Duties Of Retirement Plan Fiduciaries In The Wake Of Mutual Fund Settlements

John E. Rich, Jr.
Director & Chair, Tax Department
April 1, 2005

In the last several months, a number of mutual fund providers have either been fined or reached multi-million dollar settlements with regulators over investment practices. Most recently, Citigroup and Putnam were fined $20 million and $40 million respectively to resolve allegations of federal regulators that these firms did not inform investors that brokers were paid to recommend certain mutual funds creating a conflict of interest. This round of settlements follows earlier announcements of investigations and settlements involving other mutual fund practices such as late trading and market timing. These settlements and investigations raise a number of issues for employers who utilize mutual funds as investment vehicles for retirement plans.

Federal Law Governing Fiduciary Responsibilities in Retirement Plans
The Employee Retirement Income Security Act of 1974 (“ERISA”) requires employers and other fiduciaries associated with 401(k) and other types of retirement plans, to act solely in the interests of plan participants and beneficiaries. Fiduciaries must act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting as a fiduciary and familiar with retirement plan matters would use to manage a retirement plan. As a result, fiduciaries must make a careful inquiry into the merits of any investment offered by the retirement plan. This inquiry must include consideration of all fees and expenses paid from plan assets because generally the higher the fees and expenses, the lower the return for participants’ plan accounts. This inquiry would include amounts that are not disclosed to the fiduciary because of the mutual fund company practices. In other words, fiduciaries have a duty to inquire about non-disclosed fees and expenses regardless of the source and recipients of these fees and expenses. The recent conflict of interest settlements have brought to light the existence of some of these hidden payments. If the fiduciaries do not have sufficient time, knowledge or skill to evaluate investments, the fiduciaries must obtain expert advice in making the decision.

Importance of Investment Policy Statement
In addition to an initial inquiry into the investments offered by the retirement plan, fiduciaries have a continuing duty to monitor the investments selected. In the case of a 401(k) plan that allows employees the opportunity to self-direct their own accounts among various mutual funds, the fiduciaries must monitor and evaluate whether it is prudent to continue to offer the original funds. In addition, when fiduciaries become aware of events involving or potentially involving their plan’s service providers, the fiduciary has a duty to investigate the situation to ensure that there will not be any adverse impact on their plan’s investments.

Employers should adopt a written investment policy statement to formalize the process for a plan’s investment-related decision making. The policy statement will describe how investment decisions are related to a plan’s goals and objectives, as well as the plan’s strategic vision for plan investment. The policy statement should also contain the standards for investment selection and monitoring criteria. An investment policy statement ensures continuity in decision making as plan fiduciaries change and helps protect the sponsor from inadvertently making capricious or arbitrary decisions. If a retirement plan does not have an investment policy statement, it could be difficult for the fiduciaries to demonstrate that they have satisfy their duty to appropriately monitor investments. ERISA provides that fiduciaries are financially responsible for reimbursing a retirement plan for losses that are incurred if the fiduciaries have not complied with their responsibilities.

What Fiduciaries Should Do in the Current Environment?
Given the number of investigations and settlements, as part of their duty to monitor plan investments, fiduciaries need to consider whether to investigate or review the practices of the funds owned by their plans regardless of whether any currently implicated funds are owned. If a plan owns a fund that has been implicated, some action is required. The first step is to review public information and request specific information from independent investment consultants and, where possible, fund managers to determine whether the plan is paying undisclosed fees to the mutual fund, brokers or other parties. The next step is to seek the elimination or reduction of the fees. If plan fiduciaries do not have the expertise to evaluate the information and analyze the alternative courses of action, investment and legal advisors should be consulted to ensure that plan fiduciaries are acting prudently.

It is important to keep in mind that a fiduciary does not always have to make the right decision. Fiduciaries are not responsible for ensuring that retirement plans pay the absolute lowest fees and expenses. The legal standard is whether the fiduciary’s action and conduct led to a well-informed evaluation of the fees and expenses paid by the plan. If a fiduciary diligently investigated the relevant information, a court will generally uphold the fiduciary’s judgment even if in hindsight it is possible to conclude that the fiduciary did not make the correct decision. In order to prove that a prudent decision-making process was utilized, the fiduciary should document the process followed in writing.

In summary, retirement plan fiduciaries must continually monitor their investments. The best way to ensure that this is done appropriately is to implement a detailed investment policy statement. The recent publicity about broker conflicts of interest is a reminder that fiduciaries need to ask their service providers about all nondisclosed fees and expenses. If fiduciaries become aware that their service providers may be paying hidden fees and expenses that adversely impact plan participants, fiduciaries must make additional inquires in order to comply with their fiduciary duties.