Understanding Your Fiduciary Liability: 3(21) vs. 3(38) Services

Transcription

1 Understanding Your Fiduciary Liability: 3(21) vs. 3(38) Services Mark J. Grushkin Employee Benefits Shareholder Littler Mendelson, P.C. (Littler) There is considerable confusion in the marketplace regarding the fiduciary liability that accompanies retirement plan sponsors and trustees, and how that liability can be mitigated. One way that retirement plan sponsors and trustees may mitigate their risk is by engaging a third party to provide investment advisory services as an ERISA fiduciary. It is therefore important for plan sponsors and trustees to understand these services including the extent to which they actually help mitigate risk or relieve them of fiduciary liability under ERISA. In reality, there may be limited actual transfer of fiduciary duties or liability from the plan sponsor to a third party providing investment advice as an ERISA 3(21) fiduciary. This is especially important for plan sponsors who are not investment experts, as such plan sponsors are still held to ERISA s prudent expert standard. The meteoric rise in fiduciary litigation has rightfully caused many plan sponsors to consider utilizing an ERISA 3(38) investment manager, which can provide a meaningful transfer of liability. This paper is intended to provide an overview of fiduciary standards under ERISA and how plan sponsors can utilize third-party fiduciaries to assist with plan investment decisions including the relative benefits and drawbacks of the two most common types of thirdparty investment fiduciaries to qualified retirement plans: ERISA Section 3(21) investment advice fiduciaries and ERISA Section 3(38) investment managers.

2 Who Is a Plan Fiduciary? ERISA fiduciaries are either named in the plan document or are deemed fiduciaries based on the function they perform for the plan. A named fiduciary is a person either specified in the plan document 1 or identified pursuant to a procedure specified in the plan document. The named fiduciary has authority over the plan s operation and is often the employer or an officer of the employer. 2 A person or entity that is not a named fiduciary will still be deemed a plan fiduciary under ERISA Section 3(21) if they: render investment advice for a fee, have any discretionary authority or control regarding management of the plan, or over the management or disposition of its assets; or have any discretionary authority for the administration of the plan. In addition, there is another type of fiduciary: an investment manager under ERISA section 3(38). A Section 3(38) investment manager is a fiduciary who: has the power to manage, acquire or dispose of any asset of the plan; is a Registered Investment Advisor (RIA), bank or insurance company; and has acknowledged in writing that they are a fiduciary with respect to the plan. When plan sponsors hire a third party, such as a financial advisor, to provide investment advice as an ERISA 3(21) fiduciary or to take responsibility for the management or disposition of the plan assets as an ERISA 3(38) investment manager they need to understand how these engagements can assist them in carrying out their fiduciary duties. 2

3 General Fiduciary Standards ERISA establishes extensive standards governing fiduciary conduct in the management of retirement plan assets. 3 It requires that any plan fiduciary discharge its duties for the exclusive purposes of providing benefits to plan participants and beneficiaries, and defraying the reasonable expenses of administering the plan. 4 In other words, a fiduciary has a duty of loyalty to the plan and its participants and beneficiaries. ERISA requires plan fiduciaries to act with the highest standard of care. Fiduciary duties under ERISA are the highest known to the law. 5 Plan fiduciaries must act with the care, skill, prudence and diligence that a prudent person acting in a like capacity and familiar with such matters would use in the same situation, including in the selection of providers. 6 This is also known as the prudent expert standard, because fiduciaries are required to act at the level of a prudent person who is familiar with such matters when taking action with respect to plan investments. If the plan permits participant-directed investments, plan sponsors are responsible for the prudent selection and monitoring of the plan s investment offerings. ERISA also requires diversifying the plan s investments, so as to minimize the risk of large losses. 7 In that regard, it is also considered best practice to follow a prudent investment policy statement. Fiduciaries must also avoid conflicts of interest and acts of self-dealing. 8 Finally, a plan fiduciary must carry out its duties in accordance with the plan and trust documents insofar as they are consistent with the law. 9 If a fiduciary violates any of these duties, he or she will be liable to the plan or the plan participants for any losses resulting from such violations. 10 The fiduciary may also be personally liable for significant statutory and criminal penalties. 11 Criminal penalties for a willful violation can be up to $100,000 in fines and up to 10 years in prison. 12 With respect to civil penalties, ERISA section 502(l) provides for a civil penalty of 20% of the applicable recovery amount from the fiduciary, which represents losses incurred by the plan, disgorged profits, and any amount necessary to achieve correction of the fiduciary breach. To that end, participants and the Department of Labor (DOL) can file lawsuits against the fiduciary in order to provide for money from a fiduciary either as a result of a settlement or a court order. 3

4 Engaging Third-Party Fiduciaries As previously mentioned, plan sponsors can hire third parties to assist them with certain duties, including investment decisions. Plan sponsors typically hire financial advisors to either provide investment advice as a 3(21) fiduciary or to take full responsibility for investment decisions as a 3(38) investment manager. The roles and responsibilities for third parties providing these services are further outlined below. investment advice fiduciary ERISA Section 3(21) ERISA s definition of a fiduciary includes any person who exercises any authority or control respecting the management or disposition of plan assets. Even if an investment provider lacks such control, however, he or she would also be a fiduciary as a result of rendering investment advice with respect to plan assets for a fee or other compensation, or if he or she has any authority or responsibility to do so. Generally speaking, investment advice provided to a plan under ERISA 3(21) involves a third party recommending investments for the plan based on criteria that have been established by the plan sponsor or investment committee that is typically outlined in the Investment Policy Statement. This is sometimes referred to as a co-fiduciary solution, because the third party making the recommendations agrees to be a fiduciary with respect to investment recommendations and selections. Under this arrangement, a plan sponsor or an investment committee is also a plan fiduciary with respect to the selection and monitoring of the third party and the investment options. Such plan fiduciaries have a continuing duty separate and apart from the duty to exercise prudence in selecting investments at the outset to monitor, and remove imprudent, investments. 13 To that end, plan fiduciaries cannot reflexively and uncritically adopt investment recommendations. 14 In other words, plan fiduciaries must make certain that reliance on an expert s advice is reasonably justified under the circumstances, and must also periodically monitor investments to ensure continued investment is prudent. Plan sponsors who engage a third party to provide investment advice as an ERISA 3(21) fiduciary are frequently unaware that they remain plan fiduciaries, with all duties and potential liability that accompanies a plan fiduciary. They do not realize they remain jointly responsible for the plan s investments and have merely engaged an ERISA 3(21) fiduciary to help them carry out their fiduciary responsibilities. investment managers ERISA Section 3(38) Under ERISA, a plan may provide for the named fiduciary to appoint a Section 3(38) investment manager to be responsible for investment matters, including the power to manage, acquire and dispose of plan assets. 15 In contrast to the Section 3(21) investment advice fiduciary, the ERISA 3(38) investment manager does not simply provide the plan sponsor with a menu of funds to approve or reject, it selects and manages the lineup of funds the plan will use, without input from the plan sponsor. Proper use of an ERISA 3(38) investment manager allows plan sponsors and trustees to shift more of their fiduciary responsibilities to the investment manager. If an ERISA 3(38) investment manager is properly appointed and monitored by the named fiduciary, the plan sponsor will not be liable under ERISA for the acts or omissions of the investment manager, and will not be required to invest or otherwise manage any asset of the plan which is subject to the authority of the investment manager. 16 This means that the investment manager becomes responsible for all aspects of the investment process and is required to act prudently when it decides to buy or sell securities or make investment decisions on behalf of the plan. 4

5 The plan sponsor will then remain only liable for selection and monitoring of the investment manager. In that ERISA allows more fiduciary obligations to shift under a Section 3(38) arrangement, the substantive and procedural requirements an investment manager must satisfy under ERISA are more stringent than those for an ERISA 3(21) investment advice fiduciary. Unlike an ERISA 3(21) investment advice fiduciary, an ERISA 3(38) investment manager must be formally appointed. An investment manager must also be either a registered investment adviser under federal or state law, a bank under the Investment Advisers Act of 1940, or an insurance company qualified to manage, acquire or dispose of plan assets under the laws of more than one state. 17 Finally, the investment manager must acknowledge, in writing, that it is a fiduciary with respect to the plan. 18 A qualified, properly appointed and properly monitored investment manager allows other plan fiduciaries to be shielded from liability for investment matters. However, the named fiduciary that appointed the investment manager always retains oversight responsibility and, therefore, must periodically review the investment manager s performance including, but not limited to, evaluating whether the investment manager s fees are reasonable. In that the Section 3(38) arrangement affords plan fiduciaries the ability to shift investment responsibilities, a Section 3(38) arrangement is far less risky than a Section 3(21) arrangement for plan fiduciaries who do not want or intend to retain investment fiduciary control or liability. Note that if a plan sponsor appoints a person as investment manager who fails to satisfy the above requirements, the appointing party may be held liable for imprudent investment decisions that result in loss to the plan. That is not to say that a defectively designated investment manager will not be a plan fiduciary; rather, other plan fiduciaries will not be protected from the consequences of the investment manager s actions. 19 5

6 How to Select and Monitor a Section 3(38) investment manager or a Section 3(21) investment advice fiduciary In both Section 3(38) and Section 3(21) arrangements, the plan sponsor is responsible for the prudent selection of a fiduciary. Failure to be judicious in this process may result in unwanted liability. In selecting an ERISA 3(38) investment manager or an ERISA 3(21) investment advice fiduciary, a plan sponsor should consider the following questions (in addition to ensuring the third party meets the requirements of ERISA Section 3(38) or 3(21), as previously set forth): 1. Is the 3(38) investment manager or 3(21) investment advice fiduciary adequately insured? It is important to also evaluate the financial health of the organization beyond insurance how is the advisory firm positioned for longevity? What assets does the organization have to support potential claims? Does the 3(38) investment manager or 3(21) investment advice fiduciary have an investment process which conforms to that of an expert? What are the composition and credentials of its investment team? How many professionals support the investment process? Does the firm have appropriate resources and processes to prudently cover all asset categories offered to plan participants (i.e., stable value)? How are potential conflicts of interest addressed in the contract or ADV? Are proprietary investment options explicitly prohibited/ excluded from the contract? Has the investment manager/adviser s organization been the subject of an investigation by any regulatory or government agency relating to their ERISA fiduciary services? Have regulators or independent auditors routinely examined the investment manager/adviser s organization? Has the investment manager/ adviser s organization ever been the subject of any litigation? Have there been any material changes to the investment manager/ adviser s organization s written fidelity bond or errors and omissions insurance? Have there been any changes to the investment manager/adviser s organization s written fiduciary status in relation to the plan? Has the investment manager/ adviser s organization disclosed all sources of compensation? What are the investment manager/ adviser s Section 3(38)/3(21) assets and plans under advisement? Does the organization have appropriate policies and internal controls relating to ERISA 3(38) and 3(21) services? 6

7 Ongoing Monitoring of Investment Fiduciaries The plan sponsor is also required to prudently monitor a Section 3(38) investment manager or a Section 3(21) investment adviser. Because plan sponsors are typically not investment professionals (hence the desire to shift responsibility for investment decisions), they are expected to monitor investment managers and advisers as they would any other service provider, focusing on their overall performance and the extent to which their promised services are being delivered for a reasonable fee. Following are the types of questions for a plan fiduciary to consider when monitoring a 3(38) investment manager or 3(21) investment advice fiduciary: 1. Has the investment manager/adviser acknowledged in writing that it is considered a plan fiduciary? Has the investment manager/adviser delivered all promised fiduciary reports to the plan sponsor? Has the investment manager/ adviser assisted in the development of the Investment Policy Statement for the plan? Has the investment manager/adviser selected plan investment options consistent with the Investment Policy Statement? Does the investment manager monitor (and replace, as necessary) investment options consistent with the plan s Investment Policy Statement? Does the investment adviser monitor (and recommend, as necessary) the replacement of investment options consistent with the plan s Investment Policy Statement? Does the investment manager/adviser report performance compared to peer groups, appropriate benchmarks and strategy objectives? Does the investment manager provide adequate rationale and documentation for investment changes it makes? Does the investment adviser provide adequate rationale and documentation for investment changes it recommends? Are there periodic meetings to explain the plan s investment performance, and interim communications when required, with a written report for every meeting? Does the investment manager work with your provider to execute fund changes? Since the investment manager/ adviser first became a plan fiduciary, have there been any changes to the management or ownership of the investment manager/adviser s organization? Since the investment manager/ adviser first became a plan fiduciary, have there been any organizational changes to the investment manager/ adviser s organization that may impact plan management? Since the investment manager/ adviser first became a plan fiduciary, has the investment manager/ adviser s organization s status under the Investment Advisers Act of 1940 changed? In Conclusion An ERISA 3(38) investment manager will clearly relieve a plan sponsor of more of the fiduciary risk associated with the plan s investments and can assist the plan sponsor in complying with the fiduciary requirements of ERISA. When working with an ERISA 3(21) investment advice fiduciary, the plan sponsor retains full responsibility for the investment selection decisions; whereas when working with a 3(38) investment manager, the plan sponsor is only responsible for the oversight of the 3(38) investment manager s performance, which can be a less involved process. Still, because an ERISA 3(38) arrangement affords plan fiduciaries the ability to shift investment responsibilities, an ERISA 3(38) arrangement is more beneficial for plan fiduciaries that do not want or intend to retain investment fiduciary control or liability. However, there are circumstances under which a Section 3(21) investment advice fiduciary may be preferred, such as in the case of a plan with an investment committee that has members with significant knowledge and experience with investment matters who are willing to assume more fiduciary responsibility. In summary, engaging an ERISA 3(21) investment advice fiduciary or an ERISA 3(38) investment manager can assist plan fiduciaries in mitigating their fiduciary risk. It is therefore important to understand the differences between these arrangements and determine which one can best address their needs. 7

8 1 ERISA Section 402(a)(2). 2 ERISA Sections 402(c) and 403(a). 3 ERISA Section ERISA Section 404(a)(1)(A). 5 Donovan v. Bierworth, 680 F. 2d 263, 271 (2nd Cir. 1982). 6 ERISA Section 404(a)(1)(B). 7 ERISA Section 404(a)(1)(C). 8 ERISA Section ERISA Section 404(a)(1)(D). 10 ERISA Section 409(a). 11 See ERISA Section 502(l) and Code Section ERISA Sections 501(a) and 501(b). 13 Tibble v. Edison Int l, 135 S.Ct. 1823, 1828 (2015). 14 Tibble v. Edison Int l, 729 F.3d 1110, 1138 (9th Cir. 2013), vacated and remanded on other grounds. 15 ERISA Section 402(c)(3). 16 ERISA Section 405(d)(1). 17 ERISA Section 3(38)(B). 18 ERISA Section 3(38)(C). 19 Whitfield v. Cohen, 682 F. Supp. 188 (S.D.N.Y. 1988). Tax laws are complex and subject to change. Morgan Stanley Smith Barney LLC ( Morgan Stanley ), its affiliates and Morgan Stanley Financial Advisors and Private Wealth Advisors do not provide tax or legal advice and are not fiduciaries (under ERISA, the Internal Revenue Code or otherwise) with respect to the services or activities described herein except as otherwise provided in writing by Morgan Stanley. Individuals are encouraged to consult their tax and legal advisors (a) before establishing a retirement plan or account, and (b) regarding any potential tax, ERISA and related consequences of any investments made under such plan or account Morgan Stanley Smith Barney LLC. Member SIPC. KP /17 CRC (02/17) CS /17