November 13, 1996
The Working Group on Guidance in Selecting and
Monitoring Service providers presents its interim report and
recommendations to the 1996 ERISA Advisory Council.
I. THE WORKING GROUP'S PURPOSE AND SCOPE
The 1996 Advisory Council on Employee Welfare and
Pension Benefit Plans created a Working Group on Guidance in Selecting and
Monitoring Service Providers. The Working Group was charged with studying
and making recommendations concerning the need for, appropriateness and
form of guidance to plan sponsors and fiduciaries in the Selection and
Monitoring of Service Providers.
The 1996 Working Group determined that its study would
focus on welfare plans as well as pension plans. The Working Group also
determined that its study should take place over the course of two years.
After reviewing the universe of common service providers (see below), the
Working Group concluded that, unless it focused its inquiry, the large
variety of service providers would preclude a thorough evaluation of this
topic.
The Working Group concluded that, the first year, the
study would focus primarily on pension plans with an emphasis on the
selection and monitoring of investment managers, investment consultants
and bundled service arrangements for small 401(k) plans. The Working Group
chose this approach based on testimony that the decisions involving
investment management were likely to have the most significant impact on
plan participants. The Working Group recommends that this study continue
for a second year, to focus primarily on service providers to welfare
plans.
The Working Group decided to review general principles
and industry practices in the selection and monitoring of service
providers that could be determined from the specific areas studied.
Preliminary conclusions and recommendations would be reported after the
first year and modified, as appropriate, after the second year of the
study.
The need for discussion on this topic was reinforced by
the work of the 1995 Advisory Council's Working Group on Real Estate
Investments. Among its recommendations, the 1995 Real Estate Working Group
recommended:
The Department of Labor should explore the feasibility
of developing and disseminating a publication which simply details the
duties of fiduciaries as they relate to plan investments in real estate.
Further study of the issues of plans with less access
to sophisticated real estate expertise is warranted.
These recommendations were based on testimony before
the 1995 Real Estate Investment Working Group that Trustee Guidance and
education was necessary so that trustees better understand their potential
liability, especially trustees of small and medium sized trusts.
II. WORKING GROUP PROCEEDINGS
The Working Group received oral and written testimony
at a series of public hearings. The Working Group also received and
discussed research and material from public sources that related to the
topic of study.
At the meeting on May 7, 1996, the Working Group
discussed the various types of service providers that might be retained by
both pension and welfare plans (see page 1). The Working Group
acknowledged that different selection and/or monitoring procedures might
be appropriate for different types and sizes of plans and with respect to
different types of service providers. However, the Working Group
determined that it would attempt to identify general principles that apply
to the selection and monitoring of various service providers by different
types of plans.
The Working Group decided to look at the practices and
problems with specific providers and industries. From both the industry
practices and the gaps in those practices, the Working Group would provide
suggestions both with respect to those areas in which guidance would be
helpful and the nature of the guidance. The Working Group would also
attempt to identify sources of information for fiduciaries concerning the
practices and/or qualifications of specific service providers.
At the hearing on June 18, 1996, Marc Machiz, Associate
Solicitor of Labor, Plan Benefit Security Division, reviewed the cases
brought by the Department of Labor concerning fiduciary misconduct in the
selection and monitoring of service providers. Jack Marco, Marco
Consulting, testified concerning practices of both investment managers and
investment consultants.
At the hearing on July 16, 1996, the Working Group
heard testimony concerning the procedures for selection and monitoring of
investment managers and codes of conduct from the perspective of corporate
plans, public plans and foundations. The witnesses were Joseph P. Craven
of Putnam Investment Company and Carter F. Wolfe from the Howard Hughes
Endowment. Barry Mendelson, Senior Special Counsel in the Investment
Management Division of the Securities and Exchange Commission, testified
concerning procedures, practices and information sources to aid
fiduciaries in the selection and monitoring of mutual funds and investment
advisors.
The hearing on September 10, 1996, focused on issues
and procedures with respect to bundled service arrangements, including
investment management services, often provided to small 401(k) plans. The
Working Group heard testimony from Leonard P. Larrabee, III Assistant
General Counsel, the Dreyfus Corporation, representing the Pension
Committee of the Investment Company Institute and from Edmond F. Ryan,
Senior Vice President, Defined Contributions Operations Department for
Massachusetts Mutual Life Insurance Company.
At its meeting on October 9, 1996, the Working Group
discussed the testimony and written material received and the Working
Group's preliminary conclusions.
The Working Group held a public teleconference on
November 4, 1996, to discuss its draft report.
A list of the Exhibits and written material received
can be found in Sections IV and V. A summary of the oral testimony can be
found in Section VI.
III. FINDINGS AND RECOMMENDATIONS: PENSION PLANS
The testimony and case law concerning service providers
indicate that some form of easily accessible educational material would be
useful for both large and small plans. Not only are plan fiduciaries faced
with the substantial requirements of due diligence in the selection and
monitoring of service providers, but in the case of investment managers,
fiduciaries also face the difficult task of understanding and evaluating
the risk in the underlying investment proposed by the provider.
Many of the problems with respect to service providers
arise because the responsible plan fiduciary either does not understand
his role and responsibility in the selection and monitoring of service
providers or exercises poor judgment because he does not have experience
or an appropriate source of information concerning legal requirements and
industry practices. The Working Group heard testimony that many of the
cases also involve an element of self-dealing.
Although the case law indicates that a large portion of
the cases involve small to medium sized plans and Taft-Hartley plans, the
misunderstandings and poor judgment based on lack of information also
affect larger plans. However, in the case of single employer defined
benefit plans where the sponsor is ultimately responsible for funding the
plan benefits, or where plan assets are not at issue, the financial
consequence of poor selection and monitoring of service providers tends to
fall on the sponsor. In many such cases, it appears that problems with
service providers are borne directly by the plan sponsor.
Therefore, the Working Group concludes that educational
information would be useful to fiduciaries of plans of all sizes but would
particularly benefit fiduciaries of small and medium size plans.
The Working Group acknowledges the concern expressed by
Marc Machiz in his testimony that any form of guidance carries with it
both the promise of improving practice among the weaker segments of the
industry as well as the danger of inducing undue complacency if the
Guidance is too formulated, sets too low a standard or is insensitive to
the wide variations and circumstances that plan fiduciaries face. However,
the Working Group concludes that information could be developed for
fiduciaries based on clearly defined general principles of fiduciary
conduct and industry practices that would serve as a resource to the
industry and not provide a refuge for those who would willfully disregard
their responsibilities. The majority of the Working Group does not believe
that new legislation or regulation is required.
Educational material is needed and is appropriate for
both small and large plans in the form of sponsor and fiduciary education.
However, educational material will be most useful to small and midsize
plans. While educational material will not change the behavior of those
who would act in their own self interest and/or with deliberate disregard
of their fiduciary obligations, it can still have an impact to discourage
such activity by equipping others to recognize and object to improper
conduct.
The Working Group collected a wealth of valuable
information on this topic. This information has been categorized by
subject in Sections IV and V of this report. The oral testimony of
witnesses has been summarized in Section VI. In order to make this
information more accessible, the Working Group recommends that the
Department of Labor develop and disseminate educational materials to plan
sponsors, participants and service providers that include the following
information:
A plain language description of the duties of
fiduciaries with respect to selection and monitoring of various kinds of
plan service providers, including the Department's views on the importance
of maintaining a written record of the due diligence process and of
disclosing potential conflicts to plan participants (see Sections IV and
V).
An explanation of the legal effect of a plan
fiduciary's delegation of responsibilities to various service providers
including the ongoing duty to monitor and evaluate the performance of the
service providers selected by the fiduciary (see Section IV).
An explanation of the ability of a fiduciary to rely on
the advice of service providers (see Section IV).
Examples of questions a fiduciary should ask or
procedures a fiduciary should follow in connection with the selection and
monitoring of service providers (see Section V).
Sources of information concerning various types of
service providers (see Section IV).
The Working Group also recommends that the 1997 ERISA
Advisory Council continue the work on this topic with a focus on service
providers to welfare plans.
IV. EXHIBITS AND WRITTEN MATERIAL RECEIVED
A. Selection and Monitoring Criteria
Procedures for Selecting Investment Managers Appendix A
to consent decree in Arizona State Carpenters Pension Trust Fund, et al.
v. Miller, et al.
Procedures for Monitoring Investment Managers Appendix
B to consent decree in Arizona State Carpenters Pension Trust Fund, et al.
v. Miller, et al.
Department of Labor Regulation 29 CFR § 2550.404a-1
Investment Duties, and the preamble thereto, 42 FR 54122.
Letter from Olena Berg, Assistant Secretary for Pension
and Welfare Benefits Administration, to Honorable Eugene A. Ludwig,
Comptroller of the Currency, concerning the Department of Labor's views
with respect to the utilization of derivatives in the portfolio of pension
plans subject to the Employee Retirement Income Security Act.
Labor Department Interpretive Bulletin No. 94-2
Relating to Written Statements of Investment Policy, Including Proxy
Voting Policy or Guidelines, 29 CFR 2509.94-2.
Labor Department Interpretive Bulletin No. 95-1 on Plan
Selection of Annuity Provider, 29 CFR 2509.95-1.
Labor Department Interpretive Bulletin No. 96-1
Relating to Investment Education, 29 CFR 2509.96-1.
B. Cases on Fiduciary Responsibility and Liability for
the Selection and Monitoring of Service Providers; Fiduciaries' Reliance
on Service Providers:
-
Donovan v. Mazola, 716 F.2d 1226
(9th Cir. 1983)
-
Donovan v. Tricario, 5 EBC 2057 (SD
Fla. 1984)
-
Brock v. Robbins, 830 F.2d 640 (7th
Cir. 1987)
-
Benvenuto v. Schneider, 678 F. Supp.
51 (ED NY 1988)
-
McLaughlin v. Bendersky, 705 F.
Supp. 417 (ED IL 1989)
-
Morgan v. Independent Drivers
Association, 15 EBC 2515 (10th Cir. 1992)
-
In Re: Unisys Savings Plan
Litigation, 74 F.3d 420 (3rd Cir. 1996)
-
Glaziers and Glassworkers Local 252
Annuity Fund v. Newbridge Securities, Inc., 20 EBC 1697 (3rd Cir.
1996)
C. Conflicts of Interest and Compensation
Code of Ethics and Standards of Professional Conduct
for financial analysts, Association for Investment Management and Research
(AIMR).
Investment Management Consultants Association (IMCA)
Standards and Practices for the Professional Investment Management
Consultant, received Nov. 1, 1996.
"Firm Views on Soft Dollars," Institutional
Investor
Investment Manager Questionnaire, The Marco Consulting
Group
Contract language concerning other compensation, The
Marco Consulting Group
Eugene B. Burroughs, "Checklist of Elements for
Inclusion in Investment Policy Statement," Investment Policy
Guidebook for Trustees, International Foundation of Employee Benefit
Plans, Brookfield, WI, 1995.
Presentation of Joseph P. Craven, Outline and Exhibits:
Summary of MASTERS' Investment Policies and Procedures
Request for Proposal for Investment Management
Services, The Commonwealth of Massachusetts
Disclosure Statement, The Commonwealth of Massachusetts
Massachusetts State Teachers' and Employees' Retirement
Systems Trust, Manager Search, Manager Analysis
Howard Hughes Medical Institute, Standard Operating
Policy and Procedure Manual, Conflict of Interest Policy
Written Testimony of Barry Mendelson including Article
on "How to Find a Qualified Financial Planner."
D. Information and protection available from the
Securities and Exchange Commission:
"Invest Wisely: Advice from Your Securities
Industry Regulators," Securities and Exchange Commission, 1994.
"Ask Questions - Questions You Should Ask About
Your Investments...and What To Do If You Run Into Problems",
Securities and Exchange Commission
"Invest Wisely: An Introduction to Mutual
Funds," Securities and Exchange Commission, 1994
"What Every Investor Should Know," Securities
and Exchange Commission, 1995
"Investor Fraud and Abuse Travel to
Cyberspace," Investor Beware, Securities and Exchange Commission,
1996
"Consumers' Financial Guide," Securities and
Exchange Commission, 1994
"How To Avoid Ponzi and Pyramid Schemes,"
Securities and Exchange Commission
"Information For Investors," Collection of
Fact Sheets from the Securities and Exchange Commission
V. EXAMPLES OF QUESTIONS A FIDUCIARY SHOULD ASK.
The following are examples of questions which
fiduciaries may consider in hiring and monitoring the performance of a
service provider. Given the wide range of plan needs, it is impossible to
provide a complete list of questions which will be applicable to all plans
and all circumstances. Nevertheless, the Working Group believes that the
following are representative of the types of questions to which
fiduciaries should seek answers to satisfy their obligations as
fiduciaries under ERISA.
A. ISSUES FOR FIDUCIARIES WHO ARE HIRING A SERVICE
PROVIDER
What service or expertise does the plan need? Is the
service or expertise necessary and/or appropriate for the functioning of
the plan?
Does this service provider propose to provide the
service that is necessary or appropriate for the plan?
Does this service provider have the objective
qualifications to properly provide the service that is necessary and/or
appropriate for the plan? Generally, the fiduciary should seek the
following information that will vary with the type of service provider
being retained:
-
business structure of the candidate
-
size of staff
-
identification of individual who
will handle the plan's account
-
education
-
professional certifications
-
relevant training
-
relevant experience
-
performance record
-
references
-
professional registrations, if
applicable
-
technical capabilities
-
financial condition and
capitalization
-
insurance/bonding
-
enforcement actions; litigation
-
termination by other clients and the
reasons
4. Are the service provider's fees reasonable when
compared to industry standards in view of the services to be performed,
the provider's qualifications and the scope of the service provider's
responsibility?
5. Does the plan have a conflict of interest policy
that governs business and personal relationships between fiduciaries and
service providers and among service providers? Does the plan require
disclosure of relationships, compensation and gifts between fiduciaries
and service providers and among service providers?
6. Does a written agreement document the services to be
performed and the related costs?
B. ADDITIONAL ISSUES WHEN HIRING AN INVESTMENT MANAGER
1. Does the Plan have a Statement of Investment Policy?
Some or all of the following issues may be addressed by a Statement of
Investment Policy:
(See Department of Labor Interpretive Bulletin 94-2.)
Evaluation of the specific needs of the plan and its
participants
Statement of investment objectives and goals
Standards of investment performance/benchmarks
Classes of investment authorized
Styles of investment authorized
Diversification of portfolio among classes of
investment, among investment styles and within classes of investment
Restrictions on investments
Directed brokerage
Proxy voting
Standards for reports by investment managers and
investment consultants on performance, commission activity, turnover,
proxy voting, compliance with investment guidelines.
Policies and procedures for the hiring of an investment
manager
Disclosure of actual and potential conflicts of
interest
2. What is the position to be filled? Why is the Plan
hiring an additional investment manager? Is the Plan replacing a
terminated manager with a manager of the same investment style or hiring
an additional manager with a different investment style? Is the hiring of
this manager consistent with the Statement of Investment Policy?
3. Does the Investment Manager have the objective
qualifications for the position being filled? (See questions concerning
qualifications above.) Does the candidate qualify as an investment manager
pursuant to ERISA section 3(38)?
4. How does the investment manager manage money? What
is the manager's performance record and how does the manager achieve his
performance? What are the risks of the investment manager's style and
strategy compared to other styles and strategies? Do you understand what
the manager does and the risks involved? Is this risk level acceptable in
view of the return? How do this manager's investment style and strategy
fit into the portfolio as a whole? (See Department of Labor Regulation 29
CFR § 2550.404a-1 Investment Duties and Letter from Olena Berg, Assistant
Secretary for Pension and Welfare Benefits Administration, to Honorable
Eugene A. Ludwig, Comptroller of the Currency concerning the Department of
Labor's views with respect to the utilization of derivatives in the
portfolio of pension plans subject to the Employee Retirement Income
Security Act.)
5. How does the investment manager measure and report
performance? Does the process ensure objective reporting?
6. Is the investment manager a qualified professional
asset manager? What is the investment manager's process to comply with the
prohibited transactions provisions of ERISA?
7. What is the investment manager's process to insure
compliance with the plan's investment policy and guidelines?
8. What is the investment manager's record with respect
to turnover of personnel?
9. Has the manager's investment style been consistent?
10. Has the investment manager been terminated by plan
clients within a relevant time period and why?
11. Has the ownership of the investment manager changed
within a relevant time period and how will this affect the ability of the
manager to perform the services needed by the plan?
12. What are the investment manager's fees? Are the
fees reasonable in comparison with industry standards for the type and
size of the investment portfolio? Does the fee structure encourage undue
risk taking by the investment manager?
13. Does the investment manager have a personal or
business relationship with any of the plan fiduciaries, or with another
service provider recommending the investment manager? If a relationship
does exist, how does it impact on the evaluation of the objective
qualifications of the investment manager and the recommendation?
14. If the plan has adopted a directed brokerage
arrangement with a broker affiliated with the plan's investment
consultant, how does the investment manager determine when to use broker
affiliated with the investment consultant? What are the per share
transaction costs?
15. Does the investment manager have insurance which
would permit recovery by the plan in the event of a breach of fiduciary
duty by the investment manager? What is the amount of the insurance? Who
is the insurance carrier?
C. ADDITIONAL ISSUES WHEN HIRING AN INVESTMENT
CONSULTANT
What is the role of the investment consultant? Are the
investment consultant's duties clearly stated in the Statement of
Investment Policy and/or the contract with the Investment Consultant?
Does the Investment Consultant:
Monitor and advise concerning asset allocation
Monitor and advise concerning riskiness of investment
strategies, styles and individual investment managers Monitor and advise
concerning the performance and riskiness of
investments under the direct investment control of the
fiduciaries
Monitor and advise concerning the compliance of the
investment managers and direct investments with the Statement of
Investment Policy and Investment Guidelines
Accept fiduciary responsibility in writing for all or
some of the services it performs? Does the contract state specifically for
which services the consultant accepts fiduciary responsibility?
3. Is the investment consultant's fee reasonable when
compared to industry standards in view of the services to be performed and
the scope of the consultant's fiduciary responsibility?
4. What are the investment consultant's performance
measurement process and techniques including the performance data base
used to evaluate the investment manager's performance? Do you understand
the process? Are these processes and techniques appropriate?
5. Does the investment consultant have a personal or
business relationship with any of the plan fiduciaries, or with one or
more investment managers? Does the consultant receive compensation from
investment managers either through the sale of services or through
directed brokerage arrangements? If a relationship does exist, how does it
impact on the evaluation of the consultant's recommendation of the
investment manager?
6. What investment managers were recommended by the
investment consultant in recent searches for other clients?
7. Does the investment consultant have insurance which
would permit recovery by the plan in the event of a breach of fiduciary
duty by the investment consultant? What is the amount of the insurance?
Who is the insurance carrier?
D. ADDITIONAL ISSUES WHEN HIRING A BUNDLED SERVICE
PROVIDER
Is the bundled service provider financially stable and
committed to the defined contribution business for the long term?
What is the bundled service provider's track record for
delivering accurate and timely record keeping, and other administrative
services, and insuring regulatory compliance?
Does the bundled service provider offer a wide range of
investment options that will allow participants to make appropriate asset
allocation decisions and achieve their investment objectives?
Has the bundled service provider demonstrated the
ability to generate superior investment performance over time?
Does the bundled service provider have the
administrative capability to provide assistance with employee enrollment,
investment education and ongoing plan communication?
Does the bundled service provider have knowledgeable
and dependable service representatives available to consult with plan
participants?
Has the plan sponsor been provided with advance written
disclosure indicating the expenses and commissions, if any, that the
bundled service provider will receive?
Are the bundled service provider's expenses reasonable
in relation to the level of services provided?
Has the plan sponsor received sufficient information to
make a true comparison of the services provided by the various bundled
service arrangements available to select from?
What procedures or mechanisms are in place to assure
that any mistakes that may be made by the bundled service provider will be
disclosed to the plan sponsor and corrected?
Does the plan sponsor understand its role in monitoring
the bundled service provider?
Has the bundled service provider disclosed in writing
the capacity in which it is acting, and has the plan fiduciary
acknowledged its understanding of this role?
Has the bundled service provider disclosed any
potential conflicts of interests?
E. ADDITIONAL ISSUES IN MONITORING SERVICE PROVIDERS
Who is responsible for monitoring the service provider?
What is the process to monitor the service provider?
Are written reports provided by the service provider?
With What frequency are the written reports provided?
Do the written reports describe the performance of the
service provider as compared to the applicable written guidelines and/or
contract?
Do the written reports provide sufficient information
to adequately evaluate the performance of the service provider compared to
benchmarks or industry standards?
Is there a process in place to either: (a) correct any
non-conformance with guidelines/contract, benchmarks or industry
standards; or (b) to terminate the service provider and retain a
successor?
Has the responsibility for monitoring a service
provider been delegated to an individual or another service provider?
If the responsibility to monitor a service provider has
been delegated, has the individual or service provider to whom the
delegation has been made accepted fiduciary responsibility in writing for
the monitoring?
VI. SUMMARY OF TESTIMONY RECEIVED
Meeting of June 18, 1996
Testimony of Mr. Marc Machiz,
Associate Solicitor of Labor,
Plan Benefits Security Division
Mr. Machiz opened his testimony by saying that the
perspective that he brought to the group's discussion was based upon his
review of investigations and supervision of enforcement litigation. He
stated that if he had to pick one part of the service provider universe
where improper selection and lack of monitoring had the potential for
causing the most harm to plans, it would be investment managers. He felt
this because of the investment managers' direct control of plan assets.
Mr. Machiz went on to make the important point that not
only are plan fiduciaries faced with the requirement of diligence in the
selection and monitoring of providers, but that they also had the
difficult task of understanding and evaluating the question of risk in the
underlying investments proposed by the provider. In his view, in many
cases, fiduciaries do not adequately understand and evaluate the
investment risk. As examples of this last point, he cited the Arizona
State Carpenters case and Lowen v. Tower Asset Management.
In evaluating an investment manager's performance, it
is fairly simple to calculate the rate of return. It is more difficult to
measure and appreciate the amount of risk involved in achieving that
return. Trustees must also understand the investment manager's fee
arrangements both in terms of ultimate cost to the plan and in terms of
any incentive the fee arrangement gives the investment manager to take
inappropriate risk.
Mr. Machiz made the point that a written statement of
investment policy can be a useful tool in the selecting and monitoring of
investment managers. He pointed out that in 1994 the Department had issued
Interpretive Bulletin 94-2 that explained the use of such a statement and
encouraged plan fiduciaries to adopt written statements of investment
policy.
Interpretive Bulletin 94-2 also states that compliance
with ERISA's prudence requirement requires maintenance of proper
documentation of the activities of the Investment Manager and of the named
fiduciary of the plan in monitoring the investment manager.
Mr. Machiz stated the Department's concern that
trustees be aware, not just of the rate of return of an investment, but
also the types of risks inherent in the rate. A greater risk should be
rewarded with greater return. Some investments require a much higher
degree of financial sophistication and expertise to understand the nature
of the risks and potential returns. He said that the Department's concern
concerning fiduciaries' awareness of risk could be seen in the Letter of
Guidance released with the Comptroller of the Currency, Statement on
Derivatives, March 28, 1996.
Concerning the focus of the Working Group, Mr. Machiz
cautioned that the prospect of official guidance carries with it the
promise of improving practice among the weaker segments of the industry as
well as the danger of inducing undue complacency if the guidance is too
formulated, sets too low a standard, or is insensitive to the wide
variations and circumstances that plan fiduciaries face. He said that the
Department would rely on the Council's wide practice experience to
instruct them on the value and risks of proceeding with guidance.
Mr. Machiz noted that if you looked at the full range
of the Department of Labor's litigation, there are a tremendous number of
cases involving small to medium-sized plans. The small plans' cases
usually had a self-dealing tinge to them and there was not really a
selection and monitoring service provider aspect to them.
He also noted that a significant portion of the cases
about selection and monitoring service providers involve Taft-Hartley
plans. He noted, however, that the reasons for this probably having
nothing to do with where the service provider problems arise. In the case
of single employer defined benefit plans, sponsors are ultimately
responsible for funding the benefits regardless of the performance of the
investment manager and other service providers. The sponsor must pay the
money to fund the plan sooner or later. If the sponsor discovers a
problem, he simply fires the investment manager or other service provider.
Mr. Machiz commented that investment manager's sales
pitches to trustees generally included little discussion regarding risk
and this was usually confined to a few sentences in which the trustees
were assured that the manager had figured out how to out-perform the
market while taking risks less than the market at large. When we look at
the cases, we see fiduciaries who have a service provider -- either an
investment consultant or the investment manager -- who is giving the
fiduciaries updates on how the plan is performing but really no assessment
of the underlying risk of the portfolio. Another issue for trustees is
whether the consultant hired to do performance tracking has been hired to
perform the right service for the plan. Will the performance consultant
give an assessment of the risks in the portfolio and not just performance
numbers.
In response to a question, Mr. Machiz responded that
the theme of overpayment for services showed up in a number of the
Department's cases. Overpaying for services by either not doing
competitive bidding or taking other steps to ascertain the correct price
for services shows up often in welfare plan cases. In investment cases the
issue is usually not the fee but the way services were provided. His sense
is that fees for investment managers tend to be fairly competitive. In the
Department's cases, the investment managers got their profit on the other
end by investing in investments in which they owned an interest. Once an
investment manager has discretion over the plan assets, the potential for
making himself wealthy comes not so much from charging a few extra basis
points for management but from abusing the power that's been given to him,
whereas with a welfare plan's contract administrator oftentimes the price
at which services are provided is the abuse itself. In the case of other
service providers, the pricing is really a different problem than the
quality issues that are the focus of investment manager cases.
Mr. Machiz said that his feeling is that service
provider abuse cases are the result of ignorance and with plan fiduciaries
being "too cozy" with service providers. A formal process for
selecting and monitoring makes it more difficult to rely on inappropriate
factors. However, he stated his view that there is virtually no process
that with enough will and ingenuity can't be fixed. However, to the extent
problems are the result of ignorance and not the fact that the decision
makers are "ethically challenged," guidance and education can
attempt to address this.
Mr. Machiz also discussed other potential areas of
service provider abuse. He discussed the selling of insurance to the plan
by the administrator and inadequate disclosure of commission income. He
also mentioned the potential for conflict of interest when the investment
performance monitors are also in the brokerage business. How much does the
brokerage income influence whom they recommend? It is something that the
Trustees need to be aware of and question.
Mr. Machiz agreed that one of the more difficult issues
facing trustees in retaining service providers was to always be sure that
the scope of the engagement was appropriate for the type of advice that
needed to be given. It's a serious problem, particularly when the plan
fiduciary is not an expert in the particular area (that is why the
fiduciary is, in fact, hiring the service provider in the first place).
Fiduciaries need to know enough to ask the right questions and to enter
into an agreement with the service provider where the scope of the
engagement is appropriate. If the scope is too broad, the plan may
overpay. On the other hand, if the scope is too narrow it may not
accomplish the goal the fiduciary set out to accomplish by retaining the
service provider in the first place. Mr. Machiz agreed with these points
and again noted the importance of a formal written statement of investment
policy.
However, Mr. Machiz noted in response to questions
concerning investment guidelines that neither the statute nor regulations
required them. In addition, the specificity of the Guidelines affected
their utility in limiting investment managers and managing investment
risk. He looked to the Working Group for recommendations concerning
investment guidelines.
In response to questions regarding whether accountants
could become more useful in highlighting investment problems before they
became serious, Mr. Machiz said that in his experience, if you try to talk
to accountants about issues of prudent investing, they tell you that this
is not their area of expertise and that you are looking at the wrong
service provider.
In response to a question about counsel's role, Mr.
Machiz said that he believed that counsel's role was a very delicate role.
He said that he believed that counsel had a responsibility to advise the
named fiduciary who was making the decisions about the need to put
procedures in place to make sure that there is appreciation of risk. He
pointed out that counsel should advise that there be adequate processes in
place so that if the fiduciary is ever questioned about why did they hire
this manager, why did they conclude that this manager should continue to
be retained, that it can be adequately justified.
In response to a question about the possibility of
having portfolios under Department guidelines, Mr. Machiz responded that
there already exist a Department prudence regulation which people tend to
forget about. He pointed out that it talks in terms of taking into account
the risks and returns in the context of the entire portfolio. The
regulation suggests that we're not going to tell you that there's any kind
of investment that is absolutely forbidden, but you have to consider that
investment in terms of its function in the portfolio. The Department has
been very sensitive to not limiting the investments from which fiduciaries
could choose. However, if there is a type of investment for which no one
really understands the risk characteristics, the prudent thing might be
for the fiduciary to wait until the risk characteristics of the investment
are understood.
Mr. Machiz noted that the Exhibits on Selecting and
Monitoring Service Providers that were part of the consent order in the
Arizona Carpenters Case were negotiated by the Department of Labor in the
specific context of that litigation. They did not go through a general
policy review since there was not concern for universal applicability.
Therefore, they should be looked at as potentially instructive but not as
any kind of final and definitive view of the Department on what trustees
should be doing.
Testimony of Mr. Jack Marco,
Marco Consulting Company
Chicago, Illinois
Mr. Marco stated that he had been an investment
consultant for about 19 years. He said that his company helps trustees
establish investment guidelines, hire money managers, evaluate
performance, vote proxies. The company does not actually manage money for
the trustees.
He pointed out that even with Association for
Investment Management Research (AIMR) standards that have been published
about the way money managers should present numbers, this still does not
prevent some people from displaying numbers in a way that makes them look
good. It makes them look better than they really are. For example, he
recently evaluated a money manager who claimed that he had beaten the
index over a period of time. However, the time periods listed ended in
March. When he evaluated their numbers on an annual basis, they had failed
to beat the index in seven out of ten years. The AIMR standards do not
prevent this type of manipulation.
He also pointed out that in hiring a money manager, a
plan should be wary about working from a published list of top performers
or trade publications. He gave an example of investment manager who was on
the top of a list but when Mr. Marco investigated, he found that this
investment manager was a small bank, had only a small amount under
management and had one good year. In another case, an investment manager
who was on probation with Mr. Marco's client for his poor performance was
rated highly by a publication. When he called the manager he was told that
the publication was given the performance of a very specialized investment
product they offer and which is very different from the investment product
they provide most of their clients. However, this distinction was not
noted in the publication.
He noted that fiduciaries of large plans can be
unsophisticated with respect to investments. They may be just as easily
misled by information as their small plan counterpart since they are not
in the investment business. In addition, in the case of larger plans, egos
may get in the way of seeking expert information.
Mr. Marco pointed out that his firm regularly monitors
the performance of hundreds of money managers. However, in the case of a
new manager, his firm has a 15-page questionnaire that they have the money
manager fill out about the money manager. They asked for performance
information from the inception of the money management form. He pointed
out that it was important that his company get raw information regarding
the money manager's performance and not composites put together by some
marketing person at the money management firm. It is the job of the
marketing person to create a composite that makes the money manager look
good. His company then does a proper analysis of the numbers including
analysis of the individual accounts managed to note variations in
performance.
Mr. Marco said that other important things to look for
when hiring a money manager are turnover of personnel in the firm,
turnover of clients, style changes, ownership changes and litigation.
He noted that it was very difficult for fiduciaries,
who are not in the investment business, to know what questions to ask, get
all of the relevant information and evaluate it. Therefore, he feels that
fiduciaries should go to a professional to help them select investment
managers because it is a very difficult process to do correctly on their
own.
However, Mr. Marco suggested that his own field,
investment counseling, had some problems of its own. He pointed out that
they were totally unregulated and unsupervised by anybody. He suggested
that if an investment consultant was receiving a fee from a money manager,
and that money manager is hired, that is a problem. He did not suggest
regulation, but suggested that some sort of required disclosure to clients
be required.
Mr. Marco explained that for an investment manager to
get a new account is tremendously profitable. They really do not have to
do much additional work to service a new account except prepare a report
and attend some meetings. They do not have to do more research; they just
buy bigger blocks of securities. Since it is so profitable to add clients,
investment managers will do almost anything to get new business, including
trying to influence the people who advise the fiduciaries in their
decisions -- the investment consultants. Therefore, he feels that if an
investment consultant has some connection to a money manager or is
receiving some compensation from a money manager, the consultant's advice
should be suspect. He suggested that if a fiduciary hires a consultant
with some connection to a money manager, that the fiduciary may want to
stipulate at the beginning of the process that the related firm may not be
considered to be hired.
Mr. Marco stated his opinion that one of the biggest
problems in the industry is investment consultants doing business with
money managers -- selling services, doing brokerage, anything that
involves compensation. In this situation, the consultant has two employers
-- they are working for the fiduciaries and they are working for the money
manager that they are supposed to be evaluating or recommending. Mr. Marco
felt that fiduciaries should inquire of their consultants concerning
compensation from money managers. He feels consultants should be required
to disclose what revenue they receive from money managers. Fiduciaries can
then make up their minds concerning the objectivity of the consultant's
recommendations.
In response to a question, Mr. Marco acknowledged that
for very small plans, under $10 million, it was usually cost prohibitive
for them to go hire a consultant. He thought that these plans should stick
with pooled funds where they would be much better off since the
performance numbers are more reliable. However, Mr. Marco noted that
fiduciaries can end up investing in inappropriate pooled investment
vehicles.
In response to a question, Mr. Marco pointed out that
unless a consultant claimed to be an investment advisor or a licensed
broker, there were no regulations. Investment Advisors are regulated under
the Investment Advisory Act.
When asked if there were a self-regulating organization
for investment consultants, Mr. Marco said there was one called the
Investment Management Consultants Association (IMCA). Upon investigation,
he found the organization to be loaded with broker consultants. When he
talked with them about joining, he said that he would join if the
organization would simply say you cannot do business with the other side.
Let consultants be consultants and not sell services to money managers. He
felt this would totally wipe out their membership.
Mr. Wood asked if Mr. Marco thought some sort of
disclosure for plan sponsors or fiduciaries might not be a good idea.
Perhaps an annual statement that they receive no compensation or any
benefit, side benefits from any relationship they have with either
investment managers, custodians, consultants, or service providers. He
wondered if this might be particularly good for the ethically challenged.
Mr. Marco said that he did not think that it would hurt, however, anybody
that's going to do that has a much bigger problem than just hiring a
manager.
In response to a question concerning the questions he
would ask if hiring an investment consultant, Mr. Marco stated that he
would ask about experience and qualifications, potential conflicts of
interest -- what businesses is the consultant in besides consulting --
technical capabilities, measurement techniques -- what kind of data bases
are used for performance, communications and references.
In response to a question, Mr. Marco stated that
contracts with consultants should require them to acknowledge fiduciary
responsibility. Many consultants will not sign anything that says they are
a fiduciary.
Meeting of July 16, 1996
Joseph P. Craven,
Senior Vice President
Putnam Investments
Boston, Massachusetts
Based on his prior experience, Mr. Craven stated the
ultimate goal for plan sponsors and trustees in selecting and monitoring
investment managers is to have in place formalized written decision-making
policies and procedures. Investment policies and procedures should be (1)
consistent with the fiduciary responsibilities of plan sponsors/trustees,
staff and investment consultants; and (2) give plan sponsors/trustees the
best opportunity to select and retain investment managers who will serve
the long- term needs of the plan and its participants.
In hiring investment managers, Mr. Craven stressed the
importance of trustees observing five criteria. The first criterion is for
plan sponsors/trustees to have a working knowledge of the specific needs
of the plan and its participants. Plan needs include determining
investment goals, risk tolerances, staffing levels and conducting
investment manager oversight. Needs of the plan will determine its
investment structure and asset allocation. A plan's asset allocation
should determine types of investment managers evaluated for hire.
The second important criterion is for all policies and
procedures involved in the hiring of investment managers be put in
writing. Unless policies and procedures are written, there will always
exist substantial opportunity for misunderstanding. Written procedures
should be specific to plan's individual needs, and utilize a format
clearly understood by all plan sponsors/trustees. Plans should consider
utilizing a request for proposal (RFP) format to make the selection
process as fair as possible. All selection criteria for hiring managers
should be determined before a search is initiated.
The third criterion is for plan sponsors and trustees
to gather as much information as possible to help them make informed
decisions. Trustees can utilize consultant databases and other reference
sources to evaluate managers performance numbers. All client and
professional references should be carefully screened and critically
analyzed.
The fourth criterion is to require full disclosure of
all potential conflicts of interest between investment managers and plan
sponsors/trustees, staff, and investment consultants. Investment manager
candidates should complete a disclosure statement revealing all financial
relationships between their firm and all other parties doing business with
the pension plan. The fifth criterion is to carefully evaluate information
provided by investment managers before making a selection. Each step in
the selection process should be carefully documented in writing should it
be needed for later reference.
Mr. Craven testified that monitoring investment
managers is as much a fiduciary duty for plan sponsors/trustees as
selecting them. He recommended that plan sponsors/trustees consider four
important points in the monitoring process. The first point is every
pension plan should have clear and understandable written investment
guidelines applicable to each class of investment managers. The guidelines
should clearly state all restrictions and limitations placed on each class
of investment managers.
The second important point is that investment managers'
compliance with investment guidelines be closely monitored by either
internal staff or an investment consultant. Investment managers failing to
stay within established guidelines should be dealt with immediately. Mr.
Craven's third point covered the different types of due diligence required
over different time periods. Investment manager compliance with written
guidelines should be evaluated at least quarterly, while investment
managers performance against peers can be performed on a less frequent
basis.
The difficulty of investment manager oversight and
compliance was the last point made by Mr. Craven. Plan sponsors/trustees
should have either adequate internal staff or an investment consultant to
closely monitor investment managers. Mr. Craven suggested smaller pension
plans need fewer managers and should utilize less complex asset
allocation. Software packages are now commercially available to help plan
sponsors/trustees monitor investment managers' compliance. Software
packages may be an attractive alternative for plan sponsors/trustees who
are unable to afford hiring internal staff or an investment consultant.
In closing, Mr. Craven stated plan sponsors/trustees
must remember they are dealing with funds belonging to plan participants
and not their own money. Consequently, plan sponsors/trustees must
sometimes pass up appealing investment opportunities not meeting long-term
needs of the pension plan.
Carter F. Wolfe
Howard Hughes Endowment
In selecting investment managers, Mr. Wolfe stated it
was critical for plan sponsors/trustees to establish clear investment
guidelines as a first step. In drafting investment guidelines, plan
sponsors/trustees should consider three important points. The three points
are: (1) choosing the relevant index for each class of investment manager;
(2) determining the amount investment managers are expected to exceed
their index; and (3) determining how much risk plan sponsors/trustees are
willing to tolerate in order for managers to exceed their indexes.
In choosing the types of managers to be hired, plan
sponsors/trustees can utilize either individually managed accounts,
commingled funds, or mutual funds. Smaller plans have difficulty
justifying individually managed accounts because of the higher management
fees and are better off selecting commingled funds or mutual funds. In
addition, plan sponsors/trustees may choose between active and passive
management styles by managers. Mr. Wolfe's recommendation was small and
medium-size plans should utilize passively managed index funds to invest
plan assets. Index fund management fees are lower than their actively
managed counterparts. Because of lower management fees, index fund
managers cannot afford to market and entertain plan sponsors/trustees.
Plan sponsors and trustees cannot depend solely on
investment managers' historical performance in selecting managers. Mr.
Wolfe discussed a Cambridge Associates chart showing how investment market
conditions change and how few investment managers maintain performance at
highest levels due to changing market conditions. First-quartile
performing managers in the first five-year period may easily be performing
at third-quartile levels in the second five-year period and vice versa.
Mr. Wolfe stated plan sponsors/trustees should remember
the three "Ps" of investment manager selection. The three
"Ps" are (1) philosophy of the firm; (2) people qualifications;
and (3) performance numbers. Plan sponsors/trustees should evaluate an
investment management firm's philosophy for a good fit with the plan's
asset allocation. A key question for plan sponsors/trustees to ask is: Has
the firm's investment philosophy stayed consistent over time. People
qualifications include researching key staff members backgrounds and
qualifications. Plan sponsors/trustees should inquire into: How much
turnover is there among key staff members? How is the firm owned? Are
compensation packages in place to retain key staff members? Who are the
firm's clients and how long have they been associated with the investment
management firm?
Once investment managers are selected, plan
sponsors/trustees must decide how to compensate the investment managers
for their services. There are two types of investment manager fees, fixed
and performance-based fees. Performance-based fees are much more complex
and difficult to calculate. Consequently, performance fees are not as
widely used as fixed fees. Another difficulty for plan sponsors/trustees
in negotiating fees is the difficulty getting industry-wide comparable
data on investment management fees.
Mr. Wolfe advised plan sponsors/trustees to concentrate
in three areas to effectively monitor investment managers. First, plan
sponsors/trustees should ensure investment managers are complying with
written investment guidelines and terms of their individual contracts. The
second area was monitoring turnover of key personnel within the investment
management firm. Effective due diligence was the third area mentioned by
Mr. Wolfe and should involve at least one on-site visit to each investment
manager annually.
On the subject of investment consultants, Mr. Wolfe
recommended plan sponsors/trustees not let investment consultants pass
their account to a junior consultant who has less experience. When
selecting an investment consultant, plan sponsors and trustees should
interview all clients furnished as references.
Lastly, Mr. Wolfe said he was unfamiliar with the
practice of investment consultants selling informational products to
investment managers.
Barry Mendelson,
Senior Special Counsel in the Investment Management
Division
Securities and Exchange Commission
When selecting a mutual fund, a Plan sponsor should
consult a number of sources. First, the sponsor should thoroughly review
the Fund's prospectus. The prospectus contains information about the
mutual fund's investment objectives, risk profile, fees and expenses and
past performance. In addition, plan sponsors should consult a fund's
statement of additional information or SAI that contains more detailed
information about the mutual fund than is found in the prospectus. An SAI
is available from a mutual fund upon request.
Plan sponsors can obtain even more information about a
mutual fund by reviewing its most recent annual and semi-annual reports to
shareholders. These reports list all of the fund's portfolio holdings and
give past performance information. The itemization of a mutual fund's
portfolio holdings gives valuable insight into the fund manager's strategy
and philosophy.
In addition, plan sponsors should consult third-party
source material. For example, Morningstar publishes reports covering
approximately 3000 stock and bond funds. More importantly, the reports
contain an analyst's discussion of the fund and a risk analysis of the
fund's portfolio using Morningstar's risk rating system that has become
the standard in the industry. In addition to Morningstar, Lipper
Analytical Services also publishes reports that track fund performance and
fees.
Fund sponsors should consider visiting the offices of
the mutual fund. Speaking with the portfolio manager can lead to insights
into the fund's investment strategies. Sponsors should also speak to the
mutual fund's administrative personnel to find out what special services
that fund may be able to provide to the plan.
A plan sponsor should also carefully review the risks
associated with investment in a mutual fund. As part of a general review
of mutual fund disclosure requirements, the SEC is examining what can be
done to improve the discussion in the prospectus of risk and allow
investors to gauge more accurately a fund's overall risk profile.
Sponsors should pay particular attention to information
about sales charges and operating expense. Expense is particularly
important because every basis point of expense lowers the fund's return.
Sponsors should check to see how long the current fund
manager has held his or her position.
Plan sponsors often select investment advisory firms to
be responsible for investing some or all of the plan's assets. Generally,
a firm or individual that provides investment advice for a fee must
register with the SEC and comply with the Investment Advisors Act. A
fundamental element of the Investment Advisors Act is that the investment
advisor owes its clients a fiduciary duty and, therefore, must act solely
in their best interests. It is integral to this fiduciary duty to require
full and fair disclosure of all material information. Therefore, the
Investment Advisers Act requires and advisor to furnish each prospective
client with a written disclosure statement containing: the types of
advisory services, the fees its charges, the types of securities with
respect to which the firm provides advice, the methods of investment
analysis used by the firm, any affiliations with other securities
professionals, whether the firm makes securities transactions for advisory
clients, a current financial statement, the educational and business
background of the key employees and any legal action taken against the
firm's employees.
Mr. Mendelson noted that the law does not require any
educational or business standards in order to register as an investment
advisor. Anyone can register so long as they disclose the required
information. Therefore, plans sponsors must carefully check the
credentials of an advisor before hiring him or her. For this reason,
sponsors may want to hire an advisor who has been certified or accredited
by a private organization.
Since information in an advisor's disclosure brochure
is very general in nature, sponsors must obtain specific information about
how the advisor intends to invest the plans' assets and the fees it will
charge. Sponsors should ask not only about the advisor's direct
compensation but also about indirect compensation such as soft dollar
arrangements and compensation to affiliated broker dealers. Sponsors
should also ask for past performance information and references.
Plan sponsors may engage the services of an investment
consultant to assist in the selection of mutual funds for the plan.
Depending on the services it provides an investment consultant may be
required to register as an investment advisor. In any event, sponsors
should ask whether the Investment consultant or anyone affiliated with the
consultant will receive any remuneration of any kind other than the fee
paid by the plan as a result of the consulting arrangement.
Many of the same sources of information consulted
before selecting an investment fund or advisor should be consulted to
monitor the fund or advisor after selection. These should be reviewed to
determine how the fund has performed compared to the market generally.
The investment advisor is required to notify clients of
any material change in the advisory relationship. Finally, the sponsor
should arrange with periodic meetings with the advisor to discuss the
management of the plan's assets.
Mr. Mendelson noted that the mutual funds were only
required to report their holdings twice a year but that fiduciaries may
wish to check on the fund's portfolio on a more frequent basis.
Under the securities laws, investment consultants who
provide advice concerning particular investments are required to register.
If a fiduciary wants to protect the plan he or she can insist that the
consultant be registered. He felt it was more important for the fiduciary
to find out about the consultant's credentials, get references and find
out if the consultant is receiving compensation from any source other then
the pension plan.
Mr. Mendelson stated that under the Investment Advisors
Act of 1940 any one who gives personalized investment advice for
compensation is an investment advisor under the act.
With respect to fees for mutual funds, Mr. Mendelson
comments that many funds will waive the load for pension plan investments
or plan investments over a particular amount. Therefore, there is no need
for a plan to pay a load since there is a universe of funds out there that
will make the same investment management services available without a
load.
Mr. Mendelson noted that the SEC could examine an
investment advisor who fails to disclose a conflict of interest.
Mr. Mendelson discussed in general terms the current
proposals of the SEC to require better disclosure of the risk of an
investment fund. The change would be in the nature of disclosure with
respect to the current portfolio rather than with respect to potential
investments.
Mr. Mendelson commented that a similar disclosure
project was not needed for investment advisors because they were
fiduciaries under ERISA and, therefore, had an obligation to recommend
only investments that are suitable for their clients. A decision of the
United States Supreme Court from the 1960s--SEC v Capital Gains Bureau,
Inc.-- states expressly that anyone who is registered as an investment
advisor is a fiduciary.
Meeting of September 10, 1996
Edmond F. Ryan
Senior Vice President, Pension Management
Massachusetts Mutual Life Insurance Company
Mr. Ryan prefaced his remarks by stating that he is
familiar with the range of bundled products offered by the service
provider community to 401(k) plans as a result of his twenty-three years
of experience within the pension industry. His comments focused on the
bundled product offered by MassMutual in the small employer market place,
which is fairly representative of bundled products offered by the
insurance industry.
Mr. Ryan made the important point that although the
legal standards for selecting service providers does not vary depending
upon whether a 401(k) plan is small or large, what makes sense does vary.
The fixed cost of establishing and maintaining a plan is a far more
significant issue for a small employer. Additionally, the administrative
burden and complexity of maintaining a 401(k) plan is a bigger issue for
small employers. While large employers often have fully staffed Human
Resources and Treasury Departments, and many even have internal investment
units, small employers rarely have this expertise in house. Consequently,
they need a higher level of guidance and assistance.
Claims by small businesses that they do not maintain
retirement plans because they are too costly and complicated are made
manifestly clear when one looks at coverage rates relative to plan size.
The Department of Labor estimates that almost one half of private sector
workers--51 million people--do not have retirement plans. While over 80%
of large companies with over 1000 employees offer plans; less than 25% of
small companies, which are defined as having fewer than 100 employees
offer plans.
According to Mr. Ryan, the bundled service provider
approach provides small employers with a response to both the cost and
complexity hurdles to plan coverage. A bundled product can provide an
employer that sponsors a small plan with an array of valuable plan
features previously available only to large plans, all at a reasonable
cost. The bundled approach also prevents any gaps or overlaps in service
that might otherwise result when multiple service providers are involved.
While it makes sense for large employers to have multiple service
providers, the bundled approach makes sense for small employers and
provides them with a realistic opportunity to provide important retirement
benefit to their workers.
Mr. Ryan noted that providing services to the defined
contribution market is a very competitive business. Since 1982, when there
were only a handful of competitors in the full service 401(k) market
place, more and more service providers, including insurance companies,
banks, third party administrators and employee benefit consultants, have
entered the highly concentrated 401(k) provider market place. Several
years ago mutual funds began to focus on the burgeoning 401(k) market as
well. This ever increasing competition, coupled with advances in
technology and a movement toward more wide spread benefits outsourcing
have forced the leading companies to upgrade the quality of their bundled
services without increasing fees. Service providers have enhanced their
technological capabilities and resources and can now provide daily valued
funds, daily valuation participant record keeping systems, 800 telephone
numbers for participants to access account information and online employer
access to plan and participant information. These technological
innovations in plan administration and record keeping allow bundled
service providers to respond to the demand for more comprehensive and
integrated outsourcing of benefit plan administration.
On the investment side, providers need an array of
funds covering the entire risk-return spectrum. Mr. Ryan noted that the
Department of Labor's promulgation of Regulation §404(c) accelerated this
trend by encouraging employee-directed defined contribution plans to offer
a broad range of investment alternatives. When the Department published
its regulation in 1992, it insisted on a minimum of three covariant funds.
Today, a typical bundled 401(k) client has up to eight funds. Greater
investment choice and opportunity for diversification have produced a need
for more and better investment education tools and counseling for plan
participants. Mr. Ryan commended the Department for its recent release of
Interpretive Bulletin 96-1, which will encourage employers to provide
additional financial educational materials without incurring the risk of
becoming a fiduciary under ERISA.
Market data demonstrates that plan sponsors across all
segments of the 401(k) market increasingly prefer these reasonably priced
bundled products, Mr. Ryan noted. For example, a recent study found that
the number of large defined contribution plans, (those with more than
1,000 participants,) using a single vendor for plan services increased to
59% in 1995 from 37% in 1989. Mid-size plans dramatically increased their
use of bundled service to 62% in 1995 from 46% in 1989. The move toward
bundled services was also dramatic among small plans, which increased
single vendor usage to 70% in 1995 from 62% in 1989.
Mr. Ryan stated that, in his experience, plan sponsors
who purchase a bundled package of investments and administrative services
have seven essential expectations. The first essential client expectation
of a bundled service provider is financial stability, with a commitment to
the defined contribution business for the long term. Studies confirm that
prospective purchasers of a full service product rate financial stability
as the single most important vendor selection criteria. This is reasonable
since retirement plans by their very nature represent a long term
financial commitment by employers to their employees. Therefore, prudent
plan sponsors should inquire about the financial stability and experience
of the service provider, and this is information the service provider
should readily disclose.
The second essential expectation is timely and accurate
compliance and record keeping services that reduce the plan sponsor's work
load and save time and money. Mr. Ryan testified that an essential
ingredient of any successful defined contribution program is the strength
and flexibility of its administrative service capabilities. The track
record of a vendor's ability to deliver the basics, accurate and timely
record keeping, regulatory compliance and other administrative services,
should be an absolutely crucial consideration for a plan sponsor when
selecting a full service product.
A quality provider recognizes that small employers most
often lack fully staffed human resource and benefit areas to manage their
401(k) plans, and strive to provide a competitive, state-of-the-art array
of services in order to minimize the administrative burdens placed on the
employer. The following services are now the rule for most 401(k) bundled
products: (1) A daily valuation record keeping system should be able to
process all withdrawals, including hardships, terminations, and
retirements, as well as participant loans, and have the capacity to ensure
that participant records always total to plan level records for all
investment funds. (2) The record keeper should withhold federal and state
income taxes from distributions made to participants and beneficiaries,
and prepare IRS tax information forms. (3) Current information should be
routinely available via an interactive voice response system. Through
these systems participants can access account information using a toll
free 800 telephone number and obtain information that is updated on a
daily basis. (4) Comprehensive participant loan services should be
available to assist the plan sponsor in the day-to-day administration of
loans. (5) Detailed, yet easy to understand, reports should be made
available to the plan sponsor summarizing the plan related activity that
has occurred. (6) To ensure that participants know how their contributions
are being invested and how their investments are performing, written
participant account balance statements should be provided to participants
on as frequently as a quarterly basis.
The third essential expectation is an investment
manager which has demonstrated the ability to generate superior investment
performance over time and which offers a wide range of investment options
that will achieve plan participants' investment objectives. Plan sponsors
demand that the investment options available under a bundled product be
diverse and produce competitive rates of return, because employees'
ultimate retirement benefits will be based on investment performance.
Mr. Ryan noted that one of the great challenges facing
plan sponsors is getting participants to make rational investment
decisions for retirement. Many Americans make little or no provision for
their retirement security during their working years. Even those that have
made the crucial decision to begin investing for retirement often select
overly conservative investments that weaken their retirement security
because of low rates of return or are inconsistent with their investment
objectives and risk profiles. This is especially true in today's 401(k)
environment, where more and more plans allow participants, rather than
plan fiduciaries, to make their own investment selections. Consequently, a
bundled service provider must provide education and assistance to
participants planning for retirement and making asset allocation
decisions.
The fourth essential bundled 401(k) client expectation
is an administrator that assists with employee enrollment, investment
education and ongoing plan communication. To achieve maximum value and
high levels of participation, the plan must be recognized, understood and
appreciated by employees. Small employers, who typically do not have a
sophisticated human resource organization, rely heavily on the employee
communication services provided under a bundled product to achieve that
potential by assisting in the development of an effective employee
communication program. An effective employee communication program should
include the basics on investment education, and provide participants with
a means for assessing their risk tolerance as well as designing
alternative asset allocation strategies which provide them flexibility to
meet individual return objectives and risk tolerance.
Investment education and retirement planning
information for employees can take the form of written material, video
tapes, computer software, and periodic group education sessions as well as
one-on-one conversations with pension professionals. Mr. Ryan noted that
because retirement planning concepts and terminology may be complicated
for some employees, educational materials should be designed to appeal to
all levels of investment sophistication in accordance with Interpretive
Bulletin 96-1
The fifth essential client expectation is an
administrator that helps interpret the laws and regulations and keeps
their plan in compliance as the legal environment changes. Compliance with
government regulations is paramount to a 401(k) plan's existence and plan
design and ongoing regulatory compliance are critical parts of a bundled
program. Most bundled service programs include prototype plan documents.
They are flexible, comply in form with IRS regulations, and economic to
use since they save the plan sponsor time and money on qualification
filings and ongoing compliance. A typical bundled service program assists
plan sponsors in drafting Summary Plan Descriptions, completing Form 5500s
and keeping their plans in compliance with the operational requirements of
the Internal Revenue Code through testing services.
The sixth essential bundled 401(k) client expectation
is a consultant that provides personal attention from people who are
knowledgeable and dependable. The ability for participants in plans
sponsored by small employers to speak with a knowledgeable and dependable
service representative is vital to ensuring plan sponsor satisfaction. A
voice response system can be combined with personal assistance from
customer service representatives to help keep participants informed about
the plan and their accounts.
Mr. Ryan noted that while it is obvious that small plan
sponsors who select a bundled product receive a level of services that was
previously available only to the largest plans because of cost concerns,
the services are valuable only if they are provided accurately and on a
timely basis. A bundled program should operate with documented service
standards and deliver service on time, accurately, and to specifications.
The bundled service provider should establish stringent internal
measurement goals and seek constant improvement.
The seventh essential bundled 401(k) client expectation
is that expenses must be reasonable in relation to the level of services
provided. A key consideration for the plan sponsor is the method for the
payment of expenses. They can be paid by the plan sponsor, withdrawn from
participants' accounts, shared by both the plan sponsor and the
participant or paid from forfeitures. Most plans across all market
segments provide for cost sharing by the plan participants and the sponsor
company. All expenses should be fully disclosed to the plan sponsor in
writing. Mr. Ryan brought to the Council's attention an article that
appeared in the April 1996 edition of CFO entitled, Facing Up To Total
Plan Cost. The article suggests there is a wide disparity in costs of
bundled 401(k) service provider packages.
Mr. Ryan concluded his testimony by stating that he
views the role of the bundled service provider as part business-part
social engineer. Such organizations exist only because they can offer
quality services at a reasonable cost and meet their profit objectives. He
noted that he also takes pride in the fact that bundled service providers,
like MassMutual, are the only reason small companies are able to offer
401(k) retirement plans to hundreds of thousands of employees.
Leonard P. Larrabee, III
Senior Counsel
The Dreyfus Corporation
Mr. Larrabee, an attorney with the Dreyfus Corp. spoke
on behalf of the Investment Company Institute (ICI), and was accompanied
by Catherine L. Heron, Vice President and Senior Counsel, and Russell
Gaylor, Assistant Counsel, who coordinate pension activity at the ICI. Mr.
Larrabee began his testimony by stating his definition of a bundled
service arrangement. Such an arrangement is an integrated package of
administrative and investment services from affiliated or unaffiliated
entities that is offered to the defined contribution market as a single
product. That definition covers a variety of programs. The most basic one
would involve an integrated package of administrative and investment
services offered by a single financial institution. Mr. Larrabee made the
point that, in the last five years, strategic alliance programs have been
developed as an alternative to traditional bundled arrangements. The
difference is that instead of having one financial institution offering
investment and administrative services as a coordinated, integrated
product, two or more institutions band together to provide a complete
package of administrative and investment services as a coordinated,
integrated product.
Mr. Larrabee next stated that the distinction between
an alliance program and the traditional bundled service arrangement has
become blurred in that it is becoming more and more common for a financial
institution that offers a traditional, "one stop shopping,"
product to open up its program to include outside funds within its own
bundled program.
The bulk of Mr. Larrabee's prepared remarks were
devoted to the types of services a plan and its participants receive when
a plan sponsor decides to purchase a bundled package of services. They can
potentially receive every type of service involved in the daily operation
of a defined contribution plan such as investment products, trustee
services, record keeping services, communication and educational
materials, telephone voice response systems, and plan documentation and
compliance services. In essence, a plan sponsor could contract with a
bundled service provider to have all of its defined contribution needs
addressed.
Mr. Larrabee next discussed the issue of selecting
service providers and specifically addressed the concern that
participants' interests may be compromised by a plan sponsor's desire for
the administrative convenience afforded by bundled service arrangements.
Mr. Larrabee felt such criticism is unfair, and made the point that the
same types of processes and procedures that are followed in the unbundled
context carry over to the bundled service arrangement. With respect to
investment options, Mr. Larrabee stated that due to the large number of
bundled service providers to select from, if a particular service provider
does not offer competitive investment products, it will not survive.
According to Mr. Larrabee, participants' interests are
served by the number of "participant friendly" features
available in a bundled service arrangement, such as daily valuation of
participant account balances coupled with the ability to make daily
transactions. Mr. Larrabee noted that studies have shown that the ability
of participants to trade on a daily basis actually leads to better
investment decisions on the part of participants who tend to focus on
investing for the long-term without having to worry about market
volatility over the short-term. He also stated that the ability to make
frequent transactions in a bundled arrangement leads to better allocation
decisions by participants.
Investment education is another participant friendly
service typically found in a bundled service arrangement. Mr. Larrabee
noted that financial institutions and their personnel are experts in
investment matters. Many of the innovative educational materials developed
for participants in defined contribution plans evolved from the bundled
service type of arrangement. In a bundled service arrangement, investment
education materials are coordinated and targeted to the particular
investment options available under the plan. Such materials are more
effective in terms of educating employees and influencing their behavior
than generic materials that may be used in an unbundled situation.
Mr. Larrabee made the point both in his testimony and
in a question posed to him later that in a bundled arrangement the parties
available to answer participant questions about investments available
under the plan are registered representatives of the service provider.
They are licensed and trained to answer any and all questions relating to
securities and other investments available to plan participants. This is
typically not the case in an unbundled arrangement where the answers to
participant questions may be more scripted and less informative.
Mr. Larrabee concluded his remarks by stating that the
reason bundled service arrangements -- whether they are in the form of the
traditional one stop shopping arrangement or an alliance program -- are so
popular and will continue to be so popular is that they are very
responsive to the interests of the key players in a defined contribution
plan, the plan participants.
In response to questions about the cost differential of
bundled versus unbundled arrangements, Mr. Larrabee stated that he
believes a plan sponsor tends to receive a better net price on a bundled
arrangement, and that on a per participant basis, a bundled arrangement is
more economical.
Custody and money management are handled by independent
entities in a typical unbundled arrangement, and provide important
cross-checks in the reconciliation of plan assets. Mr. Larrabee was asked
to what extent do bundled service arrangements dilute this protection, and
whether errors would be less likely to be reported to plan sponsors in a
bundled arrangement. Mr. Larrabee responded that reconciliation procedures
do take place in bundled arrangements, and that the potential for errors
going unreported and uncorrected is not any greater or lesser in either
arrangement. He and Ms. Heron stated that mutual funds, like banks and
insurers, are highly regulated entities. They are regulated at both the
federal and state level. There is no indication that the regulatory
regimes are inadequate to deal with any mistakes or problems that arise,
including any conflicts of interests between affiliated entities. Plan
sponsors and participants receive numerous reports and statements. A
mistake could potentially be found by a regulator, an auditor, a plan
sponsor, a plan participant or by the service provider itself. Financial
institutions take responsibility for the errors that they make. When
mistakes occur, they are corrected so that participants are put in the
position they would have enjoyed if the transactions were processed
correctly when initiated.
VII. Members of the Working Group
Joyce A. Mader, Working Group Co-Chair
O'Donoghue & O'Donoghue
James O. Wood, Working Group Co-Chair
Louisiana State Employee's
Retirement System
Judith Mares, Chair of the Advisory Council
Mares Financial Consulting, Inc.
Glenn W. Carlson
Arthur Andersen LLP
Kenneth S. Cohen
Massachusetts Mutual Life
Insurance Company
Carl S. Feen
CIGNA Financial Advisors
Jim Hill
State of Oregon
Marilee P. Lau
KPMG Peat Marwick LLP
Richard McGahey
Neece, Cator, McGahey
& Associates, Inc.
Edward B. Montgomery
University of Maryland
Victoria Quesada
Attorney at Law
Zenaida M. Samaniego
Equitable Life Assurance
Society of the United States
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