What plan fiduciaries should be doing

The following white paper, “Investment Committee Best Practices,” was published by Principal Financial Group in Des Moines, Iowa, and is reprinted with their permission.

It is no surprise that fiduciaries charged with the oversight of the investments in retirement plans subject to the Employee Retirement Income Security Act of 1974 have an exacting responsibility for overseeing the funds held in the plans they serve. This is, however, one of those rare areas where new information from the regulators might be welcome.

It is widely acknowledged that ERISA expects a lot from fiduciaries. As the courts have often observed, the act establishes the highest standard of care under American law. Yet the rules set out in ERISA are very flexible, which has kept it relevant and modern by permitting adaptation to the many changes that have occurred in the financial and plan worlds in the last 30-plus years. However, a flexible law can pose a challenge for fiduciaries because it can lack detail; ERISA offers little specific guidance regarding the procedures and practices these fiduciaries must follow in carrying out their obligations. Even less certain is what standards would apply during an audit to measure compliance with ERISA in this area. So the people subject to these rules have to rely on what little specific guidance there is, using their instincts and their business sense to interpret the rules as best they can.

For the majority of fiduciaries, a part of the solution is the establishment of investment committees to oversee the investment functions of a plan. Often, these committees are merely informal arrangements of executives. It is, as you can imagine, much harder to perform due diligence on investments and to document or monitor investment results without a dedicated team charged with that responsibility and provided with specific procedures to monitor them.

Even where formal committees do exist, there still seems to be a tendency to take an ad hoc approach to fulfilling fiduciary investment responsibilities. While that attitude may be convenient, such a casual approach leaves one vulnerable to accusations of failing to satisfy fiduciary duties under ERISA. If nothing else, it can be difficult to prove that one has acted properly and met the very high standards of conduct and loyalty ERISA requires.

While there are no new standards or guidelines to reveal, this paper offers a collection of best practices to consider in the formation (or formalization) of an investment committee, the drafting of investment policy statements or the review (and improvement) of procedures. Of course, as in any area involving compliance, no significant steps should be taken without first seeking the input of legal counsel.

INTRODUCTION

Presenting the case for formalization. Why should practices that have been in place, sometimes for years, be changed? What is the advantage to setting up an investment committee or formalizing the operation of what seems to have worked just fine?

That is a question many plan sponsors may be asking themselves, and really, who is going to care if things just continue as they have been?

The Department of Labor does not audit this function specifically. It may become involved in specific items, such as investment operations, if it receives a participant complaint. Also, the Internal Revenue Service, in the course of auditing plans for its own reasons, may refer a matter to the DOL for further investigation.

It is also quite logical for people to assume that as long as a plan’s investment performance results are good, the plan would come through an examination just fine. The DOL, however, has made it clear that plan investment operations will not be evaluated by performance results but by the processes they employ in achieving those results. The courts have agreed with this approach — that it is process, and not results, that shows that ERISA’s standards have been met.

This creates the proverbial Catch-22. Investment fiduciaries can expect to be held to standards that are flexible and have been subject to a lot of scrutiny by courts and commentators but lack specific guidelines. It also seems counterintuitive that the final judgment on whether one has done one’s duty will be made on the basis of how one acted, as opposed to the results of the actions one has taken (i.e., solid investment performance).

There can be a cost to being found lacking in performance of one’s fiduciary duty. There can be potential liability for not having an investment committee. There can also be potential liability if you have an investment committee that arguably is not monitored properly. Fiduciaries are personally liable for the harm they do, and ERISA is virtually unique under American law in not requiring any actual harm in order to find liability. For example, if a fiduciary somehow profits from a breach of duty, that fiduciary may be required to surrender those profits to the plan, even if the plan suffered no harm. It can all get uncomfortably personal rather quickly, as the former investment committee members of Enron Corp. of Houston can attest.

The best defense is setting up a formal investment committee with carefully selected individuals who will operate subject to some clear rules and be able to document their practices and procedures. The intent of this paper is to help navigate through the structuring and operation of investment committees to improve plan effectiveness and responsiveness to participants’ needs.

The first section reviews the duties of the investment committee. Following that is a discussion on best practices in committee structuring. The next section examines the practices associated with ensuring that the committee functions effectively. The creation and maintenance of investment policy statements will then be reviewed. Finally, effective ways of selecting and monitoring investments and performance will be discussed.

All told, this discussion will provide some guidance on a reasonably effective and adaptable framework for structuring and operating an investment committee to help en-sure that fiduciary investment duties are fulfilled.

The committee begins by developing an investment program with a diversified range of investments, making sure the investment opportunities are suitable to the age and dynamics of that particular employer’s work force.

WHAT COMMITTEES DO

Investment committees provide a focus. As noted above, ERISA fiduciaries are subject to the highest standard of care known to American law. This means that any fiduciary has a lot of work to do. Limiting the responsibilities of the committee to investments only allows the committee to focus on the implantation of an investment plan, its monitoring and any changes that are needed — and nothing else.

Committee duties. Ideally, the committee begins by developing an investment program with a diversified range of investments, making sure the investment opportunities are suitable to the age and dynamics of that particular employer’s work force. The process for developing and implementing that program should be documented, as should the various steps taken to see that the investment program starts and that it runs well. Objectives must be set; benchmarks need to be identified.

This predetermined plan of action is generally called an investment policy statement. It basically serves as the “rules of the road” for committee members. While there is no specific requirement under ERISA that committees have an IPS, the DOL has noted that it is considered a key component of compliance with ERISA’s fiduciary obligations. It can be hard to argue that fiduciary duties are being met without an IPS.

After identifying the investment types that the plan should use, the fiduciaries then should turn their attention to the various investment managers and products that provide those types of investments. A selection must be made, often with the help of an outside consultant, which includes a requirement that the committee perform a diligence review of these investment managers and products. This often involves reviewing written materials but also can mean interviewing the investment managers and analyzing their investment philosophies. The final selection can be based on many factors: cost, historical returns, and investment manager style and experience are some of the factors that should be considered.

Once the investments have been selected, the committee is charged with monitoring them to ensure that they continue to represent the best fit for participants. This obligation is continual: There is no set schedule for how often a review should take place. The decision is up to the fiduciaries. It is generally accepted, however, that times of market stress or problems with a chosen investment require more frequent reviews so that the fiduciaries can react to changes in a timely manner.

Committee members may be investment experts themselves, but often they are not. ERISA fiduciaries are required to seek assistance if they do not sufficiently understand the topics with which they are dealing. This is why consultants are often brought in to help select and monitor investment managers and investments, and to evaluate performance against plan objectives and appropriate benchmarks. Even after consultants have been hired, however, the investment committee will still need to stay involved and will still need procedures for selecting and monitoring the consultants as well as the investments. ERISA does not allow a fiduciary merely to rely on the advice of consultants hired by the fiduciary. Criteria for retention or replacement of consultants, as well as investments, are needed to ensure that the plan investments continue to work as smoothly as possible and in the best interests of the participants.

Another aspect of the committee’s fiduciary duty — relative to a participant-directed defined contribution plan — may be ensuring that the plan’s participants have access to sufficient information to make reasonable choices for themselves when deciding how much to save and how to allocate contributions and holdings among the investment options available to them. This will depend on the plan’s structure and whether the people putting the IPS together want to include this in the investment committee’s role or leave them to focus solely on ensuring that the investments serve the participants’ needs.

The committee may also be made responsible for ensuring that participants receive timely and useful communication about their account elections, plan features and balances. This also is a design issue.

Can investment committee work be outsourced? Consultants and others can be very helpful in carrying out the activities of the committee, especially the reporting and educational aspects. There is, however, a big difference between hiring out some of these functions and actually taking responsibility for them. As noted above, the committee (or some other fiduciary if no formal investment committee has been established) still needs to review the materials and input from the consultants. Again, an ERISA fiduciary cannot simply rely on what a consultant or other service provider does or reports. ERISA makes fiduciaries the “hub” of responsibility and enforcement. As such, fiduciaries have to make and justify the final decisions lest the fiduciary be held accountable for something another has done.

Because an improperly structured investment committee can be doomed to be ineffective from the start, we will focus on the committee itself, then look at the best practices for ensuring that it fulfills its fiduciary responsibilities to the plan participants.

STRUCTURING THE COMMITTEE

Committee composition. Ideally, the investment committee should involve at least three people; a range of experience and outlooks helps the committee to consider all the relevant factors. The odd number helps avoid tie votes that can slow things down. Certain matters may be considered so important, however, as to require unanimous votes or a “supermajority,” though that is a matter of plan design and preference. There is no authority requiring such approaches. Too many members, however, can give rise to confusion, and the numbers may limit full participation in discussions. It seems that there is a consensus that the maximum should be held to around seven members, lest the committee become ungainly.

The people selected for the investment committee need to have the correct aptitude, attitude and capability. Some people may have agendas other than assembling the best investment program. An overworked member of the “sandwich generation” may not have the time to devote to the matter. Some background in finance or investments is a good idea, but, especially in smaller organizations, there may be limited availability.

Some people urge that committee membership be representative of the participant makeup in terms of age and status within the company. The reason for this is that it gives the committee a better perspective as to what the best interests of the participants may be. People have shared a number of ideas as to just what makes up the best committee. What needs to be remembered, however, is that the committee is obligated to put together the best investment program it can for the participants. Forays into other concerns, like job creation or social matters, can be dangerous.

While having the chief executive or chief financial officer involved with the committee has its benefits in terms of depth of knowledge, it is important to note that the committee is meant to be independent and focused on one issue alone: the assembly and operation of the plan’s investment program.

Having senior people, or too many senior people, on the committee may stifle debate or cause a shift in a particular direction. There is no clear guidance on this; one has to think and consider what makes the best committee and how one would feel explaining one’s choices to a court or seeing them in the press.

Where company stock is a plan investment option, the presence of senior executives on the committee may create a conflict of interest. The chief executive and the chief financial officer, for example, are very likely to know non-public information of material consequence to shareholders. They may also have large holdings of company stock, either inside the plan or on their own. Having these people involved in making decisions on behalf of employee shareholders could put them in a precarious position, as ERISA requires fiduciaries to avoid conflicts of interest and the failure to do so may be a breach of duty. If nothing else, the committee should be large enough to function even if certain people have to step aside on certain issues, such as continued investment in company stock.

Term limits. Where a sufficient pool of employees exists, it is advisable for membership to rotate. If terms of committee members are indefinite, there may be problems with complacency or an unwillingness to back away from prior decisions. Objectivity is a key component of a fiduciary’s actions, and objectivity can suffer when prior decisions are up for review. Some people believe that committee members are more likely to pay closer attention to what they are doing if they know others will succeed them and potentially review their actions.

The actual length of service (which should be described in the IPS) is quite subjective. Generally, a two-year term does not seem long enough — by the time a committee member begins to have some expertise, there might only be a year or so remaining in the member’s tenure. Using three- or four-year terms would seem to make better use of committee members’ experience and still keep enthusiasm and member involvement at a high level.

If terms are to be limited, the terms should be set up on a staggered schedule, so that the committee makeup shifts regularly to add a continuous infusion of fresh viewpoints and new energy to the process, while avoiding having too many novices on the committee at a given time.

EFFECTIVE FUNCTIONS

Meeting frequency. Generally, the committee should meet at least once a year, although many people prefer quarterly meetings. Others argue that quarterly meetings may be too frequent and lead to short-term views on the performance of the investment classes. As noted above, the flexibility to meet more often to address financial challenges should be a part of the IPS.

For example, special issues, such as the mutual fund industry’s trading policies controversy that arose several years ago, warrant special meetings.

It is also advisable to formalize the meeting dates to ensure full attendance and preparation. For example, if the committee meets twice a year, meeting in mid-February might make sense because the yearend investment manager statements should have been received by then. Similarly, meeting again in July, after the midyear point, may be preferred. This way, any changes in investment options can be implemented prior to the fourth quarter.

Regardless of how often the committee meets, it is important to note that the frequency is not as important as the substance of each meeting. Committee members need to be prepared and need to participate, and all discussions and decisions should be documented in the event that the committee members ever have to justify their actions to a court or a regulator.

Meeting agenda. It is suggested that an IPS be reviewed in each meeting to be sure it is current with the financial times and compliance environment. Changes should be made by the committee or suggested to whoever else may be charged with assembling and maintaining the IPS.

The primary goal of each meeting is to review the plan’s investment choices and evaluate each one to make sure it continues to conform to the IPS and still serves participants’ needs. This is done by reviewing benchmarks, changes in the investment vehicle or investment manager, changes in the financial world, expenses and other factors, including performance (while not the ultimate determinant, it is still a factor). Input from consultants should also be reviewed and any new questions for them formulated. Another issue to review is the fees being paid to consultants to ensure sufficient value is being received.

If the committee has been charged with participant communication and education, then those matters should also be reviewed at this meeting.

The meeting should also consider current or expected legislation/regulation that might affect plan investments and any relevant market trends to see if action is warranted.

Putting it in writing. Meeting attendance, discussions and any decisions that are reached should be recorded, along with their justifications. The point of creating a meeting record is to show, and be able to prove at a later date, what work was done, why and how it was done, and by whom. Then, should an inquiry ever be launched into how a specific investment decision was made or why a certain action was taken, a record defending the position would exist, along with evidence of the processes involved (and process is very important under ERISA fiduciary analysis).

Once prepared, the record should be circulated to each committee member for verification of accuracy and for his or her endorsement. The record should also be made available to any others with responsibility for overseeing the investment committee. The reason for this broad dissemination of information is to make sure everyone with fiduciary investment duties is communicating with one another. Once circulated, the record should be filed for use by the committee, by another investment fiduciary or to defend the committee’s actions, if necessary.

What each member needs to know. ERISA requires that each fiduciary act for the exclusive benefit of the participants, diversify plan assets to lessen the risk of large losses (when the fiduciary has investment obligations), and do so with the skill, prudence and diligence of a reasonable expert, and in accordance with the plan documents.

An ERISA fiduciary needs to be aware of the needs of the participants and who they are. A plan covering an older population, for example, may need more-conservative investments than a plan covering a young population. The fiduciary is in a position of trust — having been entrusted with assets that will support the retirement of others — and the fiduciary needs to live up to that trust, to be trustworthy and to do the fiduciary’s level best for the people covered by the plan.

An ERISA fiduciary needs to be prudent; that is, the fiduciary’s actions need to make objective sense. There needs to be a sound reason for action and a process that will help the fiduciary arrive at a thoughtful decision.

Part of this is an obligation simply to be engaged. Just signing off on decisions is not considered an act of fulfilling one’s own fiduciary duty; one must have reviewed and thought through the relevant issues (and sought help when needed).

The personal accountability to which ERISA fiduciaries are subject is something that potential members most need to be informed of and understand before accepting positions with the committee. Specifically, they need to know that once they assume fiduciary responsibility for the plan’s operation, they expose themselves to liability for their actions, not just at the committee level but at a personal level. For instance, the committee members at Enron were held personally liable for selecting plan vendors and monitoring investment options. Though an investment policy did exist, they were cited for failing to follow the procedures that had been put in place. These problems are not just limited to large corporate failures. Small to midsize plans, even plans of healthy companies, and their fiduciaries, have found themselves subject to investigations and participant lawsuits, and have been on the receiving end of fines and penalties.

With participation increasing in 401(k) plans, complaints — whether justified or not — and investigations or audits are apt to follow. This provides even more incentive for ensuring an IPS is in place for sound decision making and that all decisions and operations are made in accordance with that IPS and ERISA’s rules regarding the care a fiduciary must take. In this case, ignorance is far from bliss; it can be a fiduciary’s greatest enemy.

THE IPS PROCESS

ERISA makes no reference to an IPS or the need to have one. A DOL interpretative bulletin (94-2) recognized this but also stated, “The maintenance by an employee benefit plan of a statement of investment policy designed to further the purposes of the plan and its funding policy is consistent with the fiduciary obligations set forth in ERISA Section 404(a)(1)(A) and (B).” Considering the emphasis on creating and following documented processes that has developed as part of ERISA, it is difficult to argue against having a written policy covering a plan’s investment operations.

In the absence of the guidance an IPS provides, each fiduciary (committee or individual) is on its own in determining how to form, implement and monitor an investment program for a plan. Documentation may be scant. The danger in relying on an ad hoc method is that even if the decision making is sound, there is no proof of it. That would make mounting a defense against an accusation of misdeeds difficult. If an audit were to occur, the lack of documented processes could make a successful resolution of the audit quite difficult.

Yet a quarter of plans still lack a written IPS, according to the Chicago-based Profit Sharing/401k Council of America’s 50th Annual Survey of Profit Sharing and 401(k) Plans, which was conducted in September 2007. These plans and their fiduciaries seem to be taking an unnecessary risk for no real reward. This is especially true since ERISA-related lawsuits are on the rise. According to the Administrative Office of the U.S. Courts, the number of such lawsuits increased from 9,124 in 2000 to 11,171 in 2005.

While there are few clear right or wrong answers on the finer points of building and operating an IPS or investment committee, having an IPS and a committee that is dedicated to conscientious oversight not only demonstrates fiduciary responsibility but also ensures consistency in how the plan investment program is run. Hopefully, it also creates a recipe for making sound decisions that can be handed down. As committee members come and go, the IPS and committee history and experience can provide a framework for new committee members to step in quickly and contribute to the process.

Objective for every policy. The main objective for an IPS is to provide a blueprint that committee members can use to ensure the careful, documented and consistent exercise of fiduciary responsibility. This helps ensure that anyone looking at the IPS and the committee records in future years will understand how a particular decision was made. Having a written policy means that in the event of an audit or complaint, there is evidence that the committee’s decision making did not occur in a vacuum or in an erratic manner.

What should an IPS comprise? Below are some suggested components for an IPS. What will work for any particular plan may vary. These are intended only as resources to which readers can refer when drafting or amending their own IPS and are not intended for use without thoughtful review by plan officials and consultation with legal counsel or other advisers that the plan officials feel is necessary.

• Statement of purpose. This portion should state the employer’s commitment to run the plan for the benefit of its participants under the exclusive benefit clause of ERISA. It should also give the committee (or whoever establishes the IPS) the right to amend the IPS as needed.

• Investment objectives. The general objectives regarding performance, costs, diversification and other matters can be expressed in this section.

• Investment guidelines. This section of the IPS details the investment categories for which plan investment options will be provided. The types and numbers of investments to be offered in each category will also be detailed, as will matters such as benchmarks and other expectations.

• Selection of investment managers/options. This part describes the factors to be considered, such as investment manager tenure, history, experience and the like. The steps that the committee would take in choosing a manager are laid out here. If an outside vendor is retained to help with this selection, due diligence requires that the committee understand the vendor’s processes and evaluate its potential for conflicts of interest when it makes its recommendations to clients. How the committee is to do this is described here.

• Monitoring of investment managers and investment options. Due diligence also applies to continuing investment monitoring. The committee has a responsibility to monitor investments and investment managers to ensure they continue to meet IPS objectives. While, again, delegating this to an outside adviser may get the job done more professionally, it does not absolve the committee of its fiduciary duty under ERISA.

This section will also detail the process for measuring performance against benchmarks. A description of how to handle investment managers who are not meeting criteria is also appropriate. That may, for example, require putting them on a “watch list” for a probationary period before seeking a replacement.

• Elimination of investment managers and investment options. Here, the ability and process to remove investment options and replace investment managers — along with the criteria and procedure for doing either — is explained in detail.

• Policies regarding the service of committee members. This section details matters such as how many members the committee will have, how often it will meet and how long members’ terms will be. Any other requirements for membership must be included. The IPS should also spell out the intention to keep written records of meetings, including coverage of how and when decisions are made.

As with any legal document, once the particulars are drafted, an IPS should be subjected to legal review before it is finalized.

It would be a mistake to think that the performance of the plan alone was enough to fend off complaints, criticisms or other problems that can result from a failure to comply with ERISA rules. Performance does not trump adherence to the stated process (the IPS in this case) when determining whether fiduciary responsibility is being carried out appropriately. In the case of an inquiry or an audit, that adherence is what will receive focus, which is why a policy needs to be in place.

For example, under a 401(k) plan, ERISA’s prudence rule requires that a plan take a careful and thoughtful approach in selecting and maintaining a diversified lineup of investment options for participants. This is because each participant has different retirement goals, risk profiles, personal financial resources and time horizons for investing.

In selecting an array of investments or investment managers, committee members are well-advised to look at the big picture. The same advice holds true when monitoring those selections. In other words, they need to review the overall appropriateness of an investment platform as well as each element. The committee members should also understand that not all products will perform well at the same time.

This is where benchmarking performance to appropriate indexes comes into play. It helps in understanding how an investment is performing relative to its peers rather than just the broader market averages such as the Dow Jones Industrial Average or the Standard & Poor’s 500 stock index.

But beyond performance, committee members also need to look at the people behind the investment. Management changes in particular, especially if they are frequent at an investment management company, can affect performance by altering the underlying investment process. For many, such changes automatically lead to a review of alternate investment choices.

A key component in investment selection is the answer to a rather basic question: Does the management team’s underlying philosophy make sense? The next question should be: Is the team acting in accordance with this philosophy? If the answer to either question is no, then a commitment to that investment needs to be reconsidered. Changing storylines, regardless of the ultimate performance, is another red flag in the selection and monitoring processes. Have there been accusations of misdeeds? What are they? How serious do they seem? What is the investment manager’s response? All of these issues require close scrutiny.

CONCLUSION

The suggestions offered in this paper are processes and policies that have a solid grounding in ERISA fiduciary requirements (although with the flexibility these requirements provide in a wide variety of situations, these suggestions have to be given with the same kind of flexibility). In general, they may work well for a range of retirement plans and may be adapted as necessary to fit the specific needs of others.

Because the makeup of the participants in any one plan varies so widely, taking a cookie-cutter approach to creating and maintaining an IPS and investment committee for a plan is neither advisable nor in keeping with the good-faith fulfillment of ERISA’s requirements. It should be noted that there are few universally right answers when it comes to the process of selecting investment choices for any given plan.

With this in mind, these suggestions should be considered idea starters — and should not be relied upon in their current form to assist plan fiduciaries with their unique situations and obligations.

BEST PRACTICES To see the white paper and a checklist for developing an investment policy statement, visit investmentnews.com/committee.