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By Jessica R. Flores

Recent lawsuits and regulatory developments raise serious questions about whether qualified retirement plan fiduciaries have appropriately applied "prudence"—often interpreted subjectively—to their fiduciary processes. In Section 404(a)(1)(a) of ERISA, the prudence rule is written broadly, but has been interpreted by most fiduciaries, advisors, and consultants as an “investment rule," and so has been applied primarily to investment decisions. However, the prudent man rule does not limit itself to investments. Section 406(b) of ERISA establishes that fiduciaries must act in the interest of the plan and its participants. The General Provisions of ERISA define what a fiduciary is and does and is also not limited to investments. These ERISA sections establish general rules that must be applied to all fiduciary processes.

Investment Decisions and Beyond

Fiduciaries should apply the prudent man rule to all the following responsibilities:

• Plan committee members election and governance
• Fiduciaries (both internally and externally) assignment, duties and monitoring
• Legal advisor/plan consultant/investment advisor selection, roles, duties and monitoring
• Service providers/platforms/products selection, operations, performance, disclosure and monitoring
• Fees: Service provider compensation and conflicts of interest disclosure, examination and monitoring
• Fees: All other Parties-in-Interest compensation and conflicts of interest disclosure, examination and monitoring
• Decisions to participate in optional provisions of ERISA and the Code:
• Offering Participant Level Investment Advice (PPA Provisions)
• Adopting Default Investments (PPA QDIA Provision)
• Compliance with Section 404(c) (ERISA Exemption for Participant Investment Decisions)
• Election of any of the various plan safe harbors (contributions, hardship withdrawals, etc.)
• Investment selection and monitoring
• Plan operations and administration monitoring
• Participant communication, education and reporting monitoring

The question is whether the process applied in these fiduciary situations is indeed “prudent.” In most cases, fiduciaries have applied some sort of process to the tasks mentioned above; however, as many have learned through recent litigation, their process may not have been enough. Traditionally, fiduciary processes have lacked the following key aspects to make them effective:

• Implicit vs. Explicit – Most fiduciaries lack pertinent “written” policies and governance and instead try to create a document trail to demonstrate a process was involved in producing the result in question.

• Poorly Drafted – Those that do have the necessary policy and governance statements fail to properly articulate a workable process. This happens for two reasons: First, the fiduciaries may unknowingly fail to identify the appropriate resources to involve in defining the policy. Second, fiduciaries are advised against “putting too much on paper” that could be used against them later. Therefore, most of the policies governing ERISA plans today don’t really define a process, but instead describe a theory for applying a process. This goes back to implicit verses explicit—a written policy may contain many pages but not say anything at all. Most policies are prototype or canned statements that offer little value for field application.

• Fail to Cover All Bases – Since most fiduciaries and practitioners interpret prudence as an investment only rule, written policy statements are generally limited to investment processes and rarely take into account the multitude of other fiduciary responsibilities.

• Lack Substantive Measurement Process – Few practitioners advise in favor of citing specific performance measurement criteria and other language that would force fiduciaries to make changes to the plan in their policy statements. This is primarily due to liability concerns: advisors generally do not want to accept fiduciary status for advising on the criteria to be applied, while fiduciaries do not want to be held to the decision-generating methodology described. However, without specifying criteria for measuring the outcome of the process and outlining the potential actions that should be examined, fiduciaries are left open to making emotional decisions, or failing to make rational ones. This leads to investments being left in the plan after they are no longer suitable, expenses deducted from the plan for services that may no longer be useful, emerging practices that may not be appropriate, service providers that may no longer be acceptable, etc. When fiduciaries lack performance measurement criteria and specific courses for action, it is almost impossible for them to demonstrate prudent process when required to do so.

• Consistency – When all of the above situations are the case, which is most common even in some of the most sophisticated environments, fiduciaries rarely demonstrate the consistent application of a prudent process. Without written “fiduciary rules,” plan committee members are free to interpret their duties as they see fit, and such a subjective interpretation can easily change from quarter to quarter. Holding quarterly plan meetings does not meet the definition of consistency; the rules still need to be defined and regularly examined for areas of improvement. In addition, someone should be accountable for enforcing the duties described in the policies, and regular reporting should be required.

Prudent Process

Must follow several steps and considerations to meet the standards of prudence. Adopting policies requires more than drafting the documents themselves. Prudence is a mindset requiring careful thought and planning, a thirst for doing it right for participants, and an appreciation that the devil is in a lot of the details. Developing the various prudent processes fiduciaries are required to apply is no easy task and should not be taken on without appropriate attention to each aspect involved. These steps should occur in the logical sequence described below to produce the information fiduciaries need to effectively oversee the plan:

First – Prior to drafting the process, fiduciaries should examine their intentions for the exercise. Start by answering these questions:

• Purpose – What is the fiduciary responsibility that this process is to perform?
• Expectations – What is the acceptable outcome of applying this process?
• Terms – Is this fiduciary responsibility reoccurring and regularly scheduled or is it a one-time project?
• Members – Who are the parties that are involved or may be affected through the exercise of this process?
• Fiduciaries – Who are the fiduciaries with relation to the performance or the monitoring of the performance of this process? (Not by what the parties say, but by what they do.)
• Beneficiaries – How do plan participants and their beneficiaries benefit from the application of this process?

Second – Fiduciaries need to think in terms of building a process that can be applied effectively to produce the desired result. The building blocks of that process should include the following elements:

• Written – The process should be specifically defined and written in a Policy Statement that is readily available for reference and serves as the “rule book” for the performance of the fiduciary duty it entails.
• Reasonable – The process must be both descriptive and workable so that it may be adhered to effectively and consistently.
• Measurable – The results of the process must be measurable and the criteria for performance measurement should be specifically defined.
• Results Oriented – The policy should define both desired and potential outcomes.
• Actionable – The policy should provide for actions and the process for performing the actions that should be taken as a result of the outcome of the specified measurement process.

 Third – Fiduciaries should next consider their resources for defining, drafting, and performing the process described in the policy statement. Most fiduciaries use a team of advisors to assist with these matters; however, simply retaining that team doesn’t necessarily lead to applying a prudent process. Rather than attempting to design the process on their own, fiduciaries should examine and re-evaluate their resources regularly to ensure they have retained the best talent to assist them. They should start by asking these questions of their most commonly used advisors/practitioners, including benefit plan consultants, investment advisors, and ERISA legal counsel:

• Are they generalists or specialists? If specialists, in what areas of ERISA do they specialize? What qualifies them as specialists in those areas? How do they differentiate between an ERISA/benefit plan generalist and a subject matter specialist? In what parts of ERISA do they offer the most experience (e.g. Title I, code side, retirement, health and welfare)?
• What experience do they have drafting governing fiduciary policies? (e.g. Investment Policy Statement, Committee Governance Policy, Education/Communication Policies, QDIA Policy, RFP Policy, etc.) Who writes the actual policy? Who advises on the assignment fiduciary responsibilities? Who advises on the content of the policy statement and process defined therein? Are the policy statements custom drafted on a per client basis or are they some sort of boilerplate document? Does the practitioner advise on the language in the document or do they simply provide sample language to consider? How do they feel about written policies? What is their experience in implementing these polices and assisting their clients?
• Who maintains the documentation of the adherence to the policies? Who is responsible for ensuring that the policies are appropriately adhered to as described? How is it enforced?
• What experience does the practitioner have examining the internal workings and business models of service providers? What is their process for defining/requesting/gathering appropriate disclosures? How do they know the disclosures provided are sufficient? How do they identify and address conflicts of interest? What constitutes a conflict? How do they define service provider compensation? How do they identify and valuate all of the various sources of compensation when it isn’t required to be disclosed? How do they know their figures and interpretations are accurate? Who is verifying the accuracy and totality of the figures presented as “total compensation”? Who receives the compensation? How many sources for revenue are typically found?
• How do they audit/review service provider and participant activity? Are they concerned with call center and client service/education specialist practices? Are annuity and other product sales permitted within the plan? Are there ancillary product sales between the service providers and participants? How are rollovers and participant terminations handled? How is this identified and monitored? What are the fiduciary implications of these transactions? Do we have an indemnification agreement signed by our service provider for the suitability of the products being sold? Does this agreement have any value?
• Are they a fiduciary to this or any other plan they may service? Why or why not? At what point would their role in drafting policy statements implicate fiduciary status? Will that limit their role in drafting these documents? To what extent? What value is added by having them involved in the drafting process?
• Are they or their firm subjected to any material conflicts of interest? How do they define a material conflict for their firm? How is it communicated internally/externally? With whom do they do business? Do their clients include service providers? What do they offer service provider clients? Does this affect their advice to you? What about their sources for business referrals? Do they co-produce industry conferences? How does their firm earn revenue? How much of this information on the firm is readily available to the practitioner? How is this verified?
• Is their firm or any of its clients involved in any of the fee cases or other fiduciary breach cases prevalent today? If so, what action are they taking to address the accusations? How have they adapted to protect themselves and their clients from these sorts of cases? What are they reviewing for their clients to determine vulnerability to these sorts of accusations?

Fourth and Ongoing – After identifying the appropriate resources to engage for drafting the required policy statements, fiduciaries should review the conclusions of the first and second stages described above with their selected advisors. It is important to continue to refer to and communicate the basis for the documents as things are frequently forgotten and overlooked through this process. All considerations and steps of this process, as well as the conversations that transpire, should be documented. Determining the process needed is the first step in demonstrating prudence was applied and just as important as the resulting written policies.

The details of the policy statements will vary by the objective of each document; however, fiduciaries should continue to evaluate whether the drafted policy reflects the key aspects identified in the first and second stages. In addition, they should continue to ask themselves: Is the process specified? Is it workable? Is it measurable? Does it describe appropriate courses for action? Fiduciaries should always steer away from generic language that offers little application to their specific plan. Given that policies can be amended any time, there is no need to anticipate every possible change to the plan or governing entities. Generic language leads to sloppy documents with little application, which cause confusion to those performing the tasks. After the policies are drafted, fiduciaries should work through each of the processes to determine the workable nature and outcome of the application.

State of the Industry

Distraction – The financial services industry has tried to convince plan sponsors that current lawsuits are simply the result of volatile markets, tough economic conditions, and ambulance-chasing class action attorneys. As a result, many plan sponsors have not examined the underlying causes, and even those plans fighting such cases right now have made few real changes to their service providers, platforms and their own internal governance processes. It is clear that most fiduciaries haven’t addressed the accusations and so have not re-examined existing practices, leaving themselves vulnerable to future attack.

Regulation – Regulatory agencies and the Congress are continuing to review problems in the industry and responding by drafting proposed solutions. However, the various government entities charged with the regulatory authority over the many parties involved in ERISA plans do not communicate or coordinate their efforts, leaving substantial holes in their policies and compliance requirements. A good example of this is the Department of Labor’s attempt to address the disclosure issues through the proposed ERISA §408(b)(2) regulations. While the intentions are a much needed effort, their lack of regulatory coordination and industry understanding will make compliance almost impossible for fiduciaries and practitioners. Unfortunately, it appears that if/when these regulations are finalized and go into effect, they will spark more lawsuits than they prevent. This will place increased vulnerability on fiduciaries overseeing these plans.

Insufficient Disclosure – No one truly knows how much these ERISA plans cost investors, because most of the service provider compensation is not disclosed anywhere. This is true for defined contribution plans, but also defined benefits plans, which have not received the same attention in the more public fee cases. These plans commonly cost investors three, four, or even five times more than fiduciaries believe, even if the fiduciaries have thoroughly reviewed their published plan fees. Existing disclosures are insufficient for the needs of plan fiduciaries.

Litigation – Fiduciary breach cases have been a hot topic in recent months, but have not exhausted the opportunities. The continued lack of attention to the multitude of areas in which a fiduciary breach could be identified leaves most fiduciaries exposed while operating under a false sense of security. The plaintiff’s bar is covering new ground in some of the recent cases, and they are learning where the “dead bodies” lurk. The new regulations will only increase the opportunities for large class actions.

Wrong Priorities – Many fiduciaries confuse the “relationship” aspect of this business. It is not the relationship with service providers, but the relationship with participants, that is most important. Protecting participants means a willingness to do their own research and to ask tough questions of providers—regardless of the past relationship with them. Few fiduciaries appropriately monitor and measure the performance of service providers.

Summary

Applying the prudent man rule means defining and adhering to a meaningful and substantive process. The rule is not restricted to investment-related decisions and should be applied to all fiduciary situations. Fiduciaries need help defining their processes for them to be effective; however, the resources available may not always be the best answer, so they should always be willing to seek additional assistance. There are more roadblocks preventing fiduciaries from getting this right than capable helping hands who are accountable for their interpretations of the rule. Despite popular belief, failing to draft and adopt written policies does not offer better protection than having well written ones that include documentation to demonstrate consistent application and compliance. A prudent fiduciary does more than attend quarterly investment committee meetings. A prudent fiduciary recognizes and addresses all the fiduciary obligations. A prudent fiduciary understands that writing and implementing explicit polices and governance processes is the right thing to do. A prudent fiduciary wants those practitioners and advisors to be on his/her team. A prudent fiduciary recognizes that his/her client is the plan participant and works on the participant's behalf.

Jessica R. Flores is Managing Director – Fiduciary Risk Management (www.fiduciaryriskmanagement.com) and can be reached at jessica.flores@hawcpa.com