Must a fiduciary consider whether a participant can understand an investment alternative?

[Peter Gulia]

Yesterday’s proposed interpretation about selecting designated investment alternatives for an individual-account retirement plan that provides participant-directed investment seems to focus on a fiduciary’s decision-making about the investment merits of an investment alternative.

A subpart about complexity speaks to whether the fiduciary knows enough, or with an adviser can know enough, to evaluate, thoughtfully, an investment’s risks and potential rewards related to the complexities.

Some people think a fiduciary ought to consider whether a typical participant can understand the complexities and risks of a designated investment alternative. Even if a fiduciary has done a prudent-expert job in setting the menu, a participant decides whether and how to use an investment alternative.

Others think it’s unnecessary to consider whether a participant can understand a more complex investment alternative because a typical participant cannot understand even the simpler alternative, shares of a publicly available mutual fund regulated by Federal securities laws.

BenefitsLink neighbors, which is your view? And why?

[Paul I]

Many plan fiduciaries have considered these issues when considering whether to include Self-Directed Brokerage Accounts (SDBAs) in the existing investment menus.

The decisions have varied.  Based on the fiduciaries' considerations, some have:

• not added SDBAs because of a concern that the participants will invest unwisely.
• added SDBAs with restrictions on what percentage of a participant's account can be in the SDBA.
• added SDBAs with restrictions on the type of investments in which a participant may invest and often is limited to publicly traded mutual funds or ETFs.
• added SDBAs with restrictions to investments in mutual funds, ETFs or stocks that specialize in the plan sponsor's industry.
• added SDBAs permitting only publicly traded investments.
• added SDBAs permitting trading stock options excluding naked options.
• added SDBAs permitting virtually anything such as limited partnerships, real estate, annuities, physical metals, commodity futures... but subject to approval by the fiduciaries.
• added SDBAs where some of all of the above are permissible but only when a participant passes a test that indicates they comprehend the risks associated with different type of investments.
• added SDBAs and anything goes.

In almost all cases, the fiduciaries' include a disclaimer that a participant directing investments through an SDBA do so at their own risk.

I have seen clients adopt differing approaches and most clients have had a good grasp on their participants' appetite for risk tolerance.  Over the years, I can count on one hand the instances where a participant has seriously hurt themselves financially.

With the new addition of the possibility of adding private equity investments to a plan menu, could be added as permissible investments in an SDBA.  Alternatively, they could get the same consideration from plan fiduciaries that has been given to SDBAs.

To answer your question, I think plan fiduciaries need to know their own level of knowledge about the risks, rewards, and performance metrics of any and all of the investments that they approve to be included in the plan's investment menu.  If there is any investment where the fiduciaries lack such knowledge, then they should not include the investment in the plan's investment menu until they learn more and can make an informed decision.

[ErnieG]

Peter:  I don't see how a Plan Fiduciary can act for the "sole benefit" of the Plan participants and beneficiaries under  ERISA §404(a)(1)(A) when choosing alternative investments as an investment option.  Assuming procedural prudence has been used, and the Plan is intended to comply with  ERISA §404(c) (which is not a shield), how is having alternative investments in an investment line-up for the "sole benefit" when participants typically lack sophistication, liquidity constraints can impair participant rights
Fees, valuation, risk are harder to monitor, and disclosure requirements are more complex.  “The prudence of a particular investment decision depends on the facts and circumstances… including the participants’ level of sophistication and the plan’s investment objectives.” [29 CFR §2550.404a‑1(b)(1)] My belief is this will raise the Fiduciary bar.  While have alternatives in a QDIA, Target Date or Risk Adjusted Fund may lessen the risk, there remains the Plan Fiduciaries' process of choosing such Fund with alternatives as it relates to fees, performance, liquidity, etc.  Plan Fiduciaries when considering this type of investment should be prepared to defend the choice considering, "...the participants’ level of sophistication and the plan’s investment objectives."  This also assumes the Plan Fiduciaries have complete knowledge of these alternatives, or they have hired an expert.

[Peter Gulia]

ErnieG suggests a fiduciary ought to consider the participants’ level of sophistication.

Anyone with a different view or observation?

[Paul I]

This begs the question of whether a fiduciary can know the participants' levels of sophistication to be able to begin to factor this into the fiduciary's decision.

 

[Peter Gulia]

It is difficult to discern participants’ functional literacy to comprehend disclosures that describe an investment.

But some fiduciaries try—even if they guess using proxy measures, such as post-secondary degrees and knowledge-worker credentials.

For example, imagine a fiduciary knows that all of the employer’s workers have at least five years’ post-secondary education. In those circumstances, a fiduciary might reason that participants can read a collective investment trust’s offering memorandum that describes a target-year fund. And can read its explanation that the fund’s trustee anticipates investing up to 20% of the fund’s portfolio in unregistered securities not traded on any exchange and not regularly traded, seeking a 70/30 split between private equity and private debt.

A reader might not know enough to understand the consequences of that information, but might read enough to consider that she ought to ask some intelligent questions or get advice.

A different workforce might be one for which the employer requires no more than that a worker be one lawful to employ and capable of understanding spoken work directions. In those circumstances, a fiduciary might wonder whether a typical participant can meaningfully assent to a kind of investment that, but for the interposition of a retirement plan, cannot lawfully be offered to the general public.

The Labor department’s proposed rule to interpret prudence in selecting designated investment alternatives presumes the ERISA § 404(c) construct that a participant, if furnished sufficient information, is responsible for her choices within the plan’s menu (if its designated investment alternatives were prudently selected).

I recognize that for many workers (including many higher-educated knowledge workers), the § 404(c) conceit might be too much, even for the simplest of publicly available investments. But if a plan provides participant-directed investment (which a plan sponsor may decide as a nonfiduciary), a fiduciary selecting investment alternatives indulges some assumptions about how participants might understand investment alternatives.

My query asks whether a fiduciary selecting designated investment alternatives must, should, or need not consider whether participants can understand an investment alternative more complex than shares of an SEC-registered publicly available mutual fund.

In the proposed rulemaking, the Labor department deliberately sets aside those questions. Yet,  some fiduciaries, and their lawyers and investment advisers, ought to start thinking about this.

[ErnieG]

Peter:   I have interpreted a Fidicuay's duty of Prudence “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…” 29 U.S.C. §1104(a)(1)(B)  “circumstances then prevailing” to include participant characteristics, including their likely level of investment sophistication.  Also, wouldn't we turn also to the DOL Interpretive Bulletin 96‑1 that fiduciaries must consider: “the investment experience and sophistication of the plan participants” when determining the adequacy of information and education provided.  I believe this is not isolated to education but used when evaluating whether a lineup is prudently structured.
 

[Peter Gulia]

ErnieG, in this discussion I ask some open questions because I have not yet formed my view about what ERISA § 404 requires or permits.

That includes thinking about ERISA § 404(a)’s expressed duties of loyalty and prudence, implied duty of impartiality, § 404(c)’s relief for a directing participant’s, beneficiary’s, or alternate payee’s exercise of control over her individual account, and lack of relief to the extent that a loss or harm results from a cause other than the individual’s control.

Because the statute sets both duties and relief with roundly stated standards, there are questions that lack clear answers.

I ask open questions about what BenefitsLink neighbors think or observe.

Thank you for sharing your thoughts.