The Prudent Investor Blog

A Fiduciary Decision Process Tool for the Prudent Investor

Posted by Joe Young on Thu, Nov 15, 2012 @ 07:21 PM

Evaluate, Compare, Select and Document Prudent Investment Optionsfiduciary, prudent investor

The Department of Labor (DOL) and the Internal Revenue Service (IRS) have a long-standing requirement that a prudent investor and employers document the decision process they used to select the investment options they offer their employees in their 401(k) or 403(b) retirement plans. Employers as plan sponsors are fiduciaries and are legally obligated to operate the plan in the employees’ best interest. They are obligated to offer employees a selection of prudent investment funds. Now, it is even more important to meet that requirement. For the first time, as of the last quarter of 2012, employers and employees will receive a statement that clearly states the performance of the funds and compare that performance against an appropriate benchmark. In addition, it will clearly show the expenses the employees paid for each investment option. In many cases, probably most cases, the employer and employee did not previously know that information. For example, in a recent study the AARP reported “When plan participants were asked whether they pay fees for their 401(k) plan, seven in ten (71%) reported that they did not pay any fees while less than a quarter (23%) said that they do pay fees. Less than one in ten (6%) stated that they did not know whether or not they pay any fees (AARP, 1). Another surprise for plan sponsors and employees is, or will be, the amount of the hidden fees they have been paying. They may not know at first glance what performance below benchmark means. They may not know at first glance that the fees they are paying are too high. They will learn.

The numbers below are real. The employer sent the employees the information provided by the brokerage firm. The form showed the performance of each fund offered to the employees and compared that performance to an appropriate benchmark. It also showed the total expenses. For simplicity of this example, the table below only shows the Large Cap Growth funds. As you can see, the return for 1 Yr for one fund was -2.68%. In comparison, the benchmark return was +2.11%. The difference is 4.79%. In other words, the employee could have earned 4.79% more invested in an S&P 500 Index Fund which is the benchmark. The fee the employee paid for that poor performance was 2.39%. The employer could have provided an S&P 500 Index Fund for .10%. That is 10 basis points. That is 1/10th of 1%. The employer could have offered that option and reduced the employees’ fees on that one fund from 2.39% to .10% for a reduction of 2.29%. How long will it take for the employer and the employees to discover this important information?

It is important to understand that all Fidelity and T. Rowe Price funds do not have this low performance and high fees. The broker that sold this fund selection had a choice on the commission and fee schedule. Most likely, the same funds are probably available at lower fees. In addition, it appears these funds are inside a variable annuity, which adds extra fees.

With this information in front of us, the obvious questions are, “What is the decision process that led the employer to offer the employees these fund choices?” “Did the employer document the decision process?” Some ERISA attorneys advise plan sponsors not to document their decision process and not to create an Investment Policy Statement that sets the criteria for the investment options. One obvious reason is that plan sponsors should not document bad decisions. Bad decisions are hard to defend. One ERISA expert explains, “It seems simple, but the truth of the matter is that it isn't bad to be a fiduciary, it's just bad to be a bad fiduciary (Olah).”

Bad fiduciaries are targets for trial lawyers that specialize in ERISA cases. For example, one attorney sees the new disclosure regulations opening the floodgates of litigation. Fiduciary News reports:

Rosenbaum sees the DOL’s new Fee Disclosure Rule as opening the floodgates of litigation. “With fee disclosure regulations coming up,” he says, “I think you will actually see an upswing in lawsuits as plan sponsors will now have to be more diligent as it concerns paying reasonable fees because now they know how much they are being charged. They will run out of excuses.” (Carosa 3)

On the other hand, numerous ERISA attorneys like Rosenbaum specialize in helping plan sponsors avoid legal trouble. A look at the titles of their articles and blogs tells us a lot about what is going on in the marketplace. Below are a few examples:

  1. “How Retirement Plan Sponsors Can Avoid Turning 2012 Into Their Apocalypse (Rosenbaum).”
  2. “Avoid Fiduciary Liability When Choosing the Class of 401(k) Funds (Saper).”
  3. “Plan Administrators and the Risk of Personal Liability: A Primer (Rosenberg)”
  4. “Recent Case Emphasizes Importance of Fiduciary Decision-Making Process (Mayo)”
  5. “On ERISA and the Potential Liability of Senior Executives (Rosenberg)”

In future blogs, we will go into more detail on a Prudent Decision Process for Fiduciaries.

Joe E. Young, Jr. November 14, 2012

Sources and Works Cited

AARP, “401(k) Participants’ Awareness And Understanding of Fees”, Washington, D,C, AARP Research & Strategic Analysis 2011

Carosa, Christopher CTFA “401(k) Sponsors and The Risk of Fiduciary Liability” Fiduciary News February 21, 2012

Mayo, Kelsey N. H. and Griggs, Eugene S. “Recent Case Emphasizes Importance of Fiduciary Decision-Making Process” 05.14.2012

Rosenbaum, Ary “How Retirement Plan Sponsors Can Avoid Turning 2012 Into Their Apocalypse”

Rosenberg, Stephen D. “On ERISA and the Potential Liability of Senior Executives”

Rosenberg, Stephen D. “Plan Administrators and the Risk of Personal Liability: A Primer” May 18, 2012

Saper Vernon P., “Avoid Fiduciary Liability When Choosing the Class of 401(k) Funds” 11/8/2010”

Olah, Michael J. “My employer has me chairing our retirement plan committee. Am I a fiduciary? Should I be concerned?” Fiduciary Link 02/09/2011

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