Mailbag; What about Hedge Fund companies using their own hedge funds in their own 401(k) Plan?

Occasionally, we will receive a reader question that requires a little digging into.  When we get one like this, we feel like we should put it up for all to see.

Question from Steve: We have a client who is the CFO of a Hedge Fund company.  100% of their employer match is being automatically put into their own hedge fund.  We believe that this presents a real fiduciary risk for our client, but I was hoping you could site a lawsuit or DOL guidance?

Our Response:  Steve, there are several situations that I think apply to this directly, and specifically with regard to hedge funds.  The first issue is a recent case, Sulyma vs. Intel; reference article here Former Employee Sues Intel Over Hedge Fund.  This lawsuit is ongoing and only alleges imprudent investing in hedge funds meaning that it does not allege a conflict of interest which would be a violation of duty of loyalty to the participants (ERISA §404(a)).  I believe your group would have both the imprudent investing problem as well as a conflict of interest; a possible Self-Dealing violation of ERISA §406(b). So they would be potentially violating two sections of ERISA §404(a) and have a non-exempt Prohibited Transaction under §406(b)(2).

ERISA § 404(a)(1) to act solely in the interest of the participants and beneficiaries of the plans they serve and “(A) for the exclusive purpose of: (i) providing benefits to participants and their beneficiaries; and (ii) defraying reasonable expenses of administering the plan” and (B) to discharge their duties “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.”

In the Intel lawsuit it almost implies that a plan can never invest outside of the current norm (Modern Portfolio Theory, “normal” asset classes, etc.).  So the question is: “How does innovation occur in the prudent world of ERISA plans?”  This is something the industry will have to address at some point.

I also wanted to dig into whether or not there would/could be a Prohibited Transaction Exemption (PTE) for this.  For example, there are PTEs for mutual fund companies selecting their own funds for their employees 401(k) Plan.  Actually American Express tried to cite this PTE when they were sued a few years ago by their employees and when ruled they didn't meet the PTE, Amex settled the case for $15m.  Not to be too technical here but I don't think many of the PT exemptions (listed below) are going to be available to this group.  As mentioned, there is, in fact, a DOL opinion that deals with mutual funds, but, because the hedge fund is specifically not a registered investment company under the Investment Company Act of 1940, I believe they have much less room to act.

The potential conflicts of interest that could arise are numerous.  Here’s just a few.  Are they receiving any fees? Are the plan assets giving them some kind of economy of scale? Are the plan assets used as seed money for a new fund?  Here is full piece on the matter published by Groom Law Group, but the excerpt I clipped out below is what’s applicable.  See the yellow highlighted area.

http://www.groom.com/media/publication/145_erisa_for_security.pdf

Investing Plan Assets in Proprietary Mutual Funds. To the extent that a plan fiduciary also serves as investment adviser to a registered, open-end investment company, the fiduciary’s investment of plan assets in the mutual fund may involve one or more fiduciary conflicts. PTE 77-4 (for client plans) and PTE 77-3 (for the fiduciary’s own, in-house, plans) provide relief for such investments provided that certain conditions are satisfied, including disclosure and consent, and taking steps to avoid double fees. Similar relief is granted under PTE 79-13 for in-house plans of closed-end investment companies (but not for client plans, which effectively prevents most registered hedge fund managers from relying on these exemptions). PTE 84-24 also exempts, among other things, a plan’s investment in a mutual fund where the fund’s adviser or principal underwriter is also a directed trustee, prototype plan sponsor, or other service provider with respect to a plan (but not a discretionary investment manager or trustee, nor the plan sponsor), where an

affiliate of the fund’s adviser or principal underwriter will receive a sales commission with respect to the transaction. For this purpose, sales commissions generally include 12b-1 distribution fees. The PTE does not explicitly authorize the receipt of fund-level advisory and other fees (in contrast to PTEs 77-3 and 77-4), though it appears to do so implicitly. (Note that PTE 84-24 is not limited to the marketing of proprietary funds, though it is often used for that purpose.)

Steve, thank you for the excellent question and the chance to flex our research muscles.

- Jason Grantz

 

2014 ERISA settlements top $1.3 billion

The largest class-action settlements in claims brought under the Employee Income Retirement Security Act topped $1.3 billion in 2014, almost 10 times the sum of the biggest settlements from the previous year.

No other area of employment workplace law saw that kind of explosive growth last year. In fact, settlement numbers in other areas of workplace class-action claims were down, according to the 2015 Workplace Class Action Litigation Report, published by Seyfarth Shaw, a Chicago-based law firm.

The settlement figures for the biggest ERISA cases were higher in 2014 than at any other time in recent history. In 2011, sponsors settled nearly $900 million in the largest cases, the only time since 2009 when the figures were remotely close to last year’s record numbers.

Settlement figures for other areas of labor law paled in comparison: $215 million was settled in wage and hour class-actions, and about $228 million in employee discrimination cases.

By the close of 2014, ERISA lawsuits totaled 7,163, down marginally from 2013. Several “mega-settlements” pushed the ERISA tab for the 10 largest settlements beyond the billion-dollar mark. Among them: 

In August 2014, a $480 million settlement was reached in Meyers vs. Daimier Trucks North America LLC, in a class-action filed by retired UAW workers alleging the truck manufacturer illegally cut benefits. 

The next month, a $415 million settlement was approved in Healthcare Strategies Inc. vs. ING Life Insurance & Annuity Co. 

And in December, a tentative $140 million settlement was reached in Haddock vs. Nationwide after 13 years of litigation. It’s believed to be the largest ever in a service-provider revenue-sharing case. 

A couple of quick conclusions:

• The amounts here are staggering, especially from the perspective of class action attorneys.  Surely, this information will draw more attorneys into the fray.
• Based on these figures, litigation on ERISA cases seemingly is poised to increase in both quantity and voracity.
• As a result, one would naturally expect the number of players in the ERISA space to decrease due to the risks, with a natural result being those firms doing the right thing for their clients and those firms with a truly dominant position in the space where litigation can be fought or absorbed.

-Jason Grantz

Retirement Income Solutions - In-Plan or Out-of-Plan?

Very recently, we had a paper published in the Journal of Compensation and Benefits.  Dr. Greg Kasten is the primary author, and I had a small contribution to it.  You will find it linked here: 

https://www.unifiedtrust.com/documents/RetirementIncome-InPlan-vs-OutOfPlanSolutions.pdf

The paper deals with the recent trend of offering guaranteed income products, often in the form of a Guaranteed Income for Life Annuity, inside of 401(k) Plans.  The purpose of the article was to explore if real demand existed for such products and if so, were they better placed inside of a qualified retirement plan or outside of one?

Summary of findings:  Guaranteed Income for retirement, simply put, is a good idea.  However, the current availability of these products within the 401(k) space is poor.  The products are at an immature stage in their life cycle and are problematic for a variety of reasons.  Thus it would be advisable for a client to seek guaranteed income outside of their 401(k).  

Going a little deeper:

1.) Retirement Income Products are desired to provide a regular guaranteed stream of income.

2.) Many 401(k) service providers are putting these types of products into their 401(k) plan products.

3.) Question: Will employers and participants be better served with these products in a 401(k) Plan or outside of it, post retirement or in an IRA?

4.) Concerns for In-Plan Solutions:

a. Fiduciary Prudence – Is it a good idea for an employer to endorse an income product by putting in a plan as a Designated Investment Alternative?

  i.     Time and resources required to satisfy regulatory requirements for specialized products
  ii.    Lack of benchmarking and monitoring guidance for new products
  iii.   Risk of fiduciary liability for failing to meet participant expectations
        
b.      Product Feature Issues:
 i.      In order for the participant to receive the full value of the Income Product – They must be held  to term.  In many cases, early withdrawal or cancellation can be excessively wasteful.

 ii.      Diversification Issue – Currently, the insurance carrier who supplies the Income Product typically will only offer one Income product, their own.  They will not allow fair competition for the employee to select the one that’s best for them.  It is like offering a 401(k) plan with one balanced mutual fund and a money market fund and saying if they want access to the market, they can invest in the balanced fund.  What if the balanced fund isn't appropriate for that participant?
                     
 iii.     Portability – In order for employers to exercise their fiduciary duty, they must periodically check the marketplace to ensure that what they have is still in the best interest of the participants.  Over the lifetime of a plan, it is likely that a service provider change will occur, typically every 5-8 years on average.  At present, these Income Products are not portable.  This presents a practical issue for the employer.

 Do they make a provider change and force the participant to sell their Annuity early and take a large loss?  If yes, that’s a big fiduciary risk.

 If no, do they operate the plan with multiple service providers, requiring coordination between vendors, excess fees to administer, etc.?

 Do they not make a change to avoid options 1 and 2?  This is akin to being held hostage by a bad investment arrangement.

 iv.     Rollover ability – If participants change jobs, these products can’t be rolled to another employer’s plan, and perhaps not even into an IRA.  For people who change jobs periodically, this presents another practical issue.  What does the participant do in the event of a job change?

 v.     Fee transparency and reasonableness – Because these are individual annuities, the benefit of pricing power from asset aggregation is lost.  As a result, these annuities are often expensive and opaque in nature.  Further due to what is listed above, they would fail the DOL’s definition of a fair or reasonable contract or arrangement.  Specifically, the DOL views a reasonable contract or arrangement as one that is explicit in fees,
written and that can be terminated in a reasonable time frame without fee or penalty.  These currently do not meet that standard.

 vi.    Survivorship -  Most of the current versions of these Income for Life annuities are participant only, meaning that they don’t extend benefits to the surviving spouse in the event of death.  Compared to income products that exist in the open market, this is a very big disadvantage.

5.) Based on the above, the advice is that Income for Life products are a good idea, but are immature in their product life cycle.  Guaranteed Income can be found elsewhere, i.e outside the 401(k) plan, with more advantageous features and benefits.  Until the next generations of these are created, it would be inadvisable to put them into a 401(k) Plan.

Employer Investment Decisions: Any Affect on Performance?

In a recent article from the Center for Retirement Research at Boston College, the authors further validated what is commonly accepted as fact in the 401(k) industry: participants routinely chase performance and subsequently underperform most basic investment strategies (buy and hold and 1/N rule, for example).  Nothing really new here, but good to know that prevailing thought is once again substantiated.   

More importantly, the article explored investment decisions made at the plan level, seemingly by the Plan Administrator, which offered a different perspective on the “investment decisions” debate.  In their research on plan level investment decisions, the authors focused on plan fund performance versus comparable indexes/randomly selected funds (in the same asset class), as well as whether or not fund additions and replacements added value.  The results mirror the same outcome we typically observe at the participant level: like their employees, employers do not improve investment performance through their fund selection and retention decisions.  For specific details of the study’s results, see the entire article here: How Do Employers' 401(k) Mutual Fund Selections Affect Performance?                 

It’s fair to say that when monitoring potential investments, fiduciaries are confronted with an overwhelming amount of information and are often faced with the burden of interpreting conflicting statistics.  One idea that has been gaining traction for employers is to outsource (i.e., allocate) specific duties to others such as a discretionary investment manager or a discretionary corporate trustee.  Discretionary corporate trustees, as independent fiduciaries, relieve the employer of making investment decisions.  Further, they provide their clients with a systematic method for selecting, monitoring and replacing plan investments if needed. 

Third Party Fiduciaries - Myth and Reality

Well, I put together a little opinion paper discussing a recent trend we've been seeing in 401(k) products over the last year or so, the so-called "Third Party Fiduciaries".  The idea behind the paper was to share our views to our Advisor Partners and their clients to help them gain a better understanding of the limitations of arrangements that are being oversold to a degree.  Unbeknownst to me, the paper was picked up by 401khelpcenter and put online today.  So, since it is available publicly anyway, I figured I'd link it here for any to see.  Happy reading.

http://www.unifiedtrust.com/Documents/Third_Party_Fiduciaries.pdf

The Duty to Monitor - Serious Business!

Way back in June of 2009 we wrote a post called 'Fiduciary Delegation - Myth or Reality', located here;


http://the401kplanblog.blogspot.com/2009_06_01_archive.html

The post discusses the merits of (and how to do it) one fiduciary, such as the plan sponsor, delegating away fiduciary responsibility to another fiduciary, such as a discretionary trustee.  It also specifically points to the parts of the ERISA that relates to appointment and delegation.  In our minds when we wrote that we were thinking specifically of how a plan sponsor might shield itself from fiduciary responsibility surrounding selection and monitoring of investments and the risks associated.  Part and parcel to delegation is 'Prudent Selection and Monitoring'.  The idea was that in order to accomplish some risk mitigation, the plan sponsor would need to make sure the appointed fiduciary was prudently appointed and somehow monitored going forward.  What we didn't deal with in the post, but held true then and still holds true now was that ALL parties associated with the plan, fiduciary or not, must be prudently appointed and monitored.  This Duty to Monitor is part of basic fiduciary responsibility.

Flash forward to 2012.  Very recently, Plan Sponsor Magazine published an article specifically dealing with a plan sponsor, Clark Graphics, failing to properly monitor its' functional Administrator (ERISA 3(16)) or their hired service provider, the Third Party Administrator (TPA).  You can find the article here;

http://www.plansponsor.com/Employer_to_Pay_500K_for_Failing_to_Monitor_TPA.aspx

The U.S. Department of Labor (DOL) suit alleged insufficient oversight and mishandling of plan assets resulting in multiple violations of the Employee Retirement Income Security Act. Specifically, the suit alleged that the owners, failed in their fiduciary responsibilities as plan trustees by neglecting to monitor the actions of the plans’ administrator.  The results were that the owner's of the company are being asked to restore the funds to the two plans in question amounting to approx. $500k and that the administrator in question is required to restore the same sum offset by the amount paid by the owners.  One way or the other, the plan participants will be made whole from the administrative mistakes.  Both the owner and the service provider are no longer allowed to serve as fiduciaries or service providers to any other plans.


“Employers that sponsor retirement plans have a fiduciary duty to monitor plan assets and ensure they are handled appropriately and protected,” said Assistant Secretary of Labor for Employee Benefits Security Phyllis C. Borzi. “Contracting with an outside firm to manage those assets does not absolve them of their legal responsibilities.”

We can't think of a better case to illustrate the importance of monitoring service providers.  That said, this case begs the question;

Are the business owner's or an appointed internal committee of business managers the appropriate people to serve as the plan trustee or as fiduciaries responsible for service provider oversight?  

This author would argue that the answer to that question, most of the time, is no, but that these are the individuals often in charge of doing just that.  In our experience, the expert level of care required is mainly not available within the staff of most employers.  The requisite skills, interest or ERISA education is, simply put, not present.  In our opinion, the party in the best position to provide prudent monitoring of service providers is the Retirement Plan Consultant or Plan Advisor.  If you are a Retirement Plan Professional reading this post, we think it would be a great idea to list this amongst your services offered.

Self Directed Brokerage Window Brou Ha Ha!

Well,

It took a few weeks, but the industry made enough noise about FAQ 30 from the DOL's May 7th release of FAQ's pertaining to Fee Disclosure.  This author posted on June 6th that our interpretation of this FAQ is that it made it effectively impractical for Self Directed Brokerage Accounts to exist in plans of any real size.  Phyllis C. Borzi, assistant secretary of labor for DOL's Employee Benefits Security Administration (EBSA), said June 18 at the SPARK National Conference that a second set of FAQ's will be forthcoming after July 1st some time.


At the same conference, she did discuss FAQ 30 and basically stated that the industry was overreacting to it and that the spirt of it is that plan fiduciaries must have policies in place to monitor investments and ensure prudence.  See below for an article that discusses the dialogue.

http://www.bna.com/borzi-addresses-concerns-n12884910110/

Our interpretation of the FAQ remains the same.  Ms. Borzi's comments simply reiterate what we feel which is that Self Directed Accounts can still be used in plans, but from a practical perspective can become a very difficult investment choice because of the need to monitor the underlying holdings.  When these brokerage accounts are not in a vendor window, but rather are scattered among various/many brokers it can be a near impossible task for any plan with a substantial number of brokerage accounts.

MEP's - EBSA Speaks and More Opinions Coming

Well folks, for those of you who know me, you've probably come to understand that I'm a cautious (re: Prudent) person by nature. I'm suspicious of new spins on old concepts and of slick sales pitches which are used to imply one thing, but deliver something less. In that context, I've written, at times sarcastically, about Multiple Employer Plans (MEPs). My underlying message has always been, Proceed with Caution. The idea is that if sounds too good to be true, it usually is and it doesn't hurt to question the idea at its source.

Recently, I personally attended the annual 401(k) Sales Summit put on by the American Society of Pension Profesionals & Actuaries (ASPPA). At the opening of Day 2 of the conference, I attended a session which was a one on one interview of Michael Davis of the Department of Labor by Brian Graff of ASPPA. There were several topics discussed, upcoming fee disclosure rules, the proposed expanded definition of a fiduciary, and yes, MEPs. Mr. Davis, was one of the better DOL speakers I've heard present and I felt he was very clear in that he felt that the current rules governing Qualified Retirement Plans (the ERISA) do not support the concept of an "Open MEP", meaning MEPs for employers that are unrelated and subjected to a collective bargaining agreement. He mentioned this three separate times, so it was very clear. This took place on March 19, 2012.

Interestingly, this news was met with shock/surprise (perhaps anger?) by many of the members of the audience, whom are other pension practitioners like myself. It SHOULDN'T have come to a surprise to anyone as these remarks are consistent with what has been coming out of EBSA for the last year or so, and even again just two weeks prior on March 7, 2012 at Phyllis Borzi's (Assistant Secretary of Labor) testimony to the Special Committee on Aging of the U.S. Senate. Press Release Here --> http://www.dol.gov/ebsa/newsroom/ty030712.html.

In this testimony, Ms. Borzi specifically stated that the idea of "Open MEPs" is not an established concept under ERISA and went on to express concerns about aggressive marketing and promotion of Open MEPs stating that:

1. Adopting Employers are fully releived of fiduciary obligations for administering and monitoring investments and of administrative reporting duties.


2. That by pooling plans together can reduce administrative burdens and costs.

They have stated that two separate Opinions will be forthcoming dealing with the concept of the Open MEP. We are on record (see blog posts from July 2011 and again in August 2011) stating that we believe that any person/entity that may excercise discretion or control over plan assets (whether specifically named in the plan document or not) is a fiduciary as defined under ERISA Section 3(21) and that includes employers who adopt into an MEP. If the rules change, we may also change our opinion. Until then, the message remains, BE CAUTIOUS. Investigate these structures thoroughly including gaining a strong understanding of the relationship between those providing services to the plan (and charging fees) and those in a fiduciary position. We believe that many of the ones we've looked at appear to be in violation of the ERISA Prohibited Transaction rules.

Discretionary v. Directed Trustees: Fiduciary Focus

In case you haven't seen it, yesterday in Morningstar's Fiduciary Focus column, Here --> http://www.morningstar.com/advisor/t/50458854/discretionary-trustees-vs-directed-trustees.htm, author Scott Simon tackled a topic that we, and our firm, Unified Trust, have been tackling for years. The topic is Discretionary Trustees vs. Directed Trustees. I got rather excited, thinking to myself selfishly that finally, someone else is going to discuss the merits of appointing a discretionary corporate trustee and the advantages of that over the more common, less valueable step-sister, the Directed Corporate Trustee.

Note, that while the article is, in my opinion, well written, factual and fairly thorough, I was disappointed, nonetheless, to read that he was referring to Discretionary Trustees in the broader sense. He makes the valid point that all trustees appointed by the Plan Sponsor are Discretionary Trustees unless specifically appointed as a Directed Trustee. That includes individuals, such as business owners or boards or officers appointed in this role. The only place he even mentions that you can appoint a Discretionary CORPORATE Trustee is as an aside where he states how uncommon this appointment is. He doesn't go into the merits of Prudent Fiduciary Appointment, or even compare contrast the differences between the two types of Corporate Trustees. You can incidentally find that on this blog.

Here -->http://the401kplanblog.blogspot.com/2011/11/practical-differences-of-various.html
and
Here -->http://the401kplanblog.blogspot.com/2011/04/338-im-discretionary-trustee-service.html

Disappointment aside, he does make a few very good points.

1.) All trustees are Discretionary unless specifically identified as Directed in the Plan Document at which point the responsibilities of trustee fall back to the Named Fiduciary, typically the Plan Sponsor. The good example of US Airways and their relationship to Fidelity Trust Company is provided.

2.) Directed Trustees provide a very limited array of services, typically asset custody, following direction and ensuring transaction accuracy. They are a highly limited fiduciary, and most (that I've seen) disavow fiduciary status in the contracts.

3.) No one can ensure blanket relief from fiduciary liability. There are only degrees of limited relief. Unfortunately, he doesn't point out that the highest degree is to prudently appoint a Discretionary Corporate Trustee.

So, long story short (too late, I know), Scott Simon wrote a decent article making the point that the devil is in the details, and that Plan Sponsors should be wary of unscrupulous sales pitches about fiduciary relief.

How often is prudent to conduct a vendor search?

As a general rule for Plan Sponsors, it is always good to have a market evaluation that is current on hand. This way, you will always be aware of what the marketplace is offering and have a good idea as to whether your plan is current and still in the best interest of the participants. The question is, how current does this need to be and at what point do new services outweigh the financial and time costs of making plan changes.

Historically, this was always a matter of opinion. When asked, I've usually answered every three to five years should be sufficient to gauge what is new in the market and determine if a change is warranted and disclaimed that by saying that more frequent is also fine. However, it appears that this thought needs to be amended somewhat.

It now appears that if a Plan Sponsor wants to be prudent and avoid a litigation risk in the unlikely event of a law suit, that they should adopt a policy of conducting a market study AT LEAST every three years.

In the preamble to its 2010 service provider fee disclosure rules, the Department of Labor (DOL) assumes/suggests plan sponsors conduct an RFP about every three years. While, in general, preambles are not laws, the 2011 Seventh Circuit Court of Appeals decision in George v. Kraft Foods is reinforcing concerns that this is the new normal for a prudent plan fiduciary.

Kraft's 401(k) plan participants sued for breach of fiduciary duty alleging Kraft should have done an RFP every three years and this failure resulted in payment of excessive investment fees to the plan's service provider. A lower court accepted Kraft's defense that it relied on expert outside consultants to ensure fees were competitive when extending that service provider's contract multiple times and granted summary judgment in Kraft's favor. On appeal, the Seventh Circuit rejected that as an absolute defense and sent the case back for a trial, which could end up costing more than settling.

This decision on appeal has lead some to assert that the rule should be vendor search every three years. However, this is not a mandate at this time. Certainly, as an employee of a service provider, I can tell you that it is not in my firm's best interest to have our clients search the market every three years for a possible vendor change. However, as a fiduciary, we would say that adopting a policy of market evaluation periodically is a very good idea. By formalizing a policy and setting a timeframe, whether 3 years or some other, and then following it, a Plan Sponsor would be engaging in a Prudent Process to verify that what they are offering is still prudent to offer.

This would also reenforce the idea that service providers should earn their fees, not just at the time they win a client, but on a continuous basis. This will enforce better competition and ultimately better service for Plan Sponsors and participants.