Investment Advisory Services Under ERISA

By Sheldon M. Geller

In Brief

Clarification of Fiduciary Duties

CPAs take on substantial risks in their various roles as auditor, trustee, or advisor of a defined contribution pension plan. While an auditor assumes the common risks associated with conducting an audit in conformity with GAAS, CPAs in industry serving as plan trustees or CPAs acting as investment advisors are subject to the risks associated with fiduciary responsibilities under the Employee Retirement Income Security Act of 1974 (ERISA). In all these roles, a clear understanding of the responsibilities and risks associated with the regulation of ERISA by the Department of Labor and Internal Revenue Service will enhance CPAs’ professionalism and service.

On June 11, 1996, the Department of Labor (DOL) issued Interpretive Bulletin 96-1 in order to clarify its position on participant education. The bulletin indicated that the provision of asset allocation services does not cause fiduciary liability under the Employee Retirement Income Security Act of 1974 (ERISA). Nevertheless, many plan participants continue to expect specific investment recommendations, services not subject to the DOL bulletin.

Interpretive Bulletin 96-1 offers guidance for fiduciaries that want to provide investment education while remaining protected from liability for participant investment choices and for providing investment education under ERISA’s section 404(c) safe harbor. (Neither ERISA nor the section 404(c) safe harbor requires plan fiduciaries to provide investment education.)

Important concerns about the suitability of investment products and services made easily accessible by the Internet may increase liability exposure for fiduciaries. Plan sponsors and trustees also accept fiduciary responsibility for selecting and monitoring plan investments. A failure to perform fiduciary responsibilities consistent with ERISA may subject plan sponsors and trustees to potential liability for damages caused to the plan, as well as for civil penalties. To complicate matters, a plan fiduciary may also be liable for another fiduciary’s breach.

Growth in Investment Advisory Programs

At one time, the private retirement system consisted almost entirely of traditional defined benefit pension plans. In such plans, employers fund the plans, manage the investments, and bear the risks necessary to meet benefit levels. In recent years, a significant shift in the private retirement system to defined contribution plans, including 401(k) plans, has complicated the roles of all involved. While both employers and employees contribute to these plans, employees direct the investment of their assets. Concurrently, a tremendous growth in IRA assets has resulted principally from rollovers from defined contribution plans.

Mutual funds have become the preferred form of investment vehicle available for defined contribution plan participants and IRA holders. Financial institutions (e.g., brokerage firms) now offer a wide variety of mutual funds to IRA holders and 401(k) plan sponsors. These financial institutions offer affiliated as well as unaffiliated mutual funds and frequently 10 or more investment choices. On the other hand, IRA participants can choose from thousands of mutual funds, as well as an array of other investments. As a result, brokerage firms have begun offering “brokerage windows,” which permit 401(k) plan participants to invest in an unlimited choice of mutual funds and publicly issued debt and equity securities.

The growth of defined contribution plan and IRA assets, fueled by the expanded choice of investment products, has heightened the demand for investment advice from employees now managing their own investments.

Investment Advisory Services Under ERISA

The fiduciary responsibility provisions of Title I of ERISA protect pension plans and participants by imposing special duties and obligations on individuals acting as “fiduciaries” on behalf of pension plans. Not only must fiduciaries act prudently and for the benefit of plan participants and beneficiaries, they must also avoid prohibited transactions.

Under ERISA, a fiduciary engages in—

  • the exercise of discretionary authority or control over the management of a plan or its assets,
  • the provision of investment advice for a fee, or
  • the exercise of discretionary authority over the administration of the plan.

    Investment advice. The provision of “investment advice” rises to a fiduciary responsibility when—

  • recommendations are made as to the advisability of investing in, purchasing, or selling securities;
  • advice is provided “on a regular basis”;
  • advice is provided “pursuant to a mutual agreement, arrangement, or understanding, written or otherwise”;
  • this advice serves as a primary basis for the participant’s investment decisions; and
  • the advisor renders individual investment advice based on individual needs.

    Early DOL positions suggested that asset allocation services could constitute investment advice. Interpretive Bulletin 96-1 resolved the uncertainty by excluding asset allocation services from fiduciary liability under ERISA. Although the bulletin provides four safe harbors under which the provision of investment education services does not constitute investment advice—plan-related information, general financial and investment information, asset allocation models, and interactive materials—plan participants are demanding more from their advisors than is covered by these safe harbors. The bulletin does not provide a safe harbor for specific investment recommendations.

    If an individual becomes a fiduciary by providing investment advice, the prohibited transaction provisions under ERISA apply. ERISA prohibits a fiduciary from 1) dealing with the assets of the plan in her own interest and 2) receiving any consideration for a personal account from any party dealing with a plan in connection with a transaction involving plan assets. ERISA may also prohibit the receipt of 12b-1 fees from a mutual fund by a financial institution.

    ERISA Compliance for the Investment Advisor

    Programs involving investment advice can be structured to comply with ERISA without seeking an individual or class exemption. Interpretive Bulletin 96-1 enables an advisor to offer investment education services to 401(k) plan participants without providing “investment advice”: For example, “one-time” recommendations to plan participants would not constitute advice under the bulletin.

    An investment advisor might also avoid a potential conflict of interest by eliminating any disparity in fees received for the specific recommendation of mutual fund options under the plan. The DOL has indicated that institutions can comply with ERISA by offsetting 12b-1 fees received from mutual funds against fees that would otherwise be payable by the plan for trustee or record-keeping services. This offset eliminates any financial interest in recommending one fund over another.

    An institution can also comply with ERISA without a “fee leveling,” or offset, arrangement by providing investment advice through an individual independent of the mutual funds. This individual can also maintain plan participant questionnaires that assist in the recommendation of appropriate funds.

    The Investment Advisor Act of 1940 permits advisors to receive different fees from mutual funds without offsets, provided the fees are disclosed and consented to by clients.

    Managing the Risks

    The plan sponsor can properly execute its fiduciary duties by establishing and adhering to its plan documents and investment policy statement. Fiduciaries lacking the requisite education, experience, and skill to perform fiduciary functions, including investment decisions, should seek qualified expert assistance.

    Many of the fiduciary functions, including investment management, can be delegated to other parties; however, this delegation is itself a fiduciary function. Although the delegation of investment authority to investment managers or plan participants may shield the plan sponsor from liability with regard to investment decisions, the plan sponsor retains the fiduciary responsibility to prudently monitor those appointed.

    ERISA fiduciaries should establish written procedures for the specific processes governing plan administration and investment decisions, the delegation and monitoring of fiduciary responsibilities, and compliance with ERISA section 404(c), if applicable.

    Section 404(c) provides specific rules limiting the liability of a fiduciary for a participant-directed plan. Before it can receive protection under the section 404(c) safe harbor, a fiduciary must satisfy ERISA’s general prudence requirements with respect to all of the following:

  • The actual prudent selection of investment vehicles,
  • The periodic performance review of these investment vehicles, and
  • The ongoing due diligence determination that the alternatives remain suitable investment vehicles for plan participants.

    The background material in Interpretive Bulletin 96-1 governing participant-directed plans notes that a plan fiduciary can take action to move the control of investments and be held liable to plan participants only after the foregoing prudence requirements are met.

    Responsible fiduciaries should familiarize themselves with the provisions of the investment policy statement and adopt a compliance strategy designed to prevent and expeditiously identify and correct violations, as well as address selection or monitoring issues with regard to the mutual funds offered under a participant-directed plan. The employer should conduct fiduciary reviews at least annually to demonstrate that a prudent process is actually followed and that fiduciary actions, such as the selection of service providers (including mutual fund managers), investment decisions, and plan administration procedures are documented through written records. These records should include, at a minimum, fiduciary committee minutes or an executed investment policy statement, participant communications, and correspondence confirming decisions made by plan fiduciaries.

    Fiduciary Status

    The DOL considers the types of functions performed or transactions undertaken on behalf of the plan in order to determine whether they are fiduciary in nature. DOL regulations state that an attorney, accountant, actuary, or consultant who renders legal, accounting, actuarial, or consulting services to a plan fiduciary will not be considered a fiduciary unless she—

  • exercises discretionary authority or discretionary control over plan management,
  • exercises authority or control over the disposition of plan assets,
  • renders investment advice for a fee, or
  • has any discretionary authority over plan administration.

    DOL regulations further state that some positions require one or more fiduciary functions. For example, a plan trustee must, by the very nature of the position, exercise discretionary authority or discretionary responsibility in plan administration.

    An investment advisor, including a broker-dealer or an insurance agent that provides investment advice, would be a fiduciary if she regularly renders advice that serves as a primary basis for investment decisions with respect to plan assets pursuant to a mutual agreement, for a fee or without receipt of an identifiable fee other than broker or insurance commissions.

    An insurance company general account is exempt from ERISA’s fiduciary standards to the extent that the company has issued a guaranteed benefit policy to fund an ERISA plan. In this instance, the contract would be considered a plan asset but the general account assets supporting the contract would not. As the result of a Supreme Court decision, insurance companies must clarify and disclose when general account assets would be considered plan assets as a result of the sale of insurance products to fund an ERISA plan.

    Fee-Sharing Arrangements

    If an institution is not acting as a fiduciary in the plan’s decision to invest in a mutual fund, then receiving a fee on such a sale should not subject the institution to ERISA regulation. However, if the institution is providing services to the plan and therefore would be “a party in interest” to the plan, then receiving the fee may be prohibited under ERISA. In order to provide services to a plan without engaging in a prohibited transaction, a party in interest must receive no more than “reasonable compensation.” ERISA prohibits any exercise of authority, control, or responsibility that causes a plan to pay additional fees for a service furnished by a plan fiduciary or to pay a fee for a service furnished by an individual in which this fiduciary has an interest and which may affect the exercise of such fiduciary’s best judgment.

    The DOL has concluded that a plan fiduciary acting pursuant to a named fiduciary or participant direction and not exercising any authority or control to direct a plan investment could not be in violation of ERISA as a result of self-dealing in plan assets. If a fiduciary exercises no authority or control over a plan’s investment in a mutual fund, the mere receipt by that fiduciary of a fee or other compensation from the mutual fund in connection with the investment would not in and of itself violate ERISA. Consequently, if a financial institution having no investment discretion over plan assets receives fees in connection with the plan sponsor’s investments in mutual funds, the institution’s receipt of such fees would not violate the fiduciary self-dealing and conflict of interest provisions of ERISA.

    If a financial institution is acting as a fiduciary by having discretion over plan asset investment in mutual funds or by rendering investment advice, then the institution’s receipt of fees may violate ERISA, unless there is an offset or credit of these fees. Accordingly, if a financial institution acting as a fiduciary in exercising investment discretion over plan assets directs plan investment into a mutual fund that pays a fee to that institution, the institution has engaged in a prohibited transaction.

    When an institution has discretion over the investment of plan assets and mutual funds, the institution may avoid an ERISA violation by offsetting any fees received against the service fees the plan is obligated to pay, or by crediting these fees directly to the plan. To the extent that the plan’s legal obligation to pay fees is extinguished by the amount of the offset from mutual fund fees, the institution would not violate ERISA by dealing with the assets of the plan in its own interest or for its own account.

    Furthermore, because the mutual fund fees would not increase the institution’s compensation, the institution would not be deemed to receive such payments for its own account in violation of ERISA. The only party that would benefit from the institution’s receipt of the fees would be the plan, which would be paying reduced fees for services or receiving additional income in the form of a fee credit. Accordingly, the institution’s and the plan’s interests are not adverse, and thus there is no violation of ERISA.

    Disclosure of Fees

    The DOL has emphasized the need for plan participants and employers to have a full and complete understanding of the fees and charges associated with self-directed employee benefit plans, recently focusing on participant-directed 401(k) plans.

    Two DOL-developed brochures advise that fees are just one of several factors that plan sponsors must consider when deciding how to design their plans and which investment features to offer. The brochures advise that all services have costs and that cheaper is not necessarily better. The DOL has identified three types of fees generally associated with 401(k) plans: the administration fee, investment fee, and individual service fee.

    The administration fee includes record-keeping, accounting, legal, and trustee services. The investment fee includes plan asset management, sales charges, commissions, investment advisory services, and mutual fund management services. Individual service fees are charged directly to the plan participant’s account for special plan features (e.g., loan origination and annual loan maintenance fees).

    The DOL describes front-end loads, back-end loads, redemption fees, and 12b-1 fees (fees paid by a mutual fund to a broker or other salesperson as compensation for the distribution of fund shares). The National Association of Securities Dealers (NASD) prohibits a mutual fund from describing itself as no load if the fund pays distribution and service fees (i.e., 12b-1 fees) in excess of 25 basis points.

    The DOL also describes the investment fee typically charged in a variable annuity product to include investment management fees payable to the insurance company and the manager of the underlying investment vehicles (which may include both mutual funds and insurance company separate accounts). Some variable annuity products include insurance-related charges if they provide an insurance-related component, as well as mortality charges if they provide death benefits. Some variable annuity contracts include back-end surrender charges if the contract is surrendered before a stated number of years, whereas other contracts may be terminated without penalty. These contracts, closely resembling trust agreements, are merely funding vehicles for a multifund family program.

    The DOL, in conjunction with a number of trade organizations, issued a model 401(k) fee disclosure form designed to help employers understand investment fees and expenses and to facilitate comparison of competing providers’ plan services. (Editor’s note: This form is available only on the Internet at

    To underscore its view that the fiduciary charged with implementing a written plan document has significant fiduciary responsibility when designing the investment and administrative features of the plan, the DOL is emphasizing fee disclosure. This position is merely a restatement of the fiduciary’s duties under ERISA to act with care, skill, prudence, and diligence.

    The DOL has noted that fees can have a tremendous impact on asset performance and, ultimately, the amount of retirement income for each plan participant. Accordingly, a fiduciary cannot comply with ERISA duties without a basic understanding of the fee structure of various investments and plan administration options.

    Similarly, a plan participant cannot exercise effective control over a retirement account without a basic understanding of the fees charged in connection with various investment options. Fiduciaries evaluating whether to switch service providers for the plan’s investment vehicles may be deemed to have acted imprudently if they did not understand the nature and extent of plan fees and all related services. Plan fiduciaries must determine how much the plan is paying for the totality of services, and the plan sponsor should disclose fees to participants.

    Mutual Fund Supermarket

    Mutual fund distribution has changed rapidly over the last several years with the development of the mutual fund supermarket. This evolution and the concept of a mutual fund supermarket are described in an SEC letter issued to the Investment Company Institute (the trade association of the mutual fund industry). In that letter, the SEC describes a mutual fund supermarket as a program offered by a broker-dealer or other financial institution through which its customers may purchase and redeem a wide variety of mutual funds, with or without transaction fees.

    A mutual fund supermarket allows plan participants to consolidate their holdings in a single brokerage account and receive a statement listing all of the plan’s mutual fund holdings. Mutual funds pay a fee to participate in the supermarket, avoiding the imposition of transaction fees on plan participants. The broker-dealer–sponsored mutual fund supermarket is generally more cost-effective, and it provides share reporting and more funds than other multifund family programs.

    The SEC found that although the services provided to the mutual fund complexes by the supermarket sponsor are the same in all cases, various fund complexes pay the fee differently. Some fund complexes pay entirely through 12b-1 fees. Others pay through their investment advisor, in which case the payment is not subject to Rule 12b-1 but is functionally equivalent to 12b-1 fees.

    As a result, the plan fiduciary would receive services from the supermarket or broker-dealer entity without actually being charged by that entity. This arrangement effectively permits the plan fiduciary to recapture the 12b-1 fee, or other advisory fee payable to the broker-dealer, and offset plan expenses that otherwise would be paid to the supermarket sponsor.

    Some supermarket broker-dealer sponsors offer payments directly to a potential plan client if the plan meets certain specifications (e.g., if the plan deposits a minimum level of plan assets with the broker-dealer sponsoring the mutual fund supermarket, limits the number of funds it offers in its menu, includes a number of the broker-dealer’s proprietary funds, or agrees to retain the broker-dealer’s affiliated trust company for a reduced fee).

    It is common for a plan to recapture the 12b-1 fees generated by its investment of plan assets from a mutual fund supermarket operator. In one case, the DOL permitted a bank to credit the 12b-1 fees it received from mutual fund complexes in which a client plan invested against trustee fees otherwise due from the client plan and permitted it to apply any excess to the plan. This approved arrangement provides evidence that a prudent plan sponsor can recapture fees if it is in the position to do so.

    On the other hand, the DOL did not permit an insurance carrier to offset the 12b-1 fees received from a supermarket sponsor, most likely because the plans purchasing the product were too small to recapture any of the 12b-1 fees paid to the supermarket sponsor. This demonstrates that the conduct under ERISA that would be demanded by the DOL from plan fiduciaries with significant plan assets is not necessarily the same conduct demanded from fiduciaries of a plan with insignificant assets. That is, plan size does count in fiduciary responsibility and ERISA compliance.

    Section 404(c) Compliance

    Since most 401(k) contributions are salary reduction contributions that would otherwise be subject to the participant’s control, many plan sponsors permit participants to direct their own investments. Furthermore, ERISA section 404(c) relieves plan fiduciaries of liability for any losses that result from the participant’s investment decisions [An ERISA section 404(c) plan is an individual account plan permitting plan participants to direct the investment of their account balances within a broad range of investment alternatives].

    Nevertheless, fiduciaries of ERISA section 404(c) plans remain responsible for prudently selecting investment alternatives, distributing information to participants and beneficiaries, monitoring the investment performance, and carrying out participants’ and beneficiaries’ investment instructions.

    Adherence to section 404(c) rules is voluntary, and noncompliance or improper compliance would result only in a loss of relief from liability for investment losses suffered by participants. Similarly, participants need not be allowed to direct the investment of all funds in their accounts; protection from liability will exist only with respect to the funds that satisfy section 404(c). However, the IRC protects the right to direct investments and limiting that right to certain accounts or individuals may violate the nondiscriminatory requirements and disqualify a plan.

    Section 404(c) regulations require extensive disclosure of information to plan participants. That being said, the regulations expressly state that the plan sponsor or fiduciary is not required to provide investment education or advice.

    Fiduciary Issues in Changing Record Keepers

    Even if a plan sponsor meets the requirements of ERISA section 404(c), different issues arise during a change in 401(k) plan record keepers. The most often used means of changing record keepers is to temporarily halt participants’ ability to self-direct their account balances during a “blackout” period.

    In order to qualify for ERISA section 404(c) protection, a plan sponsor must provide the opportunity to change investment elections at least once within any three-month period. Therefore, it appears that the maximum duration for a blackout period would be 90 days. The DOL has taken the position that a participant will not be considered to have exercised control if apprised of investments that would be made on her behalf in the absence of instructions to the contrary. Therefore, potential liability may arise where a plan sponsor determines to invest plan assets that are not actively directed by participants, whether in new investment options conforming to the participant’s prior investment election or in the most conservative option available. At a minimum, participant deferrals during a blackout period may not be subject to the participant’s investment direction. Failure to adequately invest these new plan assets may likely constitute a breach of fiduciary duty.

    ERISA requires plan fiduciaries to discharge their duties solely in the interest of participants and beneficiaries and with the care, skill, prudence, and diligence that an individual with similar capacity and experience would use under the same circumstances. This duty extends to the selection of service providers for the plan. If a plan sponsor or other fiduciary fails to select a record keeper in a prudent manner or selects a particular vendor for improper reasons, the fiduciary may be held liable for breaching her fiduciary duties.

    A plan sponsor or fiduciary has a duty to ensure that a blackout and transfer is executed prudently. This duty often requires the fiduciary to monitor the progress of the transition; failure to do so can, at some point, reach a level of imprudence. If a plan sponsor or other fiduciary were to promise that the blackout period would conclude by a certain date, it may be a violation of ERISA if the transition is not completed on time. A plan sponsor may be sued for failure to fulfill its promises regarding the investment of new, postblackout plan assets. If participants are able to prove that the plan sponsor had promised certain investments and failed to do so to the detriment of plan participants, plan participants may be able to recover lost earnings.

    Plan sponsors face multiple risks in instituting a blackout period. As a result, the prudent plan sponsor is well advised to consider the implications of a blackout or any other action taken in conjunction with changing record keepers, and to consult with advisors or other professionals before and during the process.

    The DOL has stated that a plan sponsor will not be liable for the advice provided by a third-party investment advisor if the sponsor acts prudently in selecting and monitoring the advisor, the advisor is licensed to provide advice, and the sponsor obtains written documentation that the advisor will be acting as a fiduciary. The plan sponsor should emphasize that the third-party advisor is wholly separate and independent from the sponsor and that the sponsor does not endorse the advisor but merely offers its services as a source of investment education for plan participants. If plan participants choose to use the advisor, they should review their own sources of information before making any investment decisions. These types of disclaimers help plan sponsors avoid the increase in fiduciary liability associated with the maintenance of participant-directed investment accounts.

    During a blackout period, ERISA fiduciaries would only be liable for losses of participant accounts that resulted from imprudent decisions. For example, it would not be an imprudent decision for plan fiduciaries, including the trustee, to invest plan assets in money market funds during the blackout period. Losses are limited to the declines in principal, and not the opportunity for loss or potential gains. The trustee may direct the investment of plan assets in money market funds even beyond the blackout period to the extent it is a prudent exercise of control over plan assets.

    The liquidation to cash method, in conjunction with a transfer of plan assets to a successor custodian, is a prevalent and preferred method of transferring plan assets. It is the trustee’s responsibility to reinvest plan assets as soon as practicable. The discretionary decision to change 401(k) plan providers is a set law function, and thus the employer and trustee retain responsibility for effective and timely changes. ERISA requires that a plan be able to terminate a service agreement with reasonably short notice and no penalty.

    Self-Directed Brokerage Accounts

    Some plans permit plan participants to access any investment through a brokerage account. The plan sponsor may put limits on the available investments; usually, these accounts make available any mutual fund, any traded stock, and direct ownership of corporate and government bonds. ERISA section 404(c) protection is available to plans that include self-directed brokerage accounts.

    Some argue, however, that relief from fiduciary liability will not be granted if the participant is permitted to make an “imprudent” investment decision. If a plan sponsor makes mutual funds available for investment, it is responsible for determining that each of the mutual funds is a prudent investment. However, whether this principle extends to brokerage accounts remains unclear.

    The IRC’s nondiscrimination tests for a brokerage account option or window apply to the availability of funds rather than to their usage. Accordingly, even if only highly compensated employees take advantage of brokerage accounts, the plan will not be subject to disqualification. The plan sponsor is prohibited from limiting the brokerage account to a certain size or level of income, which would result in discrimination and disqualification. Since all investments must be generally available to all participants, it is not clear whether a plan can offer investments under a brokerage account that has large investment minimums.

    Employee Benefit Audits

    The AICPA has prepared Employee Benefit Plans Industry Development 2000, an audit risk alert intended to help CPAs expand their knowledge and understanding of the employee benefit plan industry and the related regulatory environment and plan and perform employee benefit plan audits.

    The audit risk alert includes a review of section 401(k) fees and advises that expenses are either netted against investment earnings or charged as administrative expenses that are then allocated proportionately to participant accounts or charged as a flat fee per participant. The alert cautions that if administrative or investment expenses payable by the plan are significant, auditors should consider whether the plan’s financial statements have appropriate footnote disclosure.

    CPAs should evaluate the design and documentation of qualified employee benefit programs when conducting employee benefit plan audits in order to provide assurance that the plan’s operation conforms to the term of the plan document as well as IRS rules and DOL fiduciary responsibility provisions. If an auditor identifies any failures in the plan’s operational compliance with IRC qualification requirements and ERISA fiduciary responsibility provisions, the auditor should advise the responsible fiduciaries. The IRS has emphasized that sanctions will be imposed for failure to follow the terms of the plan document, even if plan operation otherwise complies with the qualification requirements.

    The issues identified by the IRS on audits rarely constitute intentional or blatant violations. Rather, the majority of problems appear to involve failures that occur in the administration of qualified plans and can easily be discovered during an audit. The audit provides a cost-effective means of sanction avoidance, operational compliance, and fiduciary responsibility compliance. Finally, CPAs acting as investment advisors or plan trustees should also take care to understand and comply with ERISA fiduciary requirements.

    Sheldon M. Geller, Esq., CPA, is a pension attorney and principal in Geller & Wind, Ltd., a benefits consulting firm with corporate offices in New York City. He has written for several professional journals.

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