Journal of Pension Benefits (Volume 9, Number 2, Winter 2002)

By Fred Reish and Joe Faucher

Does ERISA explicitly require that a 401(k) plan have a written investment policy statement? No. Should a 401(k) plan have one anyway? Absolutely, say the authors, who review ERISA and case law to explain why.

This column addresses the question of whether the Employment Retirement Income Security Act of 1974 (ERISA) requires 401(k) plans to have a written investment policy statement (IPS), and if it is not clearly required, whether a fiduciary should nonetheless develop and document one.

As discussed in previous columns, the legal responsibility for the investments in a 401(k) plan rests with the corporate officers who oversee the management of the plans assets. Although those duties may be delegated to investment managers [see ERISA 3(38), 402(c)(3) and 405(c)], this article assumes that the responsibility for selecting the investment options rests with key corporate officers. To the extent they are responsible for selecting those funds, the officers are ERISA fiduciaries either because they are appointed to the task (e.g. as plan committee members) or because they take on the responsibility as functional fiduciaries [See, Reish and Faucher, Who Are the Investment Fiduciaries for a 401(k) Plan? Part I, Journal of Pension Benefits (Autumn 2000) at 73.]. Whether ERISA requires an IPS is an important question to any corporate officer with the responsibility for selecting 401(k) investment options.

For readers who are not familiar with the term investment policy statement, in Interpretive Bulletin 94-2, the DOL offered the following definition: the term statement of investment policy means a written statement that provides the fiduciaries who are responsible for plan investments with guidelines or general instructions concerning various types or categories of investment management decisions.

The key points covered by an IPS for a 401(k) plan are these:

• Investment structure
• Core funds
• Non-core funds
• Life-style or asset allocation funds
• Mutual fund window
• Stock brokerage accounts
• Employer stock
• Criteria and procedures for the selection, monitoring, removal, and replacement of each part of the investment structure, including standards for evaluating the designated core and non-core funds
• The services ancillary to the investments, such as investment education, investment advice to the investment fiduciary and the participants

Although it is an investment best practice to have an IPS, there is no specific requirement in ERISA that an IPS be drafted. As a word of caution, however, at least one court has found that a fiduciary breached his ERISA duties under the general fiduciary requirements by not establishing an IPS for the plan (see below). In addition, it seems difficult — if not impossible — to prudently select and monitor investments for a 401(k) plan without an investment policy, but does an investment policy need to be reduced to a written IPS?

ERISA

ERISA requires that every employee benefit plan provide a procedure for establishing and carrying out a funding policy and method consistent with the objectives of the plan and the requirements of this title. [ERISA 402(b)(1) (emphasis added).] ERISA also requires that fiduciaries generally 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 conduct of an enterprise of a like character and with like aims. [ERISA 404(a)(1)(B).] A funding policy, however, is not the same thing as an investment policy (although an IPS could address the investment needs of a plan relative to issues such as the anticipated timing of the distribution of benefits, that is, the need for cash for benefit payments in a pooled investment trust), and none of these provisions specifically require that a plan sponsor have a written policy describing the guidelines for investment decisions. Therefore, in the context of a 401(k) plan in which participants select their investments from among a list of options chosen by the plan fiduciaries, ERISA does not explicitly require that the investment fiduciaries have a written policy regarding the selection and monitoring of the investment options.

LISS v. SMITH

On the other hand, at least one federal district court judge has held that failure to maintain a written investment policy constituted a breach of fiduciary duty under the facts of that case. Liss v. Smith, [991 F.Supp. 278 (S.D.N.Y. 1998)] involved a wide range of purported breaches of fiduciary duties in the administration of multiemployer plans. The court found that the plaintiffs claims:

relate[d] to the trustees complete and total failure to take even the most minimal and basic steps to ensure that Fund assets were invested and spent properly. The list of omissions is a prototype for breached fiduciary duty: the trustees failed to investigate the risks and propriety of investments, and instead accepted their brokers recommendations blindly; they failed to question or learn the extent of the commissions this same broker was charging them; they never compared such charges to the charges of other brokers or investment advisers; they never adopted an investment policy or guidelines; they never hired a professional money manager; they never considered their statutory duty to diversify investments; they failed to take any action for years in light of evidence of the Pension Funds growing insolvency; and they failed to conduct any investigation into the Health Funds service providers, most of whom were making regular payments to the [family of trustees counsel].

[Id. 991 F.Supp. at 288.]

As you can imagine, when the court used this language in introducing the plaintiffs claims, it didnt look particularly good for the trustees.

The plaintiffs claimed that the failure of the trustees to adopt a formal written statement of investment policy constituted an independent breach of fiduciary duty. While the defendants conceded that the plan had no formal written policy regarding plan investments, they argued that they had a de facto policy in place, since plan assets were invested only in U.S. government securities, U.S. Treasury issues, various other government-backed securities or bonds, guaranteed investments issued by insurance companies, contracts, money market and mutual fund accounts with accredited institutions, and taxi-medallion loans.

The court first noted that ERISA does not contain a specific requirement that a written investment policy be maintained by the trustees. [Id. at 296.] Nevertheless, the court rejected the defendants arguments that a policy was implicit in the types of investments that the plan actually made, holding that Defendants argument would render any investment decision, no matter how arbitrary, part of a self evident policy to make such investments. [Id. n.21.] The court then found that a written policy statement was necessary at least in this instance. The court cited Interpretive Bulletin 94-2 as support for its conclusion, even though that interpretive bulletin does not specifically require plans to adopt written IPS:

While this regulation states only that a written investment plan is consistent with ERISAs fiduciary duty requirements, in the circumstances here, absence of any plan constitutes a breach of fiduciary duty.

[Id. at 296.]

In footnote 23 of the decision, the courts analysis was even broader and stronger:

The regulations reference to the role the investment. plays in. the plans investment portfolio further supports the conclusion, discussed above, that plans require investment policies, for it is only against such a benchmark that the determination can be made as to what role a particular investment plays in the overall portfolio.

[Id. at 298]

Thus, from Interpretive Bulletin 94-2, which allows, but doesnt require, a written IPS, and Liss, which held that ERISAs general fiduciary rules required one in the circumstances of that case, it is clear that an IPS is not required in every case, but is required in some cases, depending on the facts. Unfortunately, there is little guidance to help fiduciaries determine whether, in their specific situation, an IPS is required.

INVESTMENT POLICY

A remaining question is whether the law requires a plan to have an investment policy, written or otherwise. Although ERISA does not explicitly require an investment policy, ERISA has indirectly imposed such a requirement by mandating that investment fiduciaries prudently select plan investments and monitor their performance. In the preamble to the final ERISA Section 404(c) regulations, the DOL explained:

in the case of look-through investment vehicles [e.g. mutual funds], the plan fiduciary has a fiduciary obligation to prudently select such vehicles, has a residual obligation to periodically evaluate the performance of such vehicles to determine, based on that evaluation, whether the vehicles should continue to be available as participant investment options.

In a similar vein, one court has said: Once the investment is made, a fiduciary has an ongoing duty to monitor investments with reasonable diligence and remove plan assets from an investment that is improper. [Harley v. Minnesota Mining & Mfg Co. 42 F.Supp.2d 898, 906 (D.Minn 1999).]

For a fiduciary to prudently perform its selection and monitoring duties, it must select the appropriate benchmarks, for each investment, compare the investment performance and expenses to those benchmarks and analyze any difference. (The determination of investment prudence will ultimately be decided by the courts after receiving testimony from investment experts — most likely consultants and academics. Those experts will say that 401(k) fiduciaries should, among other things, compare performance, expenses, and volatility to appropriate peer group and index benchmarks.)

In performing those duties, the fiduciaries should document the selection of the peer groups and benchmarks, the information gathered for comparison, the application of the benchmarks to the plans investment options, and the conclusions reached. In Interpretive Bulletin 94-2, the DOL said:

It is the view of the Department that compliance with the duty to monitor necessitates proper documentation of the activities that are subject to monitoring.

In other words, ERISAs general fiduciary rules require that the fiduciaries determine the key elements of an investment policy, even if those elements are not documented in writing. If a fiduciary does not prudently select and monitor a 401(k) plans investment options, however, a court — much like the Liss court — may find that the failure to document the selection and monitoring criteria in an IPS is a breach of ERISAs fiduciary requirements. That is, one possible outcome is that if a fiduciary prudently performs its duties (e.g. the selection and monitoring of 401(k) investment options), a court may find that it was not a breach to fail to document an IPS. On the other hand, if the fiduciary fails to perform the duties typically described in an IPS, then a court may hold that the fiduciary breached its ERISA duties by failing to establish an IPS.

WHY HAVE A POLICY IF ERISA DOESNT REQUIRE ONE?

Since ERISA does not explicitly require that a 401(k) plan have an IPS, should a plan have a policy?

ERISA and the cases and the DOL guidance that interpret it impose a duty on fiduciaries to prudently select and to periodically monitor their plan investments and their investment courses of action. There are few hard and fast rules for determining whether a fiduciary has succeeded or failed in that duty. Instead, ERISA defines fiduciary compliance in terms of procedural prudence. That is, in determining whether an investment fiduciary has fulfilled its duty, an investment options performance is not as important as the procedure that the fiduciary employed in selecting and monitoring the investment options. As explained in a leading case:

[ERISAs] test of prudence. is one of conduct, and not a test of the result of performance of the investment. The focus of the inquiry is how the fiduciary acted in his selection of the investment, and not whether his investments succeeded or failed.

[Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983).]

The first step in employing a prudent procedure is having a procedure. Although it may be possible for investment fiduciaries to follow a procedure that they keep in their heads, that approach has its downfalls. First, any procedure or policy that isnt reduced to writing is going to be difficult to articulate if it comes into question. And, if the fiduciaries conduct comes into question, it will be unlikely that all of the plan fiduciaries (assuming the plan has more than one) will have consistent understandings of what that unwritten policy is. Second, it will be difficult to document compliance with a policy that hasnt been documented itself. In short, if investment fiduciaries are procedurally prudent in the selection and monitoring of plan investments, a logical — and prudent — place to start is with a written IPS.

On the other hand, some may argue that there is a reason for a 401(k) plan not to have a written IPS. Specifically, they point out that if the investment fiduciaries fail to comply with their own written policies, it makes them an easy target for complaining participants and the Department of Labor. Others argue that, in the real world of 401(k) plan investing, the plans investment fiduciaries abdicate their roles to brokers, insurance companies, and investment consultants and should not set themselves up for failure by implementing a policy that they have no intention of following.

In our opinion, these doomed to failure theories are not valid reasons for avoiding a written investment policy. With or without a written IPS, plan fiduciaries are subject to requirements of procedural prudence. If fiduciaries are unable to consistently articulate the standards by which they judge the investments they make available to 401(k) plan participants, they are off to a bad start in satisfying the procedural prudence standard. By adopting and following an IPS, plan fiduciaries will be in a better position to establish that they did what the law requires.

That being said, IPSs should be drafted in a way that does not increase the risk of failure by the investment fiduciaries. Like any other legal document, an IPS should be carefully drafted, typically by an attorney familiar with employee benefits issues working in concert with the fiduciaries and their investment consultants. A well-crafted IPS should provide guidelines for the investment fiduciaries, but should leave the decisions to their judgment, rather than mechanically requiring that funds be removed for failure to meet those guidelines. This flexibility will minimize the risk of a breach of fiduciary duty for a failure to follow the terms of the IPS.

Finally, there is an important practical reason for having an IPS—an IPS is a part of a well thought out and executed investment strategy, which should, over the long haul, provide superior investment results for all of the participants, including corporate officers who serve as investment fiduciaries.

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