Joe Investor walks into his broker’s office and says he wants to invest some money for retirement. His broker, Sophia, sets him up with an IRA and a high-expense-ratio actively managed mutual fund called The Maximum Safe Return Fund. On the same day, Angelo Saver decides to save some money for his retirement. He puts his money in the Zvi Bogle S&P 500 Index Fund.
In year two, Joe starts a small business, hires Angelo to work for him and sets up a retirement plan. On Sophia’s recommendation, Joe puts in a core fund menu made up entirely of high-expense-ratio actively managed funds.
In year three Joe comes in and says Angelo has this fund that he really wants to invest in, the Zvi Bogle S&P 500 Index Fund. Sophia says that’s a very bad idea, but Joe insists that they do something to accommodate Angelo. Sophia then suggests that Joe add a brokerage window to his plan—that will provide the choice of thousands of funds, including the Zvi Bogle S&P 500 Index Fund.
In year four, after the core fund menu has a particularly bad year, Joe goes back to Sophia and says he wants to get rid of the core menu and just have a brokerage window. “You know,” he says, “just like when I came in here the first time. Then I can pick whatever I want, and Angelo can pick whatever he wants.” Sophia thinks this is a very bad idea. “I mean,” she says, “you and Angelo are not sophisticated investors—you could invest in something really stupid.” But Joe is adamant, and so in year four they go with a “brokerage window only plan.”
What do ERISA's fiduciary rules say about any of this, and why?
The Employee Retirement Income Security Act (ERISA) only applies where an employee is covered under a plan. Since Joe and Angelo, in year 1one, are just ordinary individual investors, ERISA does not apply. Maybe Joe's investment in The Maximum Safe Return Fund is "imprudent," but the securities laws do not provide any protection to consumers who are a little too enthusiastic or gullible.
ERISA does apply in year two, because Joe has an employee and has set up an "ERISA plan." Has Joe violated ERISA? Maybe. Arguably, the plan is overpaying for investment services.
What about year three? Clearly ERISA applies. If Joe has a problem in year two, does adding a brokerage window “cure it” in year three? It's not clear. But there's a good argument that Joe should still be liable for overpriced core funds: research indicates that some participants will buy some of every fund in a core menu. So putting any bad fund in a fund menu "costs participants money."
What about year four? Here's what I want to ask: why isn't year four just the same as year one? Why does ERISA or the Department of Labor) have any interest in regulating this transaction?
Like Sophia, the DOL doesn't like brokerage windows.
Here's what Department of Labor (DOL) says on the issue of brokerage window-only plans:
[A] plan fiduciary’s failure to designate investment alternatives, for example, to avoid investment disclosures under the regulation, raises questions under ERISA section 404(a)'s general statutory fiduciary duties of prudence and loyalty. (Field Assistance Bulletin 2012-02 Q&A 39.)
So, it sounds like the DOL doesn't like what Joe did in year four. As DOL stated in an earlier version of this FAB, they are particularly concerned (as is Sophia) that Angelo may not be "financially sophisticated."
DOL's theory of the ERISA fiduciary burden
The DOL seems to think that an employer-fiduciary has a minimum affirmative duty to construct a core fund menu that is superior to what is available in the market. Too many choices are "unmanageable."
This approach creates an either-or of problems. Joe is (obviously) not a sophisticated investor. So he will either (1) unwisely rely on the advice of someone with obvious conflicts or (2) unwisely choose the core fund menu without that advice. Or, he just won't set up a plan, opting for the situation in year one. Because adequately living up to his DOL-imposed fiduciary obligation simply costs too much.
In Congress, in think tanks and in states like California and Illinois there is great angst because small employers don't adopt retirement plans. The critical feature of the proposals to solve this problem—Senator Harkin's (D-Iowa) USA Retirement Funds and the state initiatives—is relieving the small plan sponsor of its ERISA fiduciary burden. Duh.
DOL's solution to this problem is to make Sophia a fiduciary too.
Here's my theory of the ERISA fiduciary burden
The difference between year one and year two is that Joe has limited Angelo's investment choices. Because of that, Joe has an obligation to make sure that those limited choices are prudent. If Joe is going to stack his fund menu with overpriced funds, he should be liable.
Year three is a slightly closer call—because Angelo in fact does have prudent choices. But I'm ok with a rule that requires that core menus be prudently constructed.
In year four, I don't see any reason for DOL to get involved in any issues other than: (1) are there enough choices to reproduce the "free market" situation of year one; and (2) is the brokerage window utility itself overpriced?
But isn't the employer always a fiduciary?
In making this argument I realize that I'm bumping up against a near-universal preconception—that the "employer" has an implicit fiduciary obligation with respect to her/his/its employees. Since Joe set up a plan, he has (to paraphrase DOL) an obligation to designate specific investment alternatives to enable participants, who often lack sufficient resources to screen investment alternatives, to make better choices.
But look: in real life, when you ask Joe to do this, he makes things worse. When it comes to investments, Joe doesn't know what he's doing. And he's not going to learn, just so he can have a plan. Why not let him off the fiduciary hook here? Why not, in year four, put Angelo in the very same situation he was in in year one? If you are concerned that Angelo may (as a result of implicit employer paternalism) somehow think that Joe has recommended something, let's provide a disclaimer, in bold print and caps.
What about defaults?
This is actually a really good question. What if Angelo doesn't select an investment? Well, Joe could make him—by only letting Angelo in the plan if he designates an investment. But that would frustrate the nearly universally accepted policy that defaults are good. Maybe the simple answer is: why doesn't the DOL, or Congress if necessary, prescribe some all-purpose "prudent" default? How about a MyRA bond?
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What is going on here? Why does Joe set up a plan at all? The answer to that question is a complex of social/business norms, workforce imperatives and tax incentives for which there is not here enough space to describe in the detail it deserves. Suffice it to say, we want him to set up a plan. So why are we—and especially DOL—making it so hard for him to do so?
Michael Barry is president of the Plan Advisory Services Group, a consulting group that helps financial services corporations with the regulatory issues facing their plan sponsor clients. He has 30 years’ experience in the benefits field, in law and consulting firms. Read his blog at moneyvstime.com and follow him on Twitter @PlanAdvisorySvc.
This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the authors do not necessarily reflect the stance of Asset International or its affiliates.