Giving due diligence its due

Financial advisers to retirement plans need to recalibrate their thinking about Section 408(b)(2) of the Employee Retirement Income Security Act of 1974.

Rather than focusing on what it means for their own disclosure obligations, they need to remember that the law is truly about the due-diligence obligations of plan sponsors.

It is understandable that retirement plan service providers, including advisers to plans, are preoccupied with what the Labor Department requires of them under the new rules. Service providers are under the gun to have disclosures of their services, compensation arrangements, affiliations and fiduciary status ready to provide to their plan sponsor clients and prospects by July 1.

However, the explicit requirement of Section 408(b)(2) is for responsible plan fiduciaries to enter only into reasonable agreements with service providers and, by implication, to exit or amend service provider relationships that cease to be reasonable.

The new rules clarify that a plan sponsor’s due-diligence process will be deemed inadequate, and a service provider agreement will be considered unreasonable, if the plan fiduciary fails to obtain and evaluate information about the services, compensation arrangements and fiduciary status of the service provider.

The problem is that too many plan sponsors either don’t fully understand their due-diligence obligations or neglect them.

Although the new disclosures will help assure that plan fiduciaries can get the information they need, that won’t matter if the information isn’t applied properly in a prudent due-diligence process. In fact, by defining minimum due-diligence criteria, the Labor Department’s new rule could heighten litigation and regulatory risks for those plan sponsors who aren’t attentive to their due-diligence responsibilities.

CASE IN POINT

The consequences of not using a prudent process for the selection and management of service providers can be severe, as a recent class action by participants of two retirement plans offered by manufacturing firm ABB Inc. demonstrates. The plaintiffs in this case alleged a number of breaches of fiduciary responsibilities tied to faulty selection and monitoring of service providers that damaged retirement account balances.

The plaintiffs named not only the company as a defendant but also the major company committees charged with overseeing the retirement plans, the individual who directed the committee responsible for service provider selections and the service providers themselves (Fidelity Management & Research Co. and Fidelity Investments). The case (Ronald Tussey, et al., v. ABB Inc., et al.) was decided last month in favor of the plaintiffs on most of the key points.

In the ABB case, the court highlighted four key findings of fiduciary breaches by the defendants.

The first pertained to the failure of the defendants to monitor record-keeping costs, negotiate rebates from investment companies selected to be on the investment platform, select less expensive share classes available for the funds on the platform and apply reasonable due-diligence criteria when deciding to replace one fund on the platform with another.

The second finding targeted a conflict of interest when the ABB defendants agreed to pay Fidelity above-market costs for services to the retirement plan in order to subsidize certain corporate services provided by Fidelity to ABB, such as company payroll services.

Finally, the third and fourth findings pertained to the handling of float income generated when deposits to the plan were briefly held in interest-bearing bank accounts before the money was invested.

It is significant that over about 10 years, ABB selected Fidelity for an expanding number of retirement plan and corporate services. Unfortunately, ABB evidently failed to have sufficient understanding of fiduciary obligations to avoid clear conflicts between corporate interests and the interests of retirement plan participants and failed to have a sound, consistent due-diligence process to manage service provider relationships.

Damages assessed for the findings against the ABB defendants totaled $35.2 million.

The court also issued injunctive relief in this case. It ordered ABB to institute a number of corrective actions to establish or strengthen fiduciary processes.

Think of the Labor Department’s new disclosure rules as the tip of the iceberg. Plan sponsors and their advisers must be aware of the much more significant due-diligence obligations that lie out of sight for many.

Blaine F. Aikin is chief executive of fi360 Inc. and a member of the steering committee for the Committee for the Fiduciary Standard.