ERISA and Fiduciary Prudence


Uneasy Lies the ERISA Fiduciary’s Head:

Complying With ERISA’s Duty of Prudence

James W. Watkins, III, J.D., CFP®. AWMA®

CEO/Managing Member
InvestSense, LLC

“Uneasy lies the head that wears a crown” is a famous line from Shakespeare’s play, “Henry IV.”  While referencing the worries incumbent upon a king, the line is equally applicable to an ERISA fiduciary.  The courts have often referred to an ERISA fiduciary’s required standard of care as the “highest known to the law.”  And yet, while many plan fiduciaries feel that they are in compliance with the required standards of care, many experts in the area of ERISA law state that few ERISA plans are actually compliant with ERISA’s requirements, especially ERISA 404(c) plans.

Based upon my experience, I too believe that many ERISA plans mistakenly believe that they are in compliance with ERISA, especially ERISA 404(c) plans. Fortunately, I believe that many of those misperceptions can be easily remedied with a review of ERISA’s requirements and modern investment theory.  While a complete explanation is beyond the scope of this post, the information provided will hopefully be helpful to ERISA fiduciaries in following through on the issues presented.

Based upon my experience, there are three liability areas in particular that often ensnare ERISA fiduciaries: the “good faith” defense, the lack of understanding regarding effective diversification, and the misconception regarding an ERISA fiduciary’s ongoing duties.  The “good faith” defense is the belief by many ERISA fiduciaries that as long as they act in good faith, they cannot be held liable for any losses suffered by the plan and/or its participants.  In the words of many courts, “a pure heart and an empty head is no defense.”

Courts assess the prudence of an ERISA fiduciary’s action based purely on objective standards.  If the fiduciary does not have the education, skills or experience to make the necessary decisions for a plan, then the fiduciary has a legal obligation to retain outside help to meet the applicable fiduciary standards. Failure to do so constitutes a breach of the fiduciary’s fiduciary duty.

Quite often I have heard ERISA fiduciaries state that they believed that a plan provider had agreed to serve as the plan’s fiduciary and to handle such matters.  Unfortunately, what many ERISA fiduciaries are not aware of is that plan providers often draft their contracts with a plan in such a way that their use of the term “fiduciary” is perfectly legal, but deliberately misleading to the plan sponsor and its named fiduciaries, often resulting in resulting in liability for the plan sponsor and its fiduciaries.

The confusion lies in the fact that ERISA recognizes several types of fiduciaries, each with various levels of responsibilities and liability exposure. Without getting into too much legalese, let’s just say that the two most common forms of ERISA fiduciaries are the 3(38) and the 3(21) fiduciary.

The 3(38) fiduciary assumes the duties of an investment manager for the plan and assumes liability for its recommendations and actions.  The 3(21) fiduciary generally agrees to provide recommendations to the plan, but unless the fiduciary does more, the plan sponsor retains all liability for the plan.  Most plan provider contracts are written in terms of their serving only as a 3(21) fiduciary, with many plan sponsors and plan fiduciaries mistakenly believing that the plan provider has agreed to assume liability under the plan.

Again, this is perfectly legal, but it can be extremely misleading and often results in surprise liability for the plan fiduciary.  The plan sponsor and the plan fiduciary should have all contracts reviewed to ensure that they are properly covered and receiving the benefits they desire.  Hopefully, this issue will become moot under new fiduciary regulations to be announced by the Department of Labor and the Securities and Exchange Commission, with anyone advising ERISA plans being required to accept fiduciary status and liability for the services provided.

The second area of concern has to do with the ERISA fiduciary’s duty to diversify the plan’s investment options in order to minimize the chance of large losses.  Both the Department of Labor and the courts have adopted modern portfolio theory as the applicable standard in assessing the prudence of an ERISA fiduciary’s decisions.

In 1952 Dr. Harry Markowitz introduced the concept of Modern Portfolio Theory (MPT).  Before the introduction of MPT, investment portfolios were constructed using only an investment’s return and the variability of those returns.  MPT introduced the idea of factoring in the correlation of returns of the investments under consideration, the idea being that one could produce more consistent returns by combining investments that had a low correlation of returns.

The most common method of analyzing the correlation of returns among investments is to prepare a matrix that sets out the correlation of returns for the investments being considered.  While it is relatively easy to prepare such a matrix, my experience is that very few ERISA fiduciaries create or use a correlation of returns matrix in making their investments decisions.

Based upon my experience, many ERISA fiduciaries make their diversification decisions upon either blind trust in the plan’s provider or by relying on the asset categorization given to the investment, e.g., large cap growth, small cap value, international.  The result is often a plan that is “pseudo” diversified in that there are various types of investments, but the plan is not effectively diversified due to the fact that most of the equity investments’ returns are highly correlated, thereby failing to provide plan participants with needed downside protection against large losses.

“Pseudo” diversification presents another prudence issue for ERISA fiduciaries.  In many cases, “pseudo” diversification produces, in essence, nothing more an expensive index fund, which in turn raises issues regarding a fiduciary’s duty to avoid unnecessary costs.

Plan fiduciaries cannot simply blindly rely on representations or advice from third parties.  Plan fiduciaries have a legal duty to do their own independent investigation and evaluation.  The courts have consistently ruled that the failure of an ERISA fiduciary to conduct their own independent investigation constitutes a breach of fiduciary duty.

When I analyze a plan as a consultant or in determining whether to take a case, I perform three separate analyses in assessing whether the fiduciary was prudent.  I construct a correlation of returns matrix to assess the effective diversification of the investment options.  I perform a stress test on each of the investment options to assess the basic prudence of the investments.  The final analysis involves a proprietary formula that I use to assess the quality of each investment option in terms of both quality of performance and cost efficiency.

While neither ERISA nor court decisions requires any specific analyses for analyzing prudence, the analysis method chosen must be effective in protect and promoting the interess of the plan participants.  Each of the three tests I perform is based upon my experience as a securities compliance officer and is consistent with ERISA, both the statute and its related regulations, and legal decisions involving a fiduciary’s duty of prudence.  Whatever method of analysis an ERISA fiduciary chooses to adopt, the fiduciary should document the procedure used and the results of the analysis.

The final area of concern involves an ERISA fiduciary’s ongoing duty to monitor once the fiduciary has delegated some of his fiduciary duties to others.  An ERISA fiduciary has a duty to continue to monitor the performance of those to whom fiduciary duties have been delegated to ensure the quality of performance and that the services have been performed in a manner consistent with the plan’s parameters.

Far too often I encounter ERISA fiduciaries who fail to monitor third party delegates altogether, believing the delegation of fiduciary duty relieves them of any responsibilities, or fail to effectively monitor such delegates due to a lack of understanding of how to assess the delegate’s performance.  In the event that a delegate has not acted or performed properly, the ERISA fiduciary has a duty to act to redress any wrongdoing by the delegate and recover any financial losses resulting from such wrongdoing.  A failure of the fiduciary to monitor delegates or to redress any uncovered wrongdoing constitutes a breach of a fiduciary’s fiduciary duties.

An ERISA fiduciary faces a formidable task to ensure compliance with ERISA’s requirements.  ERISA experts have stated that while many ERISA fiduciaries believe they are ERISA compliant, very few actually are.

At some point an ERISA fiduciary has to decide whether to retain outside assistance in order to stay current and comply with ERISA’s numerous requirements. In determining whether to outsource any of their ERISA fiduciary duties, fiduciaries should remember that they face potential personal liability for a failure to comply with any of their fiduciary duties. As mentioned earlier, good faith, blind trust, or a lack of education, skill or experience will not protect an ERISA fiduciary against personal liability for a breach of their fiduciary duty of prudence.

I am often asked how I can represent plan participants and offer consulting services to ERISA plans and their fiduciaries.  To me, the ultimate goal is to create a win-win situation for an ERISA plan, its fiduciaries and its plan participants.  Fortunately, it is not that hard to reach that goal.  Whether an ERISA fiduciary decides to take the time to properly educate themselves on ERISA’s rules and regulations or decides to maximize their time and minimize some of their potential risk exposure by outsourcing some of ERISA’s fiduciary duties,  creating and maintaining an ERISA compliant pension plan that benefits and protects all parties, and reduces an ERISA fiduciary’s uneasiness, does not have to be that difficult.