As an ERISA attorney and compliance consultant, I often hear plan sponsors and service providers attempt to justify an imprudent investment option by claiming that they are simply complying with the DOL’s and the courts’ adoption of Modern Portfolio Theory (MPT) as the applicable standard for assessing the prudence of investments. Now that latter point is true. But there’s just one little detail that was addressed in a key ERISA decision, DiFelice v. U.S. Airways(1), one little, yet significant, detail that was in footnote 8 of that decision that ERISA attorneys, plans sponsors and other plan fiduciaries should consider to avoid potential fiduciary liability issues
In footnote 8, the court distinguished between the reliance on MPT in choosing investment options for defined benefit plans and choosing investment options for a defined contribution plan.
Laborers Nat’l Pension Fund v. Northern Trust Quantitative Advisors, Inc.,173 F.3d 313, 315 (5th Cir.1999), cited by the district court in support of its heavy reliance on modern portfolio theory, involves a plaintiff challenging the prudence of one investment, contained within a monolithic, fiduciary-selected portfolio. The court there determined that the defendant fiduciary could properly rely on modern portfolio theory because the fiduciary himself consciously coupled risky securities with safer ones to construct one ready-made portfolio for participants…. Here, in contrast, modern portfolio theory alone cannot protect U.S. Airways, which offered the Company Fund — an undiversified investment alternative — just because it also offered other investment choices that made a diversified portfolio theoretically possible.
So, essentially, the court draws the distinction between one person putting together one investment portfolio, who can ensure that the investment options are put together in such a way as to take advantage of MPT’s cornerstone principle – effective diversification by factoring the correlation of returns of the investments chosen – as opposed to including an otherwise imprudent investment option in a menu of investment options for a defined contribution plan , where the plan participants may, or may not, understand MPT and how to properly design an effectively diversified investment portfolio. Since ERISA does not even require that 401(k)/404(c) participants be provided with correlation of returns data for the investment options offered by their plan, the danger of inclusion of otherwise imprudent investment options is even easier to understand.
Most non-attorneys reading the DiFelice would probably not even bother to read a decision’s footnotes. A lot of attorneys also neglect to read the footnotes in a decision, figuring that the key information is in the body of the decision. There are some who, when faced with the rationale of footnote, point out that footnotes are arguably not part of a decision.
Others will argue that even if footnotes are part of a legal decision, the DiFelice decision is only binding on the 4th Circuit Court Appeals. While DiFelice is technically binding on the the 4th Circuit, history has shown on more than one occasion that other courts are quick to adopt the logic of a well-reasoned decision by a sister court, including any footnotes within the decision.
Attorneys, financial advisers, plan sponsors and others involved in the financial services/investment industry are well aware of the controversial issues associated with MPT. Nevertheless, MPT is still the standard used by the DOL and the courts in assessing fiduciary prudence. And trust me, an experienced ERISA or securities attorney is going to have the correlation of returns data on a plan’s investment options in his file.
And trust me, the attorney is going to ask the plan sponsor and the other plan fiduciaries if they included a review of such data as part of their fiduciary duty of prudence and their fiduciary duty to conduct an independent investigation and evaluation of the funds chosen as the investment options for their plans. If the plan fiduciaries indicate that they did review the correlation of returns, they had better be telling the truth and be able to answer the questions correctly or hello breach of fiduciary duty. The again, if the plan fiduciaries admit that they did not review and factor in such correlation of returns data, that’s an admission of a breach of their fiduciary duties as well.
Bottom line, a prudent ERISA attorney or consultant will prove their value to a plan sponsor or other plan fiduciary by making sure the plan does review and factor in correlation of returns data on all funds being considered by a plan to ensure that the investments ultimately chosen are prudent on all counts, including cost efficiency, performance and risk-related performance, and diversification/risk management criteria. As the DiFelice court and other court have pointed out, with regard to defined contribution plans, each individual investment option must be deemed to be prudent for a plan’s sponsor and other plan fiduciaries to avoid any potential fiduciary liability.
(1) 497 F.3d 410 (4th Cir. 2007)
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