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:
- A description of the investment,
- The term of the investment,
- The timeline of capital contributions,
- A summary of the fees that the manager or their affiliated companies will receive by introducing us to this particular investment or strategy, and
- 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:
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Josh Yager, Esq., CFP®, ChFC®
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.