Interpreting Prudence and Loyalty Under ERISA

The Employee Retirement Income Security Act (ERISA) requires plan fiduciaries to act with prudence and loyalty, but what do those terms actually mean for plan sponsors?

According to Charles Field, partner and co-chair of Sanford Heisler Sharp’s Financial Services Litigation Practice Group in San Diego, under the duty of loyalty, employers must act solely in the interest of participants, for the exclusive purpose of providing benefits to participants and defraying reasonable expenses when administering their plan.

“Courts have said that this fundamental duty requires fiduciaries to act with ‘an eye single’ to the interests of participants and beneficiaries,” Field explains. “This means fiduciaries must avoid and mitigate conflicts of interest when selecting and monitoring a plan’s investments and in any other dealings with the plan.”

ERISA includes complex prohibited transaction rules, such as Section 406, that are designed to prevent self-dealing, notes David Klimaszewski, a partner at Culhane Meadows PLLC in Dallas. The Internal Revenue Code (IRC) also contains a rule in Section 401(a)(2) that requires plan assets be used “for the exclusive benefit” of participants and their beneficiaries.

For example, providing goods and services that are overly priced or perform poorly are common instances of prohibited transactions. Plan sponsors using plan assets for quid pro quo deals to benefit themselves or dealing exclusively with friends and family while eschewing more established market participants are other examples of how plan sponsors could put their own interests above those of plan participants, Field says.

In addition, financial institutions—including banks, brokers and investment advisers—that offer their own products and services to their company’s plan will always face duty of loyalty questions, he adds.

When it comes to the duty of prudence, ERISA says fiduciaries are to act with “the care, skill, prudence and diligence of a prudent person acting in a like capacity and familiar with such matters,” Field says. “Courts have said that prudence dictates that fiduciaries vigorously and independently investigate and regularly monitor each of the plan’s investment options with the skill of a prudent expert.”

For example, a prudent decisionmaking process would include evaluating the reasonableness of a plan’s service provider fees by comparing them against the marketplace. While the duty does not require a fiduciary to obtain the cheapest option, a fiduciary that fails to consider competitive bids runs the risk of being charged with an imprudent process, Field notes.

A prudent expert would also want to measure an investment option’s performance relative to both a recognized benchmark and investments within a comparable peer universe.

“While a fiduciary is not required to get the absolute best performance, investment options that consistently underperform their benchmarks and peers over an extended period of time expose fiduciaries to claims that their process is tainted by a failure of effort or competency,” Field continues.

It’s worth noting that ERISA’s prudent-man standard is a bit more flexible than what common law states, Klimaszewski adds. “ERISA fiduciaries may take into account more than just investment performance, such as the plan’s cash flow, upcoming distributions or the liquidity of the investments,” he points out.

Klimaszewski goes on to explain that prudence and loyalty apply to all fiduciary decisions made by the plan sponsor, but they’re most important when selecting service providers and choosing investments.

Selecting the right service provider, whether it be a trustee or third-party administrator (TPA), is crucial. In this case, the plan sponsor must investigate providers before making a decision and consider all the costs and the quality of services provided, including responsiveness and accuracy, Klimaszewski says.

When considering investments, most 401(k) plans allow participants to choose how they’d like to invest their plan benefits. “In this case, a fiduciary—often the plan sponsor—chooses which investment alternatives to make available to participants,” he says. The fiduciary/sponsor should therefore establish a process for evaluating different investment alternatives and a procedure for monitoring the performance of each alternative, Klimaszewski advises.