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Discretionary Trustees vs. Directed Trustees

The perception that trust companies and other such entities ordinarily provide legal protection to plan sponsors for the selection, monitoring, and replacement of plan assets is wrong.

W. Scott Simon, 01/05/2012

In November's column, I discussed qualified retirement plans that are "trustee-directed" but noted that "directed trustee" is a whole different kettle of fish. To kick off the New Year, I thought that advisors might find it interesting to peer into that kettle this month and see what's cookin'.

Back to the Basics
The statutory scheme of the Employee Retirement Income Security Act (ERISA), which governs qualified retirement plans such as 401(k) plans, provides that certain fiduciaries will "run" a plan. One kind of fiduciary is a trustee who--apart from an employer that makes the initial decision to sponsor a plan--is, in a way, the most essential fiduciary of them all in the process of establishing a retirement plan. Indeed, under ERISA, the Internal Revenue Code and the Internal Revenue Service rules, a qualified retirement plan cannot come into existence until the trustee who is identified in the plan document or trust agreement (or appointed by a named fiduciary identified in the plan document) executes the trust document and, in so doing, "gives life" to the plan. (The only exception to this is qualified retirement plans with assets comprised of insurance contracts.)

Discretionary Trustees and Directed Trustees Under ERISA Section 403
ERISA section 403 provides, in part, that all assets (except, as noted, insurance contracts) of an employee benefit plan must be held in trust by one or more trustees. The trustee(s) named in a plan or trust document as "having exclusive authority and discretion over the management and control of plan assets" has been termed a "discretionary trustee" and is usually an employee (or employees) of the plan sponsor.

There are two exceptions to this general rule. The first exception is when a plan document expressly provides that the trustee(s) is subject to the direction of a named fiduciary who is not a trustee. This kind of trustee has been termed a "directed trustee." When this exception applies, such trustee(s) is subject to proper directions from the named fiduciary. But there are conditions attached to these directions: They must be made in accordance with the terms of the plan and not be contrary to ERISA. (The second exception to the general rule--which isn't relevant to this month's column--is when the authority to select, monitor, and replace assets of a plan is delegated to one or more (ERISA section 3(38)) investment managers pursuant to ERISA section 402(c)(3).) (See DOL Advisory Opinion 2002-06A, July 3, 2002.)

ERISA section 403, then, provides for two kinds of trustees (both of which are fiduciaries). First is a discretionary trustee that has exclusive authority and discretion over the management and control of plan assets. A discretionary trustee has fiduciary responsibility and liability for the selection, monitoring, and replacement of plan assets. Second is a directed trustee that is subject to the direction of a named fiduciary who is not a trustee (or an investment manager). A directed trustee has fiduciary responsibility and liability for taking direction for the selection, monitoring, and replacement of plan assets. A directed trustee also has fiduciary responsibility and liability for monitoring the timing of deposits, transactions activity and accuracy, compliance with regulations under the Department of Labor and the Internal Revenue Service, etc.

In all retirement plans, however, it is a trustee that will hold plan assets (except, as noted, insurance contracts) in trust--whether as a discretionary trustee when it calls the shots on plan assets or as a directed trustee when a named fiduciary who is not a trustee (or investment manager) calls the shots on plan assets, which the directed trustee must then follow.

DeFelice v. U.S. Airways
In cases where a named fiduciary (or an investment manager) isn't calling the shots on plan assets, a discretionary trustee will be doing so. In many plans, this trustee will be an employee (or employees) of the plan sponsor. Sometimes a named fiduciary will appoint a trust company as a discretionary trustee, empowering it with exclusive authority and discretion over the management and control of plan assets. But such appointments are quite uncommon even in the rarified air of Fortune 500 companies, as was shown in the case of DeFelice v. U.S. Airways, Inc. (497 F. 3d 410; 4th Circuit 2007).

In DeFelice, U.S. Airways was a named fiduciary (who was not a trustee) that reserved unto itself the exclusive authority and discretion over the management and control of plan assets. So U.S. Airways was calling the shots on plan assets as a named fiduciary, not as a discretionary trustee. In that capacity, U.S. Airways appointed Fidelity Management Trust Company as a directed trustee. And yet Fidelity was identified repeatedly as "the Plan trustee" in the court's opinion. At first blush, this could lead some to believe that an entity such as a trust company serving as a directed trustee provides plan sponsors with legal protection for the selection, monitoring, and replacement of plan assets. The (legal) truth is that they don't, as the DeFelice court made clear.

W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing.

Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals.

For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

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