Data & Research June 21, 2016

Investment Policy Statements Can Protect Advisers from DOL Scrutiny

In the wake of the DOL rulemaking, a financial advisory firm acts at its peril if it overlooks the prudent investor rule, a new research paper says.
Reported by

Concerned about conflicts of interest among financial advisers to retirement savers, in April 2016 the Department of Labor (DOL) finalized a rulemaking that imposes Employee Retirement Income Security Act (ERISA) fiduciary status on any person who provides “investment advice or recommendations” to retirement savers or retirement plans.

A discussion paper written by Max M. Schanzenbach, from Northwestern University – School of Law, and Robert H. Sitkoff, from Harvard Law School, notes that fiduciary status under ERISA imposes not only a duty of loyalty but also a duty of care. As the DOL acknowledged, a financial adviser to a retirement saver will now be subject to “trust law standards of care” in addition to “undivided loyalty.”

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According to the authors, the fiduciary standard of care is governed by the “prudent investor rule,” which is grounded in modern portfolio theory and requires an overall investment strategy having risk and return objectives reasonably suited to the purpose of the investment account. Under the prudent investor rule, no type or kind of investment is categorically permissible or impermissible. Instead, a fiduciary must evaluate the principal’s risk tolerance and investment goals, choose a commensurate level of overall portfolio market risk and expected return, and avoid wasteful diversifiable risk.

Because of the multiplicity of relevant considerations—including the investor’s risk preferences, age and health, family status and obligations, and other asset holdings and sources of income—application of the prudent investor rule is specific to an investor’s particular circumstances, the paper notes. Accordingly, the rule permits a wide variety of investment techniques, including active investment strategies, provided that the result is an overall portfolio with risk and return objectives reasonably suited to the investor. The rule is principles-based rather than prescriptive.

NEXT: Successfully complying with prudent investor rule

Application of the prudent investor rule to financial advisers to retirement savers creates new litigation risk for those advisers. “In the wake of the DOL rulemaking, therefore, a financial advisory firm acts at its peril if it overlooks the prudent investor rule,” the authors write.

However, they contend that compliance with the rule is feasible with the tools already in use by other fiduciaries, such as bank trust departments, that have long been subject to the prudent investor rule. The centerpiece of bank trust department compliance with the prudent investor rule is the “investment policy statement.” Such a statement sets forth the individualized investment program created to match the account’s purpose and risk tolerance with a diversified portfolio having an appropriate balance of risk and expected return.                                

The authors point out that an investment policy statement will normally specify the account’s risk tolerance” as well as its investment goals and return requirements in light of the particular circumstances of the account. An investment policy statement will also normally specify asset allocation guidelines, and facilitates rebalancing to maintain proper diversification.

Finally, the authors note, an investment policy statement also provides a paper trail in the event of an audit, litigation, or a dispute, and it facilitates selection of an appropriate performance benchmark against which to compare the account’s performance.

The discussion paper may be downloaded from here.
Compliance June 21, 2016

Lawsuit Claims a Church Plan Elected to Be an ERISA Plan

Plaintiffs in the suit contend plan fiduciaries did not follow ERISA, then claimed "church plan" status when announcing the plan would be terminated.
Reported by

In a new lawsuit, Martinez-Gonzalez v. Catholic Schools of the Archdioceses of San Juan Pension Plan, a class of plaintiffs alleges the multiemployer plan set up by the church for Catholic School employees was set up as an Employee Retirement Income Security Act (ERISA) plan, but plan fiduciaries, including service providers, failed to comply with ERISA.

According to the complaint, the plaintiffs say the Superintendence of Catholic Schools of the Archdioceses of San Juan, as settlor and/or sponsor of the plan represented to them that it made the election under Section 410(d) of ERISA for the plan to be an ERISA-governed plan. An election under this subsection with respect to any “church plan” shall be binding with respect to such plan, and, once made, shall be irrevocable.

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However, since 2009 until the present all the defendant administrators and fiduciaries of the plan failed to send a summary of the annual financial report of the plan to its participants and beneficiaries as provided by ERISA and the plan. Neither the current defendant administrators and fiduciaries of the plan nor the former ones ever sent to the plan participants and beneficiaries a copy of the actuarial studies performed to the plan or any audited financial statements. At least since 2009 until the present, the fiduciaries and trustees failed to pay the annual premiums imposed by the Pension Benefit Guarantee Corporation (PBGC) on every pension plan covered by ERISA. The defendant trustees and fiduciaries failed to pay a bond, in violation of Section 412 of ERISA and the deed of trust of the plan.

The lawsuit claims the defendant fiduciaries and administrators of the plan failed to comply with any of the provisions of Pension Protection Act of 2006 (PPA) or the Multiemployer Pension Reform Act of 2014 (MPRA) to prevent the insolvency of the plan. In addition, they failed to inform to the plan participants and beneficiaries about the deficit of the pension fund and its critical financial situation, until the plan became insolvent, during the first months of 2016.

NEXT: Investments contributed to insolvency

From 2006 until the present, the defendant fiduciaries and administrators of the plan invested more than 80% of the pension plan’s fund in close end bonds’ funds and other bonds of several instrumentalities and public corporations of the Commonwealth of Puerto Rico. The lawsuit alleges that during that period of time, such close end bonds’ funds and bonds lost between 70% and 80% of their market value. “Such loss provoked the accelerated insolvency of the plan,” the complaint says.

The defendant administrators and fiduciaries of the plan failed to diversify the investment portfolio of the pension fund in violation of ERISA. The complaint says the overall investment strategy of the defendant fiduciaries and administrators of the plan was the result of the fiduciaries and administrators merely attending monthly meetings and rubber stamping the judgment of the brokers and brokerage firms serving the plan. These brokers and brokerage firms are also listed as defendants in the lawsuit.

The compliant says the defendant brokers’ advice served as a primary basis for the investment decisions of the plan. Their advice to excessively buy closed end bonds’ funds and several bonds of various instrumentalities and public corporations of the Commonwealth of Puerto Rico for a fee resulted in substantial losses to the pension fund and provoked its insolvency. “The downward trend of the economy of Puerto Rico between 2006 and 2016 and its high indebtedness, should have warned a prudent broker that such high concentration of the plan’s assets in these bonds could very well provoke a substantial loss to the plan’s fund. These brokers violated their fiduciary duties towards the plaintiffs, as plan participants and beneficiaries of the pension plan,” the complaint says.

On or around March 2016, the plan sponsor defendants together with plaintiffs’ employers decided to terminate the plan. Once they made this decision, they publicly claimed that the plan was a “church plan” exempt from such provisions.

The lawsuit says that even if the court rules that the Superintendence of Catholic Schools of the Archdioceses of San Juan, as sponsor or settlor of the plan failed to make an election to be covered by all the provisions of ERISA, then this defendant made a false representation to all the plan participants and beneficiaries, including the plaintiffs in this case and consequently, it is liable to them and to the pension fund for any losses that such misrepresentation might have caused to them.

The complaint is here.

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