Memo to Employers: Time to Pay Attention to 401(k) Plan Governance

The twin scandals that rocked the corporate world and mutual fund industry have, among other things, refocused attention on the administration of tax-qualified retirement plans generally and 401(k) plans in particular. For years, employers were content to let their vendors (e.g., banks, mutual fund companies and insurance companies) take the lead in plan operation with a minimum of oversight or intervention. This approach worked fine in rising markets such as the bull market of the late 1990s, but it can be a disaster where plan participants experience losses and look for someone to blame.

Individuals charged with plan oversight—i.e., who have discretion over plan operation, including, in the case of a 401(k) plan, the selection of the menu of investment options—are subject to regulation as fiduciaries under the Employee Retirement Income Security Act (ERISA). There are also certain offices, such as the “plan administrator” and “trustee,” that are automatically subject to ERISA fiduciary obligations. The “plan administrator” is the individual or entity with responsibility for overall plan maintenance and operation. Where the plan administrator is not separately designated, the employer is the plan administrator.

Fiduciaries often believe—mistakenly—that they are relieved of all liability if they give plan participants the right to choose their own investments. This is only partially true, and only where a number of procedural requirements are satisfied. For fiduciaries to be relieved of responsibility for individual investment choices made by rank-and-file plan participants, they must satisfy a laundry list of requirements about which many fiduciaries are only vaguely aware. Additionally, plan fiduciaries always have the residual responsibility to prudently choose and monitor the menu of investment choices.

Without the benefit of a rapidly rising market, employers are no longer free to “outsource” the responsibility for plan operation with impunity. Employers will, of course, continue to rely on outside vendors for assistance, but it is now clear, as it should have been all along, that the bottom line responsibility rests with the fiduciaries—i.e., the plan administrator (which is almost always the sponsoring employer) and the trustees. As employers have gained a better appreciation of these rules, the norms and standards of 401(k) plan governance and operation have changed markedly.

The following summarizes some of the emerging issues that are driving the need for change:

1. Responsibility for Plan Oversight (the Duty to Monitor)

Starting with the collapse of Enron, a series of high-profile cases called into question the extent to which plan fiduciaries could be held liable to restore plan losses even where their only role was to appoint other plan fiduciaries and service providers. The losses in these cases resulted principally from plans that allowed or required investments in employer stock. The holdings of these cases were not limited to investments in employer stock, however. Instead, they apply with equal force to all participant-directed investments. These cases stand squarely for the proposition that a fiduciary has a duty to monitor that cannot be delegated, and they also suggest that the failure to adhere to exacting regulatory requirements will result in exposure even for investment choices made by participants.

2. “Late Day” Trading

It was an investigation launched by New York Attorney General Eliot Spitzer of a small, New Jersey-based mutual fund company that first focused attention on so-called “late day” trading. Late day trading occurs when a mutual fund manager accepts orders to buy or sell mutual fund shares after the 4:00 p.m. EST deadline. This practice allows certain investors (who are usually valued clients) to get the benefit of that day’s closing price while trading on market information received after the close of the markets to the detriment of other investors.

3. Mutual Fund Timing

Mutual fund timing involves frequent short-term buying and selling of mutual fund shares. While technically legal, mutual fund timing usually conflicts with mutual fund policies designed to encourage long-term investments. Its purpose is to exploit differences between net asset values and the changing prices of the underlying securities throughout the day. Market timing increases transaction costs and forces fund managers to keep a larger portion of fund assets available for redemption purposes.

4. Fee Disclosures

Fees charged against participant accounts erode returns, thereby directly affecting retirement security. Fees are charged both at the fund level (e.g., management fees and 12b-1 fees) and at the participant level (e.g., sales loads). But not all fees are disclosed in mutual fund prospectuses. For example, transaction fees, although included in determining total fund returns, are not reflected in fund expense ratios. The burden therefore falls on plan fiduciaries to understand what fees are being charged in the aggregate and to communicate them clearly to participants. The Department of Labor’s website (www.dol.gov) offers a useful starting point. It offers fee disclosure forms and worksheets developed with private sector assistance.

5. Bundled Fees and Soft Dollar Arrangements

“Bundling” occurs when multiple services are paid out of a single commission. Plan record keeping services, for example, are often bundled with plan investments. In these instances, it is incumbent on the plan fiduciary to make certain that the commissions that the plan pays to its vendor approximates the fair market value of the underlying services. There are also so-called “soft dollar” arrangements that are encountered in some instances under which a portion of the commissions are allocated to pay for such things as third-party research. Soft dollar arrangements usually involve a prior agreement under which transaction orders are directed to a particular broker in exchange for the research or other service.

Set out below are a series of suggested “best practices” that (a) shift the locus of control to the employer and plan trustees and away from the vendor, (b) systematically assist fiduciaries to comply with their legal obligations, and (c) provide a framework to address the abuses and issues described above.

1. Appoint an Administrative Committee

While a plan sponsor may hire a competent vendor such as a large mutual fund company, bank or insurance company, it is generally the employer (in its default capacity as the ERISA “plan administrator”) and the plan trustees that have bottom line fiduciary responsibility, particularly where it comes to the selection and monitoring of investment offerings. Employers ought to appoint and empower an administrative committee to fulfill these tasks. Although ERISA has a provision that exempts fiduciaries from liability for the results of investment decisions made by participants, plan fiduciaries remain responsible for the prudent selection of investment options made available to plan participants, as well as for the monitoring of costs and performance of those investment vehicles. Additionally, the hiring of service providers, such as investment advisors, is itself a fiduciary act.

2. Adopt an Investment Policy Statement for the 401(k) Plan

   The plan’s investments ought to be guided by a written investment policy statement, which ought to:

   • Describe what investments are available in each of the Morningstar “style boxes,”
   • Establish appropriate benchmarks in each case,
   • Set out procedures to make certain that investment options are periodically evaluated against the appropriate benchmarks, and
   • Set out a procedure for replacing investment options that fail to measure up.

   At least initially, this might require the assistance of an independent advisor or consultant. Since the plan’s mutual fund vendor is providing the investment vehicles, it should not be retained to provide this advice. Asking a vendor to perform this function would require them to assess the performance of their own funds (and in the case of “open architecture” plans, those of their competitors). All of this has a certain fox-and-chicken-coop quality to it that can be avoided by getting independent advice.

3. Ensure that the Requirements of ERISA § 404(c) are Satisfied

As a technical matter, ERISA § 404(c) provides a defense to plan fiduciaries against claims by participants and beneficiaries based on a breach of their fiduciary duty for the selection of investments where the participant makes the investment choices. Without this defense, plan fiduciaries may be held liable for poor investment choices made by participants. But fiduciaries only get the benefit of this defense where they satisfy all of the many technical ERISA § 404(c) requirements. While many plans comply with some or even many of these requirements, it is the rare plan that complies with all of them.

4. Address specifically the Abuses described above

The late trading and market timing issues are still with us. Fortunately, the Department of Labor has recognized that even prudent fiduciaries would not have been able to anticipate these problems. But the Department insists that fiduciaries take affirmative steps to inquire about these problems and satisfy themselves that remedial steps are being taken, if necessary. Fees too need to be investigated, and bundling arrangements should be reviewed if only to gain comfort that the plan is being treated fairly.

Recent corporate and mutual fund scandals have put plan sponsors on notice to clean up their fiduciary acts. This advisory offers a series of steps to help fiduciaries in this regard. We encourage employers to take these steps seriously and implement them without delay.

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We have assisted numerous plan sponsors spanning all major industry groups with 401(k) plan governance and related fiduciary issues. If you need help, please contact Alden Bianchi, Peter Marathas, Tom Greene, or Charles Grace at 617.542.6000, or visit us on the web at www.mintz.com. We would be delighted to work with you.

Copyright © 2005 Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.

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