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.
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.
Because U.S. Airways, in its capacity as a named fiduciary of the plan, did not appoint a discretionary trustee (or an investment manager), Fidelity's authority and discretion over plan assets was nonexistent because it was always subject to the direction of a named fiduciary who is not a trustee (i.e., U.S. Airways). So even though Fidelity was an ERISA trustee with fiduciary duties, it wasn't a trustee that had discretion or authority over plan assets, so it couldn't help U.S. Airways mitigate the risk that it continued to hold: the ultimate responsibility and liability for the selection, monitoring, and replacement of plan assets.
In these cases, trust companies such as Fidelity quite rightfully avoid responsibility (and therefore liability) by pointing to that part of the contract (e.g., trust agreement) they entered into with a plan sponsor that often tracks the language of the first exception--the directed trustee exception--in ERISA section 403, as noted. (The same outcome occurred in a WorldCom case as in DeFelice. In the WorldCom case, WorldCom was identified in the plan document as the named fiduciary (actually even more explicitly as both the named administrative fiduciary and the named investment fiduciary) while Merrill Lynch Trust Company was held to be a directed trustee under ERISA.)
Perceptions and Reality
A directed trustee is the most common kind of trustee associated with plan assets. The functions assigned to the trustee in most standardized plan documents and trust agreements such as prototype plans are those of a directed trustee. In many cases, a directed trustee is a trust company that provides an asset custody service as part of a mutual fund family that offers bundled record-keeping services such as the case with Fidelity Management Trust Company and the Fidelity investment arm in DeFelice, and Merrill Lynch Trust Company and the Merrill Lynch investment arm in WorldCom.
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. While the custodial and trustee services offered by trust companies and other such entities are valuable, even a directed trustee under ERISA, such as a trust company, cannot offer plan sponsors legal cover simply because their agreements with these sponsors make sure that the sponsors--not the directed trustee--remain ultimately liable for plan assets, in accordance with the law of ERISA.
As I've noted in previous columns, mother always said to read the fine print. So once again, I'll remind advisors to remind their fiduciary clients to read their agreements with trust companies and other such entities because it is usually these documents that will govern the ultimate legal liability of their clients, not oral sales representations or written sales brochures.
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 visit Prudent Investor Advisors or you can e-mail him at firstname.lastname@example.org. 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.