The Dilemma of Innovative Investment Strategies:  The Intel 401(k) Litigation

What fiduciary steps must be in place to prudently investigate and monitor such investments?

The responsible fiduciaries managing innovative investments must follow the following best practices:

“Solely in the interest of the participants and beneficiaries”

The first step for any plan fiduciary considering an innovative investment is that it must be absolutely clear the investment is added to the plan to meet specific needs of the participants and is in their best interest. The needs and abilities of participants vary widely.  The goal of a specific need should be included in the documentation of the prudent process.  As a part of ERISA’s general obligation to engage in a procedurally and substantively prudent process, when selecting new investments, fiduciaries must analyze the needs and goals of the plan and its participants, and evaluate the appropriateness of an investment in light of those particular needs and goals.

In a publication about selecting target date funds (“TDF”) the DOL goes to great lengths to consider individualized strategies that could better fit the needs of a particular subset of participants. Target Date Retirement Funds -Tips for ERISA Plan Fiduciaries, DOL Publication, February 2013 http://www.dol.gov/ebsa/newsroom/fsTDF.html

“For the exclusive purpose of providing benefits to participants and their beneficiaries”

Some innovative investments may be in the form of private equity or hedge funds where economies of scale are very important.  It must be clear for example that the investment of plan assets is not used to “seed” startup investments.  It can have no secondary benefit to any plan fiduciary or discretionary decision maker.  This and other similar analysis as to clear purpose should be part of the due diligence process and well documented.

“Defraying reasonable expenses of administering the plan”

The Intel lawsuit places particular emphasis on the fact that the hedge fund and private equity investments are much more expensive than simple index funds. But it would be a mistake to jump to the simplistic conclusion that passive or index funds are the only prudent investment due to cost in every plan.  In some cases higher revenue used for specific plan services such as individual meetings with employees or managed account services to improve their outcomes could be considered prudent.  This cost/benefit concept is consistent with what the DOL has outlined in their publication “Meeting Your Fiduciary Responsibilities,” http://www.dol.gov/ebsa/pdf/meetingyourfiduciaryresponsibilities.pdf].

“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”

This is the core of the fiduciary process both for standard plan investments and innovative plan investments. The ERISA prudence requirement consists of two parts, procedural prudence and substantive prudence.  Procedural prudence relates to the investigation, evaluation and decision-making process.  Substantive prudence refers to the duty to evaluate relevant information and make an informed decision based on that information. Courts have emphasized that the fiduciaries must conduct a thorough investigation and make decisions based on all of the information they have gathered.

“By diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so”

The proposed innovative investment strategy must be well diversified. It would be hard to justify why a prudent fiduciary would not want a diversified portfolio when ERISA is clear that this is generally a requirement unless it is clearly prudent not to do so.  Modern Portfolio Theory (MPT) constructs a risk reward frontier that assumes diversification always eliminates non-system risk.  Since MPT is a bedrock tenant of ERISA diversification is very important. Consideration must be given to how participants would handle the innovative investment in a participant directed plan. In other words might it be possible for a participant to only invest in the strategy when it was intended to be part of a larger diversified portfolio? Participant behavior should be taken into account when the innovative investment is added to the fund lineup.

“In accordance with the documents and instruments governing the plan insofar as such documents and instruments are consistent with the provisions of this subchapter ”

It is essential that the innovative investment strategy be consistent with the governing documents. For example, if an ERISA investment manager under section 3(38) is being hired, delegation is only permissible if the plan document expressly provides. Documents should be reviewed to make sure that this provision is in place.

Conclusion

Ultimately the plan fiduciaries in the Intel case will be judged on their documented process–which includes duty of loyalty, exclusive purpose, and the duty to act as a prudent expert to investigate and monitor while taking into account the needs of plan participants.

About Greg Kasten view all posts

Dr. Gregory W. Kasten serves as Founder and CEO of Unified Trust Company. He has published more than 100 papers on financial planning and investment-related topics in various financial and business journals; written two editions of the book Retirement Success. In 2007-2009, Medical Economics listed Dr. Kasten as one of "The 150 Best Financial Advisers for Doctors" in the country. Dr. Kasten was inducted into the Advisor Hall of Fame by Research Magazine in 2011 and in 2013 was named Retirement Plan Adviser of the Year by Employee Benefit Adviser Magazine. He has more than thirty years of investment experience.