A recent paper issued by the Center for Retirement Research documents the surge in 401k litigation over the past five years.
The three main reasons are (1) inappropriate investment options, (2) excessive fees, and (3) self-dealing.
Here is a simple recipe for minimizing the likelihood that a 401k plan will be the subject to a lawsuit. Advisors can use this recipe to help their 401k plan clients avoid trouble, or to open the door with 401k plan prospects that may appreciate a review of their current practices.
Implement a prudent process for making plan-related decisions
ERISA does not specifically identify investment options that are appropriate for a 401k plan. Nor does it impose liability if, in hindsight, an investment option does not perform well.
ERISA does, however, require that fiduciaries have a prudent process in place for selecting and monitoring investment options. The focus is on process, not outcome.
What’s a prudent process?
It starts with people. The people making the decisions must have the necessary skill to effectively deal with the issues under consideration. They must act with care, prudence, and diligence.
In other words, you need knowledgeable people working hard for the exclusive purpose of furthering the interests of the plan.
Discharging fiduciary responsibility is an ongoing effort, not a one-time event. Selecting investments and service providers for a plan is only the beginning.
A prudent process requires that every decision be reviewed periodically. The frequency of review should be determined by the nature of the decision. Create a schedule and live by it.
A prudent process requires definition. Develop an agenda of the issues and factors that will be reviewed and considered in connection with every decision.
The more specific and detailed you can be, the better. Once you develop an agenda, stick to it. Failing to follow your own procedures can, itself, create liability for plan fiduciaries.
Consider developing a statement of investment policy. Such a document can help define and guide the selection and review process for plan investments. It can also highlight the important areas for consideration and help maintain consistency of decision-making over time.
Once developed, be sure to follow the policy.
Document your actions. Even the best procedure won’t protect you if you can’t demonstrate that you followed it.
Plus, a well-documented procedure will help you establish what happened in case you are called upon to do so years later.
Keep the focus on what is in the plan’s best interest
Again, ERISA does not define the types of investments that are appropriate for a 401k plan. Nor does it set specific limits on the fees that may be charged by those investment options or the service providers who work for the plan.
But it does require plan fiduciaries to always act in the best interests and for the exclusive benefit of their plan.
It is perfectly appropriate to use actively managed mutual funds as plan investment options, even though they may have higher internal expenses than passively managed alternatives.
If you are going to do so, however, make sure the fees charged are reasonable and are justified by expected benefits to plan participants.
If you are uncomfortable with how you will justify the use of higher fee actively managed funds, consider offering passively managed funds. You may offer them either exclusively, or alongside reasonably-priced actively managed funds.
This gives plan participants a choice. But if you offer such a choice, consider whether plan participants will benefit from, or be confused by it.
If you offer passively managed funds, don’t assume that their fees are reasonable. There are many passively managed funds that come with unjustifiably high internal expenses.
And, as with actively managed funds, price alone is not the only factor to consider in selecting passively managed funds. Do a comprehensive review.
Be particularly careful if your plan is going to offer proprietary funds of your recordkeeper.
Recordkeepers are incentivized to offer their proprietary funds because of the revenue derived from the management fee. Hold such funds to a high standard if you are going to use them and document your rationale for including them.
Regardless of what investment options you select for your plan, be sure you are using the share class that is most beneficial to your plan.
If you’ve done the work to identify a good line-up of active managers, don’t undermine your effort by using a share class that has higher management fees than are otherwise available to you.
If you need it, get help
Plan fiduciaries are held to a high standard of behavior under ERISA. The liabilities for failing to meet those standards can be serious.
There are plenty of experienced professionals and now a growing number of online resources that can help plan fiduciaries discharge their responsibilities.
ERISA specifically authorizes plans to delegate aspects of investment selection and monitoring to outside professionals. For example, ERISA sections 3(21) and 3(38) allow for the retention of outside advisors and investment managers.
There are also consultants and online resources that can help identify and vet qualified service providers for your plan. This makes it easier than ever to shop and compare.
Take advantage of these resources if you have any doubt about your plan’s ability to navigate the complex requirements imposed by ERISA.
Scott MacKillop is CEO of First Ascent Asset Management, a Denver-based investment management firm. He began his career as an attorney in Washington, DC practicing in the areas of ERISA and securities law. He has been in the asset management business for over 25 years and is a 40-year veteran of the financial services industry. He can be reached at scott@firstascentam.com.
Scott MacKillop is CEO of First Ascent Asset Management, a Denver-based investment management firm. He began his career as an attorney in Washington, DC practicing in the areas of ERISA and securities law. He has been in the asset management business for over 25 years and is a 40-year veteran of the financial services industry. He can be reached at scott@firstascentam.com.
