important factor in fiduciary decision-making.

Decoding ERISA’s Fiduciary Standards

ERISA holds plan fiduciaries to certain standards of care that the courts regard as the highest standards known to law, namely:

  • Fiduciaries owe a duty of loyalty1 to plan participants and beneficiaries. This means that the fiduciaries must act solely in the interests of the plan’s participants and beneficiaries and for the exclusive purpose of providing benefits and paying only reasonable plan expenses. This standard is often is referred to as the “exclusive benefit rule.”
  • Fiduciaries owe a duty of care2 to plan participants and beneficiaries. This means that when the fiduciaries act for the plan, they must act “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of a like character and with like aims.” This standard is known as the “prudent person rule.”
  • Fiduciaries also must act consistent with the documents3 that govern the plan and must diversify4 the plan’s investments so as to minimize the risk of investment losses.

When it comes to a plan’s investments, most defined contribution plans are set up so that the participants themselves can decide how to invest their plan accounts. Even so, plan fiduciaries do have the responsibility to select and to monitor the investment options that will be made available to participants. Meeting these responsibilities requires an informed and thorough evaluation of both the needs of their plan and the options available in the marketplace. Here, the focus is on the inputs to the fiduciary’s decision-making, and not on the investment outcomes achieved. In other words, employing a good investment selection and monitoring process is a key to meeting fiduciary obligations.

A good fiduciary investment selection process may include:
 

  • Understanding the documents that govern the plan, which may set forth investment objectives or mandates for the plan. Remember, following the plan documents is a key fiduciary obligation.
  • Meeting regularly to discuss and review the plan’s investment options. Again, the focus here is on process. It is important to have a decision-making process that is thorough, consistently applied, and documented.
  • Considering key attributes of the investment options (such as performance, expenses, and volatility) when considering available options and monitoring those investments chosen for the plan.

Basics of Active and Passive Investments

Because of the variety of options in the marketplace, there are several dimensions to an investment selection decision. One key dimension that plan fiduciaries often evaluate when selecting investments is management strategy or, more specifically, “passive” or “active” management strategies.

  • Passive strategies aim to provide the return of an index that replicates the market and can be accomplished for a relatively low cost.
  • Active strategies aim to outperform the return of a benchmark by utilizing different analyses and trading strategies.

It is essential for fiduciaries to consider the value-for-cost proposition when comparing the two strategies. Actively managed funds will likely have higher research and trading costs than passively managed funds, resulting in greater overall expenses. However, the active fund manager’s objective is to produce superior returns, even after costs are taken into account.

In recent years, class action litigation has challenged many common features of employer-sponsored retirement plans, including the use of active management. It can be daunting for plan fiduciaries to read headlines about litigation trends and to keep apprised of developments in the law. In the following section, we identify five guiding principles for plan fiduciaries that have emerged from recent court cases addressing investment selection decisions for employer-sponsored retirement plans.

5 Guiding Principles for Fiduciary Investment Selection and Use of Active Management

Courts are frequently called upon to consider whether a fiduciary’s selection of an investment for the plan was consistent with ERISA’s standards. The cases have generated some guiding principles that may be helpful to plan sponsors as they consider the role that active management can play in their plan’s investment lineup.

  1. Guiding Principle 1: Fiduciary prudence focuses on the process by which investments are selected and monitored for the plan and not on investment outcomes.

    ERISA’s prudent person standard is not concerned with results.5 Time and again, courts have said that the test of prudence focuses on the fiduciary’s decision-making process, not on investment outcomes. In particular, the fiduciary must give appropriate consideration to the facts and circumstances that are relevant to the particular investment under consideration, and act accordingly.6 Relevant factors may include the sponsor’s purpose in offering the plan, the risk of loss and the opportunity for gain (or other return) associated with the investment being considered, and the role the investment will play in the plan’s investment lineup.In short, ERISA’s fiduciary standards are satisfied by an informed decision-making process. For this reason, courts are not inclined to hold liable a plan fiduciary who engaged in a reasoned decision-making process and took into account all relevant information in carrying out its fiduciary duties.Because plan fiduciaries are judged largely based on the steps they took and the information they considered in making investment decisions, a decision to include actively managed funds in a plan lineup can be entirely consistent with fiduciary standards, provided that the fiduciary considered relevant information (such as performance and fees) and made a thoughtful decision.8

  2. Guiding Principle 2: Appropriate selection and monitoring of plan investments requires an understanding of the basis for comparison.

    Plan investments cannot be evaluated in a vacuum. Part of a fiduciary’s responsibility in evaluating investment options is to consider available alternatives. In evaluating the available options, the fiduciary needs to understand certain key dimensions of investments, such as investment type (e.g., mutual fund or collective or common trust), asset class, management strategy, and cost. While a broad range of options along each such dimension are available in the market, once an investment has been chosen for a plan, any evaluation of such plan investment should be subject to appropriate comparisons. For instance, critics of active management often base their after-the-fact critique on a comparison between the fees of active and passive investment products. But such comparisons are not apples to apples. Actively managed investment products are typically more expensive than passively managed investment products because they require different levels of services. There are costs associated with active trading strategies. The courts have recognized this and have rejected claims based exclusively on inapt fee comparisons.9

    Moreover, courts have consistently recognized that fees are just one dimension to a plan’s investments and should not alone be the basis upon which an investment selection decision is judged. For example, some courts have considered the availability of cheaper options to be “beside the point” because nothing in ERISA requires every fiduciary to “scour the market” for the cheapest possible funds.10 Not only do plan fiduciaries have latitude to value investment features other than price, they are required to do so.11 This is consistent with any common sense approach to purchasing. For instance, no professional would advise a person who is looking to buy a house or a car to only consider the listing or sticker price.

  3. Guiding Principle 3: There is no one-size-fits-all approach to choosing investment options for a plan.

    ERISA does not require fiduciaries to pick any particular mix of investments for their plans, much less preclude the use of particular options such as actively managed funds. To the contrary, the law gives plan fiduciaries leeway to choose the options that make the most sense for their particular plans. After all, every plan is different, and there is no one-size-fits-all approach to selecting plan investments. In fact, courts have said that plan fiduciaries are entitled to—and indeed should—consider their plan’s unique attributes in selecting investments. For example, factors such as the age and level of sophistication of employees participating in the plan may bear on the fiduciary’s evaluation of investment options available in the marketplace.12 Based on these kinds of factors, a fiduciary may conclude that participants would benefit from a diversity of choice and the opportunity to seek excess returns above the benchmark that active management presents.

    Plan fiduciaries are also entitled to consider the preferences of their participants in choosing investment strategies for their plan. Actively managed strategies are widely offered in defined contribution plans and are a common choice among many plan investors.13 Plan fiduciaries may fairly consider whether including appropriate investments that are also preferred by participants will increase participation and investment levels among employees. After all, participation in an employer-sponsored retirement plan is entirely voluntary, and employers have often faced challenges incentivizing employees to save for retirement.

    In choosing investment strategies for their particular plans, fiduciaries may also take into account that certain strategies are offered by other similar plans. Indeed, under ERISA’s prudent person standard, fiduciary conduct is judged in part by what a fiduciary “acting in a like capacity” would do with a plan of “like character and with like aims.” This means that the investment selection choices of similarly situated fiduciaries can provide a good frame of reference.

Fiduciary Misperceptions

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The Misperception of Fiduciary Risk and Active Management in DC Plans: A Legal Perspective

1 ERISA § 404(a)(1)(A), 29 U.S.C. § 1104(a)(1)(A).
2 ERISA § 404(a)(1)(B), 29 U.S.C. § 1104(a)(1)(B).
3 ERISA § 404(a)(1)(D), 29 U.S.C. § 1104(a)(1)(D).
4 ERISA § 404(a)(1)(C), 29 U.S.C. § 1104(a)(1)(C).
5 Roth v. Sawyer-Cleator Lumber Co., 16 F.3d 915, 918 (8th Cir. 1994) (prudence is “a test of how the fiduciary acted viewed from the perspective of the time of the challenged decision rather than from the vantage point of hindsight”).
6 29 C.F.R. § 2550.404a-1.
7 Bunch v. W.R. Grace & Co., 555 F.3d 1, 6 (1st Cir. 2009) (no liability for plan fiduciary who engaged in “thorough investigative and decisional process”); DiFelice v. U.S. Airways, 497 F.3d 410, 420 (4th Cir. 2007) (no liability for plan fiduciary whose decision-making process used “appropriate methods to investigate the merits” of the challenged investment).
8 Taylor v. United Technologies Corp., No. 06-1494, 2009 WL 535779 (D. Conn. Mar. 3, 2009), aff’d. No. 09-1343, 2009 WL 535779 (2d Cir. 2009) (rejecting attack on the use of actively managed funds in a large defined contribution plan where the fiduciaries’ selection process included “appropriate consideration” of the fees and the returns of funds).
9 Loomis v. Exelon, 658 F.3d 667 (7th Cir. 2011) (rejecting challenge to inclusion of actively managed funds in plan lineup and noting costs associated with active strategies).
10 Hecker v. Deere & Co., 556 F.3d 575, 586 (7th Cir. 2009) (rejecting claims that cheaper alternatives were available).
11 White v. Chevron Corp., 2016 WL 4502808 (N.D. Cal. Aug. 29, 2016) (rejecting claims that cheaper alternatives were available).
12 See Hecker, 556 F.3d at 586 (“nothing in [ERISA] requires plan fiduciaries to include any particular mix of investment vehicles in their plan”); Whitfield v. Tomasso, 682 F. Supp. 1287, 1304 (E.D.N.Y. 1988) (fiduciary obligation includes consideration of participant needs).
13 See Deloitte Annual Defined Contribution Benchmarking Survey (2015) at 31 (88% of plans offering actively managed funds).

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201812-701249

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