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TPSnewsflash BE-04-0011: Process & Purpose 401(k) fiduciaries, like plan committee members, have a legal duty to monitor-—and remove, if no longer appropriate—-the investment options in their retirement plans. That basic ERISA duty seems to be accepted by plan sponsors, investment providers, ERISA attorneys and others in the 401(k) industry. However, is it well understood? Monitoring is forward-looking. However, most of the information evaluated is historical, such as performance over the past one, three, five and 10 years; some is current, such as the expense ratio and the continuity of the portfolio manager. Thus, plan committees examine the past and the present in an effort to predict the future. Fortunately, ERISA does not require that fiduciaries pick the investments that will perform best in the future. Instead, the law requires that they engage in a prudent process to gather and examine the appropriate information and to make a reasoned decision based on that information. The courts and the Department of Labor will not evaluate fiduciaries based on the outcome of the investment, but will look at the information gathered, the analysis of that information, and the basis for the fiduciary's decision: in plain English, whether the fiduciaries looked at the right information in the right way. That process involves both substantive and procedural prudence. The former requires that fiduciaries gather the information needed to make a prudent decision-—the danger is that facts may be overlooked that would have changed that decision. Fiduciaries, therefore, must either be knowledgeable about the issues relevant to future investment performance or ask for help from people with that expertise. Procedural prudence requires that, once the necessary information is gathered, the fiduciaries engage in a process to study and evaluate the information. If the fiduciaries do not understand the meaning or consequence of the materials that they are examining, they must turn to others with expertise. Fiduciaries cannot rely blindly on those experts, however. Instead, the fiduciaries must examine the report of the advisor and determine whether to adopt that report as their own. Moving from the theoretical to the practical, what kind of information should be gathered and studied by plan committees in evaluating the investment options in 401(k) plans? Generally speaking, the fiduciaries need to have quantitative information about the numbers related to the investment (past performance, expense ratios, turnover, and so on) and qualitative information about the management company (stability of management, style consistency, asset growth, and so on). Unfortunately, in my experience, many plan committees and fiduciaries simply review the past performance of the funds and, if the performance is middling or better, they automatically approve the retention of the funds-—perhaps believing that past performance is the best predictor of future performance. However, that is not necessarily true. As mutual fund prospectuses constantly remind us, past performance is not necessarily a predictor of future performance. Moreover, recent research by Vanguard concluded that, for actively managed funds, “ On average , funds that consistently out-perform have lower expenses and lower turnover than consistently under-performing funds.” This study suggests that plan fiduciaries should be devoting a considerable part of their monitoring effort to the expenses and turnover ratios of the funds in their plans, which, at a minimum, may serve as a filter through which performance may be evaluated. However, I am not an investment expert. As a result, I leave it to investment advisors and academics to evaluate the Vanguard article and to determine whether my interpretation is correct. Fiduciaries must act prudently and with the skill of a knowledgeable investor. Fiduciaries are required to give appropriate consideration to information that is material and relevant to the decisions that they make. The failure to monitor prudently—-that is, the failure to gather the substantive information needed to make decisions and to consider that information properly—-is a fiduciary breach. The only remaining question is whether the breach caused a loss to the participants. Fred Reish is the managing director and partner of the Los Angeles-based law firm of Reish Luftman Reicher & Cohen. This article and others written by him can be found at www.reish.com. Permission was granted by Reish Luftman Reicher & Cohen to share this information with our clients. The
Pension Specialists, Ltd. |