Retirement Plan Fiduciaries
Most tax-advantaged retirement plans require that assets be held in a trust, and to protect those assets, the law requires that those in charge of retirement plan assets be held as fiduciaries, who must put the needs of the plan participants 1st. The fiduciary is not permitted to engage in transactions that would allow him to profit at the expense of the plan participants or where there could be a potential conflict of interest. This is particularly true for fiduciaries who have discretionary authority, meaning that they can make decisions with the plan's assets without consulting others, including the participants.
Additionally, to prevent any temptation for the employer to use plan assets for its own use, employers must transfer any salary deferrals to the retirement plan account by the 15th day following the month in which the deferred wages were earned.
To ensure the value of contributions by the employer, employers can only contribute cash to the plan, not property whose valuation may be questionable. Moreover, plan assets cannot be used to purchase another company or a controlling interest in another company that may benefit the employer or plan sponsor.
Who is a Fiduciary
The law classifies anyone who administers retirement plans as fiduciaries so that they have the best interest of the participants. Hence, they have a legal liability if they fail that duty. Fiduciaries must manage the assets of the plan and pay distributions. Additionally, since the fiduciary will not have expertise in all areas, especially investments, the fiduciary can hire 3rd parties to provide investment advice.
Plan fiduciaries could include the employer, plan trustees, officers of the company who select the trustees or the paid investment managers, and any investment managers paid by the retirement plan. Although the employer establishes and terminates retirement plans, such actions are not fiduciary responsibilities, since they depend on the profitability of the business, the size of the business, and retirement plans are often used as recruitment incentives — hence, setting up or terminating a retirement plan are considered business decisions. Moreover, ancillary service providers — people who render a service to the retirement plan, such as attorneys, accountants, or external plan administrators — are not fiduciaries.
Fiduciaries are required to manage retirement plans except plans that only cover the owner or spouse or both, and 403(b) plans, or other plans where the employer does not contribute, or plans sponsored by the government or church.
To prevent conflicts of interest, fiduciaries must act to the exclusive benefit of its participants; the fiduciary cannot benefit from any transactions involving the plan's assets, which is sometimes called a collateral benefit. Pursuant to the exclusive benefit rule is that any fees paid by the retirement plan must be reasonable. If a fiduciary cannot prevent or eliminate a conflict of interest, then it must be disclosed. So, for instance, fiduciaries cannot accept any kind of incentive, such as meals or entertainment, to select an investment plan by a particular sponsor.
Fees paid by the plan participants must be disclosed, including administrative fees, and fees paid for third-party services. The schedule of fees must be reported annually and the actual fees paid must be disclosed quarterly.
One type of fee that usually cannot be eliminated are the 12b-1 fees that are commonly charged by mutual funds, which are often paid to investment managers for recommending the fund to their clients. Although 12b-1 fees cannot generally be avoided, they should be disclosed to the participants.
Fiduciaries are expected to exercise a standard prudence when managing the assets, paying distributions, or selecting investments. The fiduciary should not undertake undue risk to the plan's assets. The standard prudence requires that investments be diversified and that any undertaken risks are commensurate with the potential reward of the investment. Another primary concern is to maintain liquidity so that distributions to retirement participants can be paid when due.
The need for diversification requires that the fiduciary consider what other assets are already held by the retirement plan so that risk can be mitigated. Generally, fiduciaries should seek to maximize the Sharpe ratio, which is a measure of the portfolio return compared to the undertaken risk as measured by the standard deviation of the portfolio return over several years. Even when the fiduciary selects different sectors for investments, there should also be diversification within the sector.
Investment strategy must conform to the plan document and the investment policy statement (IPS). Generally, certain risks must be completely avoided, such as purchasing derivatives, using margin for stock purchases, or selling short.
The fiduciary's responsibility will be less for those participants who can manage, and actually do manage, their own investments. However, the fiduciary will still be responsible for only allowing safer investments, which is why most retirement plans do not offer futures, short selling, derivatives, options, and other risky assets or strategies. IRC §401(a)(35)(D) requires that at least 3 investment options with different risk reward ratios be offered to plan participants, although one of the options can include employer stock. For the safe harbor to apply, participants must be informed that they are able to change their investments at least quarterly. Sufficient information must also be provided about each investment option so that each participant can make an intelligent choice. Since most retirement plans primarily offer mutual funds, the mutual fund prospectus is considered sufficient information.
Because many employees do not exercise their option to select investments, a fiduciary can only avoid liability if the plan offers a qualified default investment (QDI) that will provide sufficient diversification to protect the plan's participants. However, the QDI cannot simply be a money market fund. Consequently, most plans select either target date funds or balanced funds as the QDI. Many plans also use an investment advisor who charges a fee for the recommended investments. Using a QDI for employees who do not choose their own investments relieves the fiduciary of any liability for imprudent investments.
To avoid conflicts of interest and self-dealing, many parties are prohibited from being involved in transactions with the plan's assets, including the employer, unions, 10% owners of the plan sponsor or employer, employees, and anyone related to the above groups or with companies where any of the above groups have a significant ownership interest.
Self-dealing is simply any transaction in which the fiduciary benefits, such as receiving kickbacks, or other perks for selecting particular investments. Additionally, fiduciaries are prohibited from buying assets for the sole purpose of increasing their price so that the fiduciary can sell his own private holdings of that same asset at a higher price.
Regulations also include a list of prohibited transactions, most of which involve parties related to the retirement plan or who provide services to the plan from engaging in transactions with the plan assets. Specifically, it may not lend or furnish any goods or services to these related groups. Furthermore, the retirement plan cannot invest any more than 10% of its assets into the plan sponsor or employer. The rule for not buying a large stake in the employer is to prevent employees from trying to gain a controlling interest in the employer and to reduce risk through diversification.
There are 3 types of exemptions to the prohibited transactions. The 1st exemption is the statutory exemption, which exempts retirement plan and ESOP loans, and reasonable compensation to plan service providers, banks or insurance companies. The Department of Labor (DOL) also provides a long list of administrative exemptions. The DOL can also provide an individual exemption if the fiduciary shows that the exemption is reasonable and serves the best interest of the plans' participants.
A fee exemption also applies to the fees charged by investment advisors for the plan, since that is how they are generally paid. However, the fees must satisfy several criteria to avoid being characterized as self-dealing:
- The fees must be flat, meaning that they cannot vary depending on the investment options, unless the investments involve algorithmic trading.
- The plan's fiduciary must approve of the fees and monitor the fees continually.
- To ensure compliance, the fees must be audited annually.
Breach of Fiduciary Duty
If a fiduciary duty is breached, then the fiduciary will have a personal liability for losses from the breach, including a clawback of any profits because of personal transactions with the plan assets. Fiduciaries can also be held liable for the breach of fiduciary duty by other fiduciaries of the plan, such as helping to cover up other's malfeasance. If the regulators do determine that there was a breach of fiduciary duty, then both of fiduciary and any parties to the self-dealing transactions may be assessed a 15% excise tax for the breach.
A major problem with assessing so much liability on fiduciaries is that few people would want to accept the responsibilities, especially without adequate compensation. The primary method to limit liability is to document every investment decision, with clear explanations of investment objectives and how it conforms to the objectives of the plan document and IPS. If the fiduciary delegates any responsibility to other parties, then the duties of those others must be well defined and fully documented. Additionally, the plan sponsor can purchase a fiduciary bond, which is an insurance contract that will indemnify the fiduciaries for any found breach of duties.