A Prudent Response to New 401(k) Developments

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A Prudent Response to

New 401(k) Developments

By Fred Reish

A Prudent Response to

New 401(k) Developments

As American workers rely more and more on defined contribution plans—and particularly 401(k) and 403(b) plans—regulation and litigation are on the rise. Keeping abreast of current developments and subsequent implications will not only help plan sponsors with their fiduciary responsibilities, it will also help protect advisers against possible liability.

This article covers four important developments and suggests what responsive actions are in the best interest of advisers.

PRUDENTLY REPLACING INVESTMENTS

Recent Development #1:

The “talk of the town” recently has been the move of the country’s best known bond manager from one firm to another. This change raises an obvious question: What should plan fiduciaries (i.e., plan committees) do about it? An easy answer that they should engage in a prudent process. But, then that begs the question: What is a prudent process in this setting?

While the fiduciary rules permit some flexibility in developing a compliant process, we feel one way to engage in a prudent process is as follows:

• The loss of an individual investment manager of a fund (or a lead manager from a team) is generally considered a reason for placing a fund on a watch list.

• Placing a fund on a watch list triggers a duty for the fiduciaries to investigate and evaluate the change. The investigation can be, and often is, delegated to an adviser, who will report back to the fiduciaries with results.

• When the investigation and evaluation are completed, the fiduciaries (i.e., the committee members) must make a decision: terminate the fund, take it off the watch list or leave it on the watch list for further investigation.

• At some point, though, a final decision must be made and fiduciaries are required to act in the best interests of the participants. As a result, many fiduciaries will choose the low-risk option— the one that has the fewest unanswered questions.

Implications #1:

Advisers play a critical role in this process and would do well to consider the following steps:

• Alert the fiduciaries to the change and the questions it raises.

• Educate the fiduciaries on the steps of a prudent process.

• Perform the investigation of the change—and its possible consequences—and report results to the fiduciaries.

• Recommend a course of action and explain the reasoning. In other words, help the fiduciaries make an “informed and reasoned” decision, which is, by definition, the product of a prudent process.

Any reasonable decision as the result of a prudent process —even if it’s a close call—is prudent, regardless of the outcome, because the decision was made using a prudent process.

Recent Development #2:

The Department of Labor’s (DOL’s) participant disclosure regulation became effective in 2012. While most plan sponsors now understand initial and annual disclosure requirements, little has been said about the notice requirements for removing investments. However, those rules are now becoming an issue.

The general rule is that, when fiduciaries decide to remove a fund, notice must be given to

participants at least 30 days, but not more than 90 days, before the effective date of the change. In most cases, a wait of that length will not be a problem. But, what if the adviser and the fiduciaries believe it is important to move quicker? For example, if the fiduciaries believed that the loss of an investment manager could result in underperformance in the immediate future, an immediate replacement – and, therefore, a shortened notice period – would be justified.

The regulation creates an exception to the general rule if “the inability to provide such advance

notice is due to events that were unforeseeable or circumstances beyond the control of the plan administrator, in which case notice of such change must be furnished as soon as reasonably

practicable.” (The reference to “plan administrator” is to the ERISA 3(16) plan administrator, which is

usually the plan sponsor.) In other words, in appropriate circumstances, such as an unexpected event, the 30-day notice can be shortened, perhaps to even a few days.

Advisers should educate plan fiduciaries about these notice requirements, and can then help them decide whether the exception is needed and determine if there are any associated charges. It’s important to include the recordkeeper in the discussion as early as possible, because it may take time to coordinate the removal and replacement and to prepare and distribute the notices. As a word of warning, while the exception is clearly stated, some recordkeepers are not aware of it in the first place and/or are not enthusiastic about taking advantage of it.

Keep in mind that it is required that the notice be delivered to everyone with an account balance (including participants who no longer work for the plan sponsor) and to all eligible employees who have not deferred into the plan (those who do not have account balances).

DOL INVESTIGATIONS

Recent Development #3:

In recent years, there have been several high profile court decisions that dealt with share class issues. In some of those cases, the issue was whether the plan should have had institutional share classes of mutual funds, as opposed to retail share classes; think of the Edison International case. There have also been cases about excessive revenue sharing (which can have its source in more costly share classes); think of the Wal-Mart1 _{and ABB}2 _cases.

A fair reading of those court opinions is that fiduciaries have a duty to use the plan’s financial heft— or purchasing power—to buy the “right” share class. It’s not about selecting the least expensive fund, but instead about spending the participants’ money in a reasonable way, considering the plan’s size and heft.

Until recently, all of the action had been in the courts. However, a few months ago, one of our plan sponsor clients received a DOL investigation notice, which included a request for information, with the following questions:

“Why did the Plan decide to use A shares for some of its investment funds rather than shares offered to employer-sponsored plans, such as R shares?”

Implications #3:

Fortunately, the plan committee had good answer and the investigation is being completed favorably. In this case, the adviser had educated the committee members about the types of share classes that were available, why and how share classes varied and how the plan received and used revenue sharing. The committee minutes reflected those discussions and the due diligence files contained the materials distributed by the adviser to the committee members.

Because of this focus on share classes, if they haven’t already, advisers will want to consider educating their plan sponsors on these issues and providing supporting documentation for the plan’s due diligence files.

Recent Development #4:

The DOL has started its investigation of plan sponsors’ receipt and review of service provider 408(b)(2) disclosures. (This is right on schedule since the initial 408(b)(2) disclosures were made in the first half of 2012, the Form 5500s for calendar 2012 were filed in late 2013 and DOL investigations for a particular year usually start about a year after the 5500 is filed.)

For example, in a recent letter from a DOL investigator to a plan sponsor, the following documentation was requested:

• Copies of . . . fee disclosures from service providers

• All written agreements . . . relating to services rendered to the Plan by all service providers

• Minutes of any Board of Directors meetings in which the Plan was discussed as well as the minutes of any Plan Trust or Plan Committee meetings

Implications #4:

Advisers should warn their clients that these investigations are underway. If a plan committee has not carefully reviewed the disclosures and evaluated the compensation and services of the providers, now is the time to do it. If a committee allowed the plan to overpay providers in the past, they may or may not be able to correct that breach. But, at the very least, the committee can fix the problem prospectively.

As a cautionary warning, both the courts and the DOL have said that to prudently evaluate provider compensation, market data about comparable services is needed. Market data can be obtained from benchmarking reports, request for proposals (RFPs) and other sources. Make sure, though, that the data is for appropriate “peers,” based, for example, on factors such as total assets and number of participants.

Intended for investment professional or institutional use.

This article was written by C. Frederick Reish, a partner at Drinker Biddle & Reath LLP. Reish is in the firm’s Employee Benefits & Executive Compensation Practice Group and Chair of the Financial Services ERISA Team. He has specialized in employee benefits law since 1973 and works with both private and public sector entities and their plans and fiduciaries; representation of plans, employers and fiduciaries before the governing agencies (e.g., the IRS and the DOL); consulting with banks, trust companies, insurance companies and mutual fund management companies on 401(k) investment products and issues related to plan investments; and representation of broker-dealers and registered investment advisers on issues related to fiduciary status and compliance, prohibited transactions and internal procedures. Drinker Biddle & Reath LLP is unaffiliated with RidgeWorth Investments.

This material is provided by RidgeWorth Investments for informational and discussion purposes only. Plan sponsors and others should consult their own counsel and designated advisor, if applicable, for specific guidance on their particular circumstances. The analysis and opinions provided may not be relied upon as investment advice and may change without notice. Statements of fact are from sources considered reliable but no representation or warranty is made as to their completeness or accuracy. Unless otherwise noted, the opinions provided by the authors and other sources are not necessarily those of RidgeWorth. Information provided is general and educational in nature. It is not intended to be, and should not be construed as, investment, legal, estate planning, or tax advice. RidgeWorth does not provide legal, estate planning, or tax advice. Laws of a specific state or laws relevant to a particular situation or pensions in general may affect the applicability, accuracy, or completeness of this information. Federal and state laws and regulations are complex and are subject to change. Consult with an attorney or a tax or financial advisor regarding your specific legal, tax, estate planning, or financial situation. All investments involve risk.

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