ERISA 1104(a)(1)(B) re Duty to Prudently Delegate

ERISA 1104(a)(1)(B) re Duty to Prudently Delegate

A trustee has a duty to prudently invest the plan assets on behalf of the beneficiaries. However, few trustees actually take on this complex responsibility alone. In most cases the trustee will hire a third party and delegate these investment duties.

When investment advisory functions are delegated a trustee is responsible for: 1) prudently selecting the vendor; and 2) periodically reviewing the “particular investment or investment course of action” that has been suggested by the vendor. Merely delegating investment duties does not absolve the trustee of responsibility if the vendor invests the trust assets imprudently.

Reliance upon an investment professional’s opinion in making trust investment decisions may be justified if the trustee has taken steps to confirm several factors including: 1) the expert’s reputation and experience; 2) the extensiveness and thoroughness of the expert’s investment process; 3) whether the expert’s opinion is supported by relevant material; and 4) whether the expert’s methods and assumptions are appropriate to the decision at hand (Bussian v. RJR Nabisco Inc., F. 3d 286 – Court of Appeals, 5th Circuit 2000).

Few trustees take the modest amount of time needed to DOCUMENT that they have established a procedure to consider these four factors at the time the delegation occurs and periodically throughout the relationship. The plan’s named trustee and the investment or fiduciary committee that supports them are encouraged to create a short, simple record that demonstrates they have recognized this duty to prudently delegate and have taken steps to periodically monitor their agent’s compliance with this delegation.

Following is a link to a series of questions that can be used by the plan’s investment committee to create this record.

Anodos helps trustees (ERISA, individual, and endowment) save time, reduce their personal risk, and fulfill their fiduciary duties.  We do this by helping the trustee conduct audits of the money managers to whom investment duties have been delegated.  Fiduciaries have an affirmative duty to provide ongoing and independent oversight of the money managers.  What makes us unique is that we do not manage money or sell insurance.  Doing fiduciary audits, benchmarking studies, and performance attribution is all we do.

UPIA §2(b) – Duty to Monitor Risk and Return

UPIA §2(b) – Duty to Monitor Risk and Return

Duty to Balance Risk and Return

The Duty

The preamble to the Uniform Prudent Investor Act notes, “The tradeoff in all investing between risk and return is identified as the fiduciary’s central consideration.”  For most trustees determining the return that was produced by the assets held in trust is a fairly straightforward exercise.

The Conundrum

Most investment managers are required to produce performance data that is compliant with SEC standards. However, defining whether the return was appropriate for the level of risk taken is more complicated.

The Bogert treatise states, “The trustee cannot assume that if investments are legal and proper for retention at the beginning of the trust, or when purchased, they will remain so indefinitely. Rather, the trustee must systematically consider all the investments of the trust at regular intervals to ensure that they are appropriate” (A. Hess, G. Bogert, & G. Bogert, Law of Trusts and Trustees §684, pp.145–146 (3d ed. 2009)).

The Record

To fulfill this duty to monitor the risk and return of the trust assets, a prudent trustee acting in good faith will make the following inquiries:

Target Return

The manager’s actual return will initially be compared to the trustee’s stated return objective. This begs the question whether the trustee has taken steps to define a targeted rate of return for the assets of which they are responsible. If they have not, they are encouraged to do so. The Target Return is stated as an absolute number (e.g., 7.0%) or as a real, inflation-adjusted number (e.g., Inflation + 4.0%).

Benchmarks

No single benchmark can precisely measure the acumen or shortcomings of the investment manager. The most prudent approach is to compare the risk and return of the actual portfolio against several key performance indicators to judge whether the client’s investment objectives are being accomplished. It is rare that a benchmarking study would ever conclusively prove that the manager was either exceptional or incompetent. More often, such a study would conclude that the manager’s performance was or was not within a reasonable range of return and risk outcomes. Common benchmarks that are used in a benchmarking study are: 1) the benchmark suggested by the investment manager; 2) a Strategic benchmark which has very little sub-asset class detail; 3) a Tactical benchmark that is designed to exactly match the sub-asset class allocation of the actual portfolio; and 4) a Peer Group benchmark which is a compilation of the actual return and actual risk of an investment manager the incumbent competes against. (Download Benchmarking White Paper)

Quantitative Risks

In addition to measuring the manager’s performance against several benchmarks, there must be an evaluation of the risk that has been accepted by each manager. Some forms of risk can be discovered through statistical analysis. Often used statistical risk measures include Standard Deviation, Value-at-Risk, Beta, Sharpe Ratio, M-Squared, et cetera.  This type of analysis for a marketable portfolio can be easily done by the software the current investment manager has access to. (If they cannot do this analysis it should put doubt in their ability to balance risk and return since they are not able to monitor the risk of the portfolio.)

Qualitative Risks

Other types of risk cannot be deduced from statistical inquiry and require a more subjective analysis.

  • Lack of Liquidity: The % of the trust that cannot be liquidated within 5 business days

  • Concentration: The % of the trust held in the single largest security

  • Leverage: The % of leverage used by the trust as reflected in a debt-to-equity ratio

  • Lack of Valuation: The % of the trust assets that do not have daily valuation

Most investment managers, if provided with this overview, can help the trustee create a record that these factors have been considered and documented. If the investment manager is unable to help the trustee develop such a record, a prudent trustee will take steps to independently evaluate these factors or find an investment manager that is willing and able to do so.

Ask for Help: Most investment managers, if provided with this overview, can help the trustee create a record that these factors have been considered and documented. If the investment manager is unable to help the trustee develop such a record, a prudent trustee will take steps to independently evaluate these factors or find an investment manager that is willing and able to do so.

Download White Paper: Trust but Verify

Anodos helps trustees develop, maintain, and manage their governance processes. Our support helps trustees and plan committees save time, reduce their personal risk, and fulfill their duties of care. What makes us unique is that providing fiduciary governance support is all that we do. We don’t manage money, sell insurance, or accept revenue sharing fees. We don’t have a horse in the race.

ERISA §1104(a)(1)(c): Duty to balance risk and return with Alternative Investments

ERISA §1104(a)(1)(c): Duty to balance risk and return with Alternative Investments

Prudence not Prescience

Trustees are required to make hard investment decisions. They are to take into consideration the risk of loss and the opportunity for gain associated with each particular investment or investment course of action. ERISA trustees are required to balance the risk and return of each investment decision under conditions of uncertainty. Because ERISA trustees do not have a crystal ball some of their investment decisions, in hindsight, are questioned by disgruntled plan participants. Fortunately, the fiduciary duty of care “requires prudence, not prescience” (DeBruyne Equitable Life Assur).

What is “Alternative”?

At times the plan’s money manager may identify so-called “Alternative” investments that they feel will contribute to a superior risk-adjusted return of the portfolio. But what is an “Alternative” investment? Is a REIT an alternative? Is a structured note an alternative? Is an MLP an alternative? For the sake of this writing we will define an “Alternative Investment” as any investment where: (1) the underlying holdings are not clearly identified or valued daily (lack of transparency); and/or (2) the investment cannot be liquidated within a 3-day settlement (lack of liquidity).

Policy re “Alternative Investments”

In those instances when an “Alternative” investment is recommended by the money manager a prudent trustee will establish a distinct series of procedures to monitor whether the risk and return outcomes expected from these more opaque products are realized. A prudent trustee will ask the money manager to provide the following documentation for the plan’s governance library:

  1. A description of the investment,
  2. The term of the investment,
  3. The timeline of capital contributions,
  4. A summary of the fees that the manager or their affiliated companies will receive by introducing us to this particular investment or strategy, and
  5. Anticipated risk/return characteristics of the investment as measured by a ratio to the S&P 500.

José M. Jara, an attorney at Fisher Broyles in New York City, wrote a fantastic article entitled ERISA fiduciary considerations when incorporating alternative investments in your pension plan’s portfolio which does an excellent job of connecting the dots between an ERISA trustee’s duties and the oversight and monitoring of Alternative Investments. A link to José‘s article follows:

Click Here for ERISA Article

 

Onward,

Josh Yager, Esq., CFP®, ChFC®
805-899-1245
jyager@anodosadvisors.com

 

Anodos helps trustees (ERISA, individual, and endowment) save time, reduce their personal risk, and fulfill their fiduciary duties.  We do this by helping the trustee conduct audits of the money managers to whom investment duties have been delegated.  Fiduciaries have an affirmative duty to provide ongoing and independent oversight of the money managers.  What makes us unique is that we do not manage money or sell insurance.  Doing fiduciary audits, benchmarking studies, and performance attribution is all we do. 

Prudent Delegation Standard of Care: Registered Investment Advisor v. Registered Representative

In the same way a trustee owes duties of care and loyalty to the beneficiaries of a trust, the investment managers also owe a particular standard of care to the trust itself. A prudent trustee will determine what standard of care is owed by the money managers to whom investment duties have been delegated.

Investment professionals can be divided into two types: those professionals for whom fiduciary duties exist and those for whom fiduciary duties to their clients do NOT exist.  Unfortunately, the distinction is sometimes hard to make.  Both call themselves “Advisor,” “Consultant,” or “Planner.” Though they may use a similar moniker their duties of care are not the same.

A Registered Investment Advisor (RIA) is bound by the SEC to apply a fiduciary standard to their advice and is obligated to act only in their client’s best interest.  A Registered Representative is required by FINRA to make investment recommendations that are merely “suitable” for the client’s situation.

A prudent trustee will seek to understand the difference between the “fiduciary standard” and the “suitability standard” and know which of these two the investment professional is bound by.

The fiduciary standard requires the RIA to make recommendations that are exclusively in the client’s best interest.  The suitability standard requires an advisor to make recommendations that are suitable, but may also be in the advisor’s best interest.  Another distinguishing factor between an RIA and a Registered Representative is that the RIA is paid for their investment advice. The advice provided by a Registered Representative is incidental to their primary business – selling investment products.

A trustee is allowed to delegate investment duties to any party – an RIA subject to fiduciary standards or a Registered Representative subject to a suitability standard –  so long as the delegation is made prudently and in good faith (UPIA §9).

At a minimum, the prudent trustee will know which standard of care the investment professional is bound by.  For those of you who serve in a fiduciary capacity and are not certain of the answer to this question, we suggest you ask and document your findings.

Below is a link to a Request For Proposal questionnaire with 24 key questions that a trustee should ask and the investment manager should answer.

Download: Sample Investment Manager Request for Proposal

 

Onward,

Josh Yager, Esq., CFP®, ChFC®
805-899-1245
jyager@anodosadvisors.com

 

Anodos helps trustees develop, maintain, and manage their own governance processes. Our support helps trustees save time, reduce their personal risk, and fulfill their duties of care. What makes us unique is that providing fiduciary governance support is all that we do. We don’t manage money, sell insurance, or accept revenue sharing fees. We don’t have a horse in the race.

 

ERISA §1104(a)(1)(C) re Diversification

DiversificationUS Code §1104(a)(1)(C) states, “A fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries… by diversifying the investments of the plan so as to minimize the risk of large losses…”

The court in Marshall v. Glass/Metal (D. Haw. 1980) noted, “Ordinarily the fiduciary should not invest the whole or an unduly large proportion of the trust property in one type of security or in various types of securities… since the effect is to increase the risk of large losses….”  The court went on to say that a “commitment of 23% of the Pension Plan’s total assets to a single loan subjects a disproportionate amount of the trust assets to the risk of a large loss.” However, neither the statute nor the courts provide clear guidelines on how much is too much. Surely there are circumstances where having 25% of the plan assets in a single investment (like a Treasury bill) would be considered prudent or having less than 20% of the plan assets in one investment would be considered imprudent. There just isn’t a bright-line the trustee can rely upon to know if they have or have not fulfilled their duty to prudently diversify the plan assets.

Fortunately, the court in Liss v. Smith gave us a handy dandy checklist. The court asserted, “In making the determination as to whether the diversification requirement was breached… the Court is to consider (1) the purpose of the plan, (2) the amount of plan assets, (3) financial and industrial conditions, (4) the type of investment, (5) the distribution as to geographical location, (6) the distribution as to industries, and (7) the dates of maturity.”

Where a plan has 10% or more of the plan assets concentrated in any once security the trustee is advised to create a record, using the seven factors of consideration noted in Liss v. Smith, of why their decision to hold this concentrated position is prudent. The code does not prohibit the concentration of the plan assets in any particular security. It merely obligates the plan trustees to exercise care, skill, prudence, and diligence when the trust assets are so concentrated. The admonition then is to create a record demonstrating why the trustees did what they did and when they did it. Write the memo.

And 401(k) trustees, beware. You also have this duty to diversify.  A 401(k) trustee has a duty to confirm that the investment options made available to the participants are themselves reasonably diversified. A 401(k) trustee is not responsible for the acts of a knucklehead participant who puts all of their assets in a fund option that exclusively holds commodities. However, the trustee can be held liable if that particular investment option is itself not reasonably diversified. (See Unisys I (3rd Cir. 1996) and GIW Indus. (11th Cir. 1990).)

As you can see, there is no simple rule to follow, but by documenting and implementing principles and procedures for diversification, ERISA trustees can demonstrate the fulfillment of their duties.

Following is a link to a series of important ERISA cases that every trustee should be familiar with.

Download: ERISA Case Briefs

 

Onward,

Josh Yager, Esq., CFP®, ChFC®
805-899-1245
jyager@anodosadvisors.com

 

Anodos helps trustees (ERISA, individual, and endowment) save time, reduce their personal risk, and fulfill their fiduciary duties.  We do this by helping the trustee conduct audits of the money managers to whom investment duties have been delegated.  Fiduciaries have an affirmative duty to provide ongoing and independent oversight of the money managers.  What makes us unique is that we do not manage money or sell insurance.  Doing fiduciary audits, benchmarking studies, and performance attribution is all we do.