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The Pursuit of Procedural Prudence: Do You Have the Expertise?

As a plan fiduciary, you are expected to possess the necessary expertise to meet all of your obligations under ERISA, and as part of and relative to those obligations, you are expected to proceed in your role in a prudent manner.

While perhaps the least defined of ERISA duties, the duty of prudence requires significant attention, as it can affect the fulfillment of all other duties for which you are responsible, and the effectiveness of your fiduciary compliance altogether.

Four Key ERISA Fiduciary Duties

  1. Loyalty, which requires plan sponsors to act exclusively in the best interest of plan participants and beneficiaries.
  2. Diversification, which requires plan sponsors to diversify portfolios to minimize chances of large losses and in the case of defined contribution plans, to offer participants at least 3 materially different investment options.
  3. Plan adherence, which instructs plan sponsors to follow plan documents.
  4. Prudence, which requires plan sponsors to act in a deliberate and methodical manner when making decisions by following a prudent process.

Prudence is the most important because it underpins the fulfillment of the other key ERISA duties. Therefore, in and of itself, it can be said that prudence carries the greatest amount of risk relative to the other duties. As such, a plan sponsor’s actions will be evaluated by the process used to make the decision (procedural prudence) and the result of the decision (substantive prudence). Anyone can follow a “process”, but a “prudent process” requires looking at the right information in the right way. This presents a greater challenge for plan sponsors.

The Risk of Responsibility

As fiduciaries, most plan sponsors are aware of the risk of personal liability if there is some allegation of wrongdoing. The litigation risk is very real and there is the possibility of significant losses, as exemplified by the ABB, Inc. case in which ABB, Inc. was found to have breached its fiduciary duties and was assessed a $35 million penalty – a penalty resulting largely from the inability to follow a prudent process (408(b)(2) Next Steps: A Call to Fiduciary Duty). Further, undesirable by products of allegations and certainly litigation are the resulting negative press  and impact on employee morale. Looking at the right information in the right way is in fact critical.

A delay in delivering a summary plan description is less likely to trigger participant displeasure compared to high fees or investment errors that can have a dramatic impact on participant retirement outcomes. In following, it is certainly not surprising that most of the allegations against 401(k) sponsors have centered on things that impact participants the most – things that cost them money, such as high fees and poor investment performance.  When left unchecked, such variables can give rise to allegations of wrongdoing. Effective procedural prudence can help to avoid such circumstances.

The Rule of Compliance

Obviously, all plan sponsors want to avoid these situations. So what does ERISA require?

ERISA requires plan sponsors to follow the Prudent Man Standard of Care in carrying out their fiduciary duties. The Prudent Man Standard of Care from ERISA 404(a)(1)(B) states that a fiduciary must act:

“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.”

The Standard of Care is clear. The actions of a plan sponsor are compared to a person “familiar with such matters.” Pay careful attention to this point.

As a fiduciary you should seek outside expertise in areas in which you do not possess the necessary knowledge so as to ensure compliance. As aforementioned, effective compliance involves a prudent process. This denotes asking the right questions, critically examining the pertinent issues, performing quality analyses, and properly documenting your prudent process. As an example, in the wake of 408(b)(2) fee disclosure, many plan sponsors are now analyzing plan fees. During such fee reviews, concepts such as allocating ERISA credits to participants, bundled versus basis point pricing models, and fee leveling (Fee Leveling – What Defined Contribution Plan Sponsors Should Know) may be introduced. As a plan sponsor are you “familiar with such matters”? Is your outside expert “familiar with such matters”? Do you have documentation that provides evidence of procedural prudence – did you look at the right information in the right way?

The Burden of Proof

If there is an allegation made against your plan it will encompass some level of procedural prudence. Documentation to prove a prudent process is paramount. The big question will be whether or not your documentation of procedural prudence stands up in court. Can the following questions be answered in the affirmative?

  • Could an “outside observer” follow your deliberations and proceedings by reviewing meeting minutes?
  • Are your documented processes related to plan investments in alignment with your investment policy statement guidelines?
  • Does monitoring criteria outlined in the investment policy statement match your performance monitoring criteria?
  • Are plan reports prepared and reviewed according to a prescribed schedule?
  • Do plan reports contain executive summaries explaining the purpose of the report?

You will be judged based on the prudent process followed, and if another knowledgeable, prudent expert in a similar situation would do the same thing.

Familiar Reality

In many organizations, plan committees, whose members are generally fiduciaries to the plan, consist of a cross-functional group of individuals whose respective day-to-day primary job functions do not include plan oversight and compliance, generally speaking, most committees lack the expertise and time to effectively fulfill their fiduciary obligations. Yet, all too often committees operate under the assumption that they are fulfilling their fiduciary duties through periodic plan initiatives and monitoring, perhaps in conjunction with the plan service provider. In reality, the absence of a fluid, documented and objective process could lead to undesirable consequences. To avoid such outcomes, many fiduciaries hire consultants or advisors to assist with fiduciary compliance. However, even if you work with an outside expert or delegate a portion of your fiduciary duties, it does not exempt you as a fiduciary, therefore, it is critical to validate the level of their expertise.

The Solution

f you have not already done so, consider hiring a qualified expert to help you meet your fiduciary duties, especially that of procedural prudence. If you are already working with a third party expert, you should review their level of expertise periodically.

A word of caution about this process. There are no standard requirements to claim the title of retirement plan advisor. There is a wide spectrum of investment professionals soliciting plan sponsors ranging from neophyte advisors to seasoned consultants. Often, existing relationships dictate the hiring decision. It certainly makes the process a bit easier, but should not be the overriding decision factor.

As a fiduciary it is critical that you identify the experts who can truly protect you and provide documented evidence of procedural prudence. Areas of focus to identify expertise:

  • Experience of the firm
    • Look for retirement plan consulting expertise in addition to investment consulting expertise
    • Know the years of experience specific to the retirement plan area
    • Identify firms with deep benches and strong intellectual capital
    • Find out the number of retirement plan clients
    • Discern whether the firm’s knowledge and market intelligence stems from third party purchased data or if it originates from hands-on experience
  • Quality of work
    • Find out if “check the box” tools are employed or customized documentation.
    • Look for the ability to link governance documents with reporting for stronger evidence of procedural prudence
    • Ensure maintenance of internal due diligence regarding plan investment recommendations to further insulate you in the event of a negative investment scenario
    • Ensure record retention to back you up in the event of an inquiry (ERISA requires record retention for 6 years)
  • Most importantly obtain a list of the specific fiduciary and non-fiduciary services that the firm will provide.

Whether you are hiring a consultant or performing an evaluation of your current consultant/advisor, carefully verify that your selected firm/individual can truly provide the level of procedural prudence necessary for fiduciary compliance.