Fiduciary Standard (White paper)

Fiduciary Standard
(White paper)

A White Paper By C. Frederick Reish, Esq. Nc Summer Conley, Esq. April 2011

July 2, 2012 at 2:23pm
Drinker Biddle & Reath LLP
1800 Century Park East, Ste. 1400
Los Angeles, CA 90067
(310) 203-4696 – (310) 229-1285 (fax)
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The Fiduciary Protections Provided By An Outside Adviser


Fiduciary litigation under the Employee Retirement lncome Security Act of 1974 (ERISA) has increased over the last few years. 1 As a result, fiduciaries, especially fiduciaries of 401(k) plans, have become increasingly concerned about satisfying their fiduciary obligations and avoiding lawsuits. The investment management services provided by Matson Money, Inc. and its Free Market Fiduciary Program offer fiduciary protections in a number of ways. This White Paper considers the program created by Matson Money, Inc. and how utilizing the program can give fiduciaries comfort about satisfying their fiduciary obligations under ERISA.


Retirement plan fiduciaries – like committee members or corporate officers who make plan decisions – have the duty to act prudently and in the best interests of participants when selecting the investment options offered by their plan. (In this White Paper, we use “plan fiduciary” and”committee member” to refer to the people who work for the plan sponsor and who make decisions about the plan’s investments and operation.) This requires that fiduciaries act with knowledge and experience to select and monitor appropriate investment options. And yet the typical committee member serving as a fiduciary may not have that knowledge and experience. This puts them at risk of a lawsuit for breach of fiduciary duty if the selected investment options perform poorly or result in excessive costs to the plan or its participants.
Often, plan committees try to address this fiduciary concern by engaging an investment adviser to assist in selecting and monitoring investment options. (These advisers typically give advice or recommendations to the plan fiduciaries – as opposed to actually picking the investments and, as a result, are labeled “non-discretionary.”) The use of experts is evidence of a prudent process. However, even with this assistance, the committee continues to be the primary investment fiduciary and thus the primary “target” for plaintiffs’ attorneys and the Department of Labor.
Instead, plan committees can obtain increased fiduciary protection by engaging a “discretionary” investment manager to select and monitor investment options (that is, the investment manager actually picks the investments for the plan). While the committee is still responsible for selecting and monitoring the investment manager, the committee insulates itself against losses (or inadequate gains) for the selection and monitoring of the investment options. Matson Money, Inc., through its Free Market Fiduciary Program, acts as an investment manager, which, under ERISA, provides committees and plan sponsors with additional fiduciary protections. Additionally, Matson Money, Inc. can protect plan committees from liability for participant investment decisions and default investments by assisting them with meeting the safe harbor fiduciary protections offered under ERISA section 404(c) and the qualified default investment alternative (or QDIA) rules.


Through its Free Market Fiduciary Program, Matson Money, Inc, (“Matson”) provides asset allocation investment management services to a variety of clients, including parlicipant-directed401(k) plans subject to ERISA. When a plan sponsor makes the fiduciary decision to utilize the Program, Matson serves as the Plan’s discretionary investment manager for selecting the investment options offered by the plan and creating asset allocation portfolios for plan participants. The investment options are typically eight portfolios with different risk and return goals, each created from some combination of Matson’s three mutual funds and a 5% allocation to a money market fund that is not managed by Matson. For example, Matson creates an Aggressive Growth portfolio with 5% in a money market fund and the rest in a mix of Matson’s Free Market U.S. Equity Fund and Free Market International Equity Fund. Matson’s fee is the same for each of the three Matson Funds. Thus, no matter how Matson allocates the 95% of non-money market portion of the portfolio, Matson receives the same compensation. Each fund is a “fund of funds” that invests primarily in shares of other mutual funds and is designed to target specified percentages of certain asset classes in different investment categories so as to seek maximum portfolio diversification, enhanced return opportunities and diminished portfolio volatility. Matson uses a different allocation of these three mutual funds for the Long-Term Growth portfolio and each of the other portfolios. Participants can then allocate their accounts among the different portfolios that are created and managed by Matson. Matson continuously supervises and manages the portfolios in order to keep each in line with its own investment strategy and goals as market conditions and investment needs change and re-balances to maintain the 5% money market holding and remaining target percentages on a quarterly basis.
In managing these portfolios, Matson uses generally accepted investment practices, including implementation of Modern Portfolio Theory, which is the basis for Matson’s investment philosophy. The portfolios are reviewed and rebalanced quarterly. The factual descriptions and information in this White Paper are based upon statements from Matson as well as Matson’s investment management agreement and program description.


In this day and age plan sponsors are extremely concerned with satisfying their fiduciary obligations as they relate to available investment options. Matson’s Free Market Fiduciary Program provides plan sponsors with a way to delegate most of their fiduciary investment responsibilities and therefore minimize the risk of fiduciary liability. As described below, Matson’s program offers plan sponsors fiduciary protection in four ways:
(1) Matson takes on the responsibilities of investment management under ERISA 3(38)
(2) Matson provides a well-diversified group of investment options consistent with the requirements of ERISA
(3) Matson offers assistance with compliance with the fiduciary protections of ERISA 404(c), and
(4) Matson offers a qualified default investment alternative safe harbor for defaulting participant investments.
Before considering how Matson’s program assists plan sponsors with their fiduciary obligations, we will first review a plan sponsor’s general fiduciary obligations for a plan’s investment options.
General Responsibilities for Investments
Under ERISA, fiduciaries have the following fundamental duties:
– the duty to prudently select, monitor, remove and replace investment options;2
– the duty to provide investment options which, in the aggregate, constitute abroad range of investments;3 and
– the duty to provide investment options and related services which are suitable and appropriate for the particular needs and abilities of the employees covered by the plan. 4
For participant-directed plans (such as most 401(k) plans), fiduciaries must select the investment options that participants can use to invest their accounts. To satisfy their fiduciary obligations, fiduciaries must select categories of investments based on generally accepted investment theories (such as Modern Portfolio Theory).5 Further, they must select and monitor the investment options in a manner that is consistent with prevailing investment industry practices (such as the use of both quantitative criteria and qualitative analysis).6
In selecting and monitoring investment options, fiduciaries must act in the best interests of participants and for the exclusive purpose of providing benefits for those participants. The standard used to measure the fiduciary’s actions is the prudent man rule, also referred to as the prudent expert rule.7
Fiduciaries 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 context of an enterprise of a like character and with like aims….”8 (Emphasis added.)
This prudent expert rule stems from the ERISA requirement that fiduciaries act in a manner similar to someone who is “familiar with such matters.”9 Essentially, this requires fiduciaries to act in the same manner as a hypothetical knowledgeable investor familiar with the concepts, such as Modern Portfolio Theory and prevailing investment industry practices, and the particular circumstances of the plan and its participants.
404(c) and Default Investments
Even though fiduciaries are responsible for selecting and monitoring the investment options offered by the plan, they can limit liability for the individual participants’ own decisions by complying with ERISA section 404(c).10 That section insulates fiduciaries from decisions by plan participants who exercise control over the investments in their own accounts.11
In the case of a pension plan which provides for individual accounts and permits a participant or beneficiary to exercise control over the assets in his account, if a participant or beneficiary exercises control over the assets in his account (as determined under regulations of the Secretary) -(i) such participant or beneficiary shall not be deemed to be a fiduciary by reason of such exercise, and (ii) no person who is otherwise a fiduciary shall be liable under this part for any loss, or by reason of any breach, which results from such participant’s or beneficiary’s exercise of control…12
The regulations under section 404(c) provide a number of detailed requirements that must be satisfied to take advantage of the 404(c) safe harbor, including that participants be offered “a broad range of investments. 13
A plan offers a broad range of investment alternatives only if the available investment alternatives are sufficient to provide the participant or beneficiary with a reasonable opportunity to:
(A) Materially affect the potential return on amounts in his individual account with respect to which he is permitted to exercise control and the degree of risk to which such amounts are subject;
(B) Choose from at least three investment alternatives:
(1) each of which is diversified;
(2) each of which has materially different risk and return characteristics;
(3) which in the aggregate enable the participant or beneficiary by choosing among them to achieve a portfolio with aggregate risk and return characteristics at any point within the range normally appropriate for the participant or beneficiary; and
(4) each of which when combined with investments in the other alternatives tends to minimize through diversification the overall risk of a participant’s or beneficiary’s portfolio. 14
When all of the 404(c) requirements are met, fiduciaries are protected from liability for the participants’ decisions – but are still responsible for the selection and monitoring of the investment options that are offered under the plan.
When all of the 404(c) requirements are met, fiduciaries are protected from liability for the participants’ decisions – but are still responsible for the selection and monitoring of the investment options that are offered under the plan.
Even for a plan that satisfied ERISA section 404(c), fiduciaries used to be responsible for the investment decision when a participant failed to make an election (that is, “defaulted”) and was invested in the plan’s default investment option. In 2006, Congress created protection for default investments – if participants are defaulted into a “qualified default investment alternative”(QDIA.) 15 If default investments are made in accordance with the DOL’s default investment regulation, the fiduciaries are entitled to a defense (or “safe harbor”) against claims by participants that they were improperly invested.16 The types of investments that qualify for the QDIA fiduciary safe harbor are age-based investments (e.g., target date funds), risk-based investments (e.g., balanced or lifestyle funds) and managed accounts (i.e., accounts managed by an investment manager). The regulation also imposes certain notice and disclosure requirements.17
Even if a plan meets the Section 404(c) and QDIA safe harbors, fiduciaries are still responsible for the selection and monitoring of the investment options offered under the plan – unless they delegate the investment authority to an “investment manager” under ERISA. ERISA specifically provides that a named fiduciary may appoint an investment manager to manage plan assets. 18 Further’ ERISA provides that fiduciaries are relieved of the authority and responsibility associated with investing plan assets upon the appointment of an investment manager.
ERISA specifically contemplates the possibility of appointing an investment manager to over see the plan’s investments:
Any employee benefit plan may provide-
(3) that a person who is a named fiduciary with respect to control of the plan or management of the assets may appoint an investment manager or managers (including the power to acquire and dispose of) any assets of a plan.(Emphasis added.)
ERISA also provides that the committee members (and the plan sponsor) are relieved of the authority and responsibility associated with investing plan asset upon appointment of an investment manager:
…the trustee or trustees shall have exclusive authority and discretion to manage and control the assets of the plan, except to the extent that-
(2) authority to manage, acquire or dispose of assets of the plan is delegated to one investment managers pursuant to section 402(c)(3). 21
When a fiduciary delegates – to a registered investment adviser (or to a bank or insurance company) – the discretionary authority to select the plan’s investment options, and the adviser acknowledges fiduciary status, the adviser is an “investment manager” under Section 3(38) of ERISA’ In that case, the investment manager becomes the fiduciary responsible for selecting and monitoring the investments’ while the fiduciary is responsible for selecting and monitoring the investment manager, the fiduciary transfers the legal responsibility for the investments to the investment manager. And that is where Matson and the Free Market Fiduciary program comes into play.
Matson Relieves the Fiduciaries of Investment Responsibility by Serving as Investment Manager
Fiduciaries often lack the time, knowledge and/or experience necessary to prudently select and monitor a plan’s investments. In many cases, fiduciaries will seek the assistance of an independent investment adviser to help with the selection and monitoring of the plan’s investments. The use of an independent adviser does not guarantee ERISA compliance, but is evidence of a prudent process. However, fiduciaries can obtain even more protection by using a discretionary investment manager.22 A non discretionary investment adviser offers advice to a plan committee, but the committee must still be the fiduciary decision-maker. On the other hand, an investment manager accepts full fiduciary status and responsibility for decisions about the plan’s investments. In other words, a discretionary investment manager becomes the primary investment fiduciary, and therefore primarily responsible, for the investment decisions. The committee’s job is limited to the prudent selection and monitoring of the investment manager, which, based on DOL guidance, is a manageable task for an attentive committee.
A non-discretionary investment adviser who provides fiduciaries with recommendations and assistance in selecting and monitoring funds is referred to as an ERISA 3(21) fiduciary. A discretionary investment manager who has authority to select and monitor investment funds for the fiduciary is referred to as an ERISA 3(38) fiduciary.
Under the Free Market Fiduciary Program, Matson, a registered investment adviser, acknowledges its fiduciary status and hence becomes the plan’s investment manager responsible for selecting and monitoring the investment options offered by the plan. This leaves the fiduciaries with the responsibility for prudently selecting Matson to manage the plan’s investments – rather than responsibility for selecting and monitoring the plan’s investment options.
The Free Market Fiduciary Program is Designed to Prudently Select Investment Options
For a discretionary investment manager to prudently select investment options, the manager must apply generally accepted investment theories.23 This refers to the fundamental and broadly acknowledged principles underlying modern concepts of investing, including concepts such as Modern Portfolio Theory. This means a portfolio should be made up of a variety of asset classes with different risk and return goals. For example, equities, bonds and cash are three different types of asset classes.
According to one court, generally “the regulations [under ERISA section 404(a)(1) quoted earlier] provide that the fiduciary shall be required to act as a prudent investment manager under the modern portfolio theory rather than under the common law of trusts standard.”
The Free Market Fiduciary Program is designed with these investment concepts in mind.24 Further, Matson’s unaffiliated co-advisors or solicitors meet with the plan fiduciary to determine the investment objectives and risk tolerance based on the plan participant demographics. Matson develops different portfolios in different asset categories using its mutual funds and applying generally accepted investment theories (such as Modern Portfolio Theory) and prevailing investment industry practices (quantitative and qualitative analysis).25 The investment philosophies and processes utilized by Matson are consistent with those designed to ensure that investments are selected according to generally accepted investment theories as well as the”broad range” requirements set out in ERISA section 404(c). In other words, Matson is engaging in a prudent process for selecting and monitoring the plan’s investment options, based on their application of those theories and principles.
404(c) Protection
As discussed earlier, fiduciaries can transfer responsibility for participants’ investment decisions by complying with Section 404(c) and the regulations thereunder. These regulations were recently amended by the Department of Labor, but generally require that participants exercise control over their account and that certain information regarding the investments be communicated to the participants. One of the requirements to illustrate that participants have control is that the plan offer a variety of investment options. Matson has eight different asset class portfolios designed for different risk and return goals. These different investment options are designed by Matson to be diversified with a range of risk and return characteristics. By offering this broad range of investment options, Matson helps fiduciaries satisfy the 404(c) requirements.
Participants do not always make their own investment elections. When that occurs, the fiduciaries must make investment decisions for them – by allocating the participant’s account to the default investment option selected by the fiduciaries. Unless the fiduciaries satisfy the QDIA requirements, they will be responsible for the default investment decision. However, even if the QDIA requirements are satisfied, the fiduciaries must prudently select the QDIA as an investment option. 26
In addition to meeting certain notice and other requirements, in order to take advantage of the QDIA safe harbor, the default investment must be a qualified default investment alternative. One such alternative is a “balanced” fund.
An investment fund product or model portfolio that applies generally accepted investment theories, is diversified so as to minimize the risk of large losses and that is designed to provide long term appreciation and capital preservation through a mix of equity and fixed income exposures consistent with a target level of risk appropriate for participants of the plan as a whole. For purposes of this paragraph (e) (4) (ii), asset allocation decisions for such products and portfolios are not required to take into account the age, risk tolerances, investments or other preferences of an individual participant. An example of such a fund or portfolio may be a “balanced” fund. 27
As Matson has explained to us, Matson offers a balanced fund (its Balanced Growth Portfolio (50% Equity and 50% Fixed Income)) through its Free Market Fiduciary Program as a QDIA. Thus, while the fiduciaries must satisfy the QDIA notice requirements, Matson will provide them with a QDIA safe harbor option for default investments.
In our experience, plan fiduciaries are concerned about the fiduciary liabilities associated with selecting and monitoring a plan’s investments. Through its Free Market Fiduciary Program, Matson offers plan fiduciaries the ability to transfer the potential liability for selecting and monitoring the plan’s investment options as well as the opportunity to obtain the fiduciary safe harbors of ERISA section 404(c) and QDIA.
The law and our analysis contained in this White Paper are current as of April 7, 2011. Changes may have occurred in the law since this paper was drafted. As a result, readers may want to determine if there have been any relevant developments since then.
1 See Employee Allegations of Excessive Fees Gain Ground, LA Times (July 29,2010).
2 ERISA 404(a)(1)(b). See, e.g., the Department of Labor’s Preamble to the Final 404(c) Regulation, 57 FR46906, 46922 (1992) (“All of the fiduciary provisions of ERISA remain applicable to both the initial designation of investment alternatives and investment managers and the ongoing determination that such alternatives and managers remain suitable and prudent investment alternatives for the plan. Therefore, the particular plan fiduciaries responsible for performing these functions must do so in accordance with ERISA.”)
3 ERISA 404(a)(1)(C); 29 U.S.C. 1104(a)(1)(C).
4 See the Department of Labor’s Preamble to the Final 404(c) Regulation, 57 FR 46906, 46922 (1992) (the investment alternatives must be “suitable and prudent investment alternatives for the plan”).
5 See Laborers Nat’l Pension Fund v. Trust Quantitative Advisors, Inc., 173 F.3d 313 (5th Cir. 1999.). See also DO LRegulation 2550.404a-1 (indicating that a fiduciary should consider whether “the particular investment or investment course of action is reasonably designed, as part of the portfolio (or, where applicable, that portion of hen plan portfolio with respect to which the fiduciary has investment duties), to further the purposes of the plan, taking into consideration the risk of loss and the opportunity for gain (or other return) associated with the investment or investment course of action.”).
6 See Id.
7 See In re Unisys Savings Plan Litigation,T4 7.3d 420 (3rd Cir. 1996)
8 ERISA 404(a)(1)(B)
9 ERISA 404(a)(1)(B)
10 ERISA 404(a)(1)(A)(ii); DOL Regulation 2550.404c-1(a)(1).
11 Id.
12 ERISA 404(c)(1)(A).
13 ERISA 404(c) 5)
14 DOL Regulation 2550.404c-1(b)(3).
15 ERISA 404(c)(5)
16 DOL Regulation 2550.404c-5(b).
17 DOL Regulation 2550.404.c-5(c)
18 ERISA 402(c)(3).
19 See ERISA 405(d)(1)
20 ERISA 402(c)(3).
21 ERISA 403(a)
22 Id.
23 See Laborers Nat’l Pension Fund v. Trust Quantitative Advisors, Inc.,173 F.3d 313 (5th Cir. 1999).
24 See Matson’s Investment Policy Statement (“Modern Portfolio Theory will form the basis of the investment philosophy.”).
25 ld.
26 DOL Regulation 2550.404c-5(b)(2).
27 DOL Regulation 2550.404c-5(e)(4)(ii).

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