In defining prudence, ERISA’s rules and regulations state that
[A] fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries…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 an enterprise of a like character and with like aims;…
Two of the primary duties enumerated within the duty of prudence are the duty to avoid unnecessary costs and the duty to avoid significant losses by diversification. In addressing these prudence issues, it is important for a fiduciary to recognize that the courts have further defined the duty of prudence as requiring both procedural and substantive prudence.
Fiduciaries need to remember that prudence is evaluated in terms of the process used by a fiduciary in carrying out their fiduciary duties, not in terms of the eventual performance of the actual investments recommended, “a test of conduct and procedure, not results.” The applicable regulations define the prudent process for fiduciary, both in terms of procedural and substantive prudence, as:
1. Determine what information is material and relevant to their task.
2. Examine and understand that information.
3. Make an informed and reasoned decision based on that information.
In evaluating a fiduciary’s compliance with their duty of prudence, procedurally speaking courts will focus on whether the fiduciary used appropriate methods to diligently evaluate investment options. Costs are an important factor that fiduciaries must consider, as costs directly reduce an investor’s return. Fiduciaries must factor in the fact that each 1 percent of investment costs and expenses reduces an investor’s end return by approximately 17 percent over a twenty year period.
The fiduciary’s investigation and evaluation must be intensive and objectively. Fiduciaries will be evaluated based on “the facts and circumstances that … the fiduciary knows or should have known (emphasis added). While fiduciaries can use the services and advice of third parties, a fiduciary must perform their own independent investigation and evaluation. A failure by a fiduciary to perform the required independent investigation constitutes a breach of their fiducairy duty.
Issues of substantive prudence focus primarily on whether the decisions/ recommendations resulted in providing the potential for reducing the risk of significant investment losses. Diversification is an important aspect of investment prudence for fiduciaries. As comment f of the Prudent Investor Act states, “diversification is fundamental to the management of risk and is therefore a pervasive consideration in prudent investment management.”
The Department of Labor has published a fiduciary education article on it website www.dol.gov/ebsa/fiduciaryeducation.html. While the article focuses on ERISA fiduciaries, the points regarding fiduciary duties are generally applicable to all investment fiduciaries.