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Case Shines Spotlight on Bundled Retirement Plans

Plan sponsors may find it more difficult to mitigate the risk of its fiduciaries and to offer plan participants institutionally priced investment options with a product-driven bundled plan solution, writes Scott Simon of Prudent Investor Advisors.

W. Scott Simon, 06/11/2012

W. Scott Simon is a principal at Prudent Investor Advisors, a registered investment advisory firm. He also provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. Simon is the recipient of the 2012 Tamar Frankel Fiduciary of the Year Award. 

In this month's column, I'd like to drill down further into the Tussey v. ABB opinion issued by federal district court judge Nanette Laughrey at the end of March. A lot more marrow can be extracted from the bones of this case.

Please note that the following discussion pertaining to Fidelity applies only insofar as Fidelity is involved with the two 401(k) plans (PRISM Plans) sponsored by defendant ABB in Tussey. In fact, this discussion could also apply to any other large and reputable service provider to retirement plans.

Fidelity Is a Manufacturer of Investment Products
Mutual fund families such as Fidelity are--God bless 'em--unabashed capitalists. They seek to sell their investment products as cost-efficiently through as many distribution channels as they can in order to generate the largest profit possible. Edward C. (Ned) Johnson III, chairman of Fidelity Investments, is not a multibillionaire for nothing.

To help generate profits, Fidelity, for instance, manufactures investment products such as its proprietary mutual funds. Perhaps the most well known of these funds is the Fidelity Magellan Fund, which is on the menu of investment options available to participants in the PRISM Plans. (Fidelity, of course, manufactures other products, but Tussey appears to involve only mutual funds.) As a manufacturer of products, Fidelity is really no different than ABB, which manufactures power and automation equipment products.

The unforeseen development of the 401(k) plan industry beginning in 1981 presented Fidelity (and other such providers) with new and potentially huge opportunities to distribute their proprietary investment products in the retirement plan market.

A Bundled Retirement Plan Exists to Distribute Investment Products
The solution that Fidelity and other service providers to retirement plans eventually came up with to vastly expand sales of their proprietary investment products came to be known as a "bundled" retirement plan. In such a plan, different Fidelity units provide a suite of services to plan sponsors. In Tussey, for example, defendant Fidelity Management Trust Company (Fidelity Trust) is the record-keeper for the PRISM Plans, providing recordkeeping and other administrative services, including providing the trading platform for the PRISM Plans. Fidelity Trust places proprietary mutual funds--after selection by ABB--on its recordkeeping platform; these funds are provided by another Fidelity unit, Fidelity Investments (not a defendant in Tussey), and made available to participants in the PRISM Plans as investment options. Fidelity Trust is also the trustee of the PRISM Plans, providing trustee and custodial services such as safe-keeping the billion dollar-plus assets of the plans.

Yet another Fidelity unit, defendant Fidelity Management & Research Company (Fidelity Research), serves as the investment advisor to Fidelity's proprietary mutual funds that are on the menu of investment options offered in the PRISM Plans. Some blogs on Tussey note that Fidelity Research is the investment advisor to ABB pursuant to section 3(21) of the Employee Retirement Income Security Act (ERISA) (to be more precise, an advisor rendering investment advice for a fee pursuant to ERISA section 3(21)(A)(ii)). However, neither Judge Laughrey's opinion nor the case record supports this assertion.

Fidelity Research is simply the investment advisor to the Fidelity mutual funds on the menu of investment options in the PRISM Plans. (Judge Laughrey did find that Fidelity Research "is a fiduciary to the Plan to the extent it manages Plan assets in FICASH as it exercises discretionary authority and control when it invests Plan assets in various overnight securities [i.e., pursuant to ERISA section 3(21)(A)(i)]." This finding, however, pertains to the issue of float income, which is beyond the scope of this month's column. In any event, this discretionary authority and control doesn't pertain to the extent of fiduciary involvement in the menu of investment options in Tussey.)

Plan sponsors such as ABB like bundled retirement plans because they are easy and convenient, offering a kind of one-stop shopping: "Hey, we'll just hire Fidelity to run the PRISM Plans." Fidelity (and other such providers) certainly likes bundled retirement plans. These plans are a particularly lucrative sales channel through which Fidelity effectively and efficiently distributes its proprietary investment products, such as mutual funds. Indeed, the primary reason why bundled plans exist is so plan service providers like Fidelity can distribute their proprietary investment products on their recordkeeping platform. When Fidelity receives money from its own funds and pays, for example, Fidelity Trust for its recordkeeping services, some refer to that as "internal" revenue-sharing, in contrast to revenue-sharing that's paid to Fidelity by third-party mutual fund companies whose own (i.e., non-Fidelity) investment products Fidelity places on its platform. In any event, the more these products pay in revenue-sharing to Fidelity, the better for Fidelity (and the worse for plan participants).

Even in those rare cases where Fidelity is the bundled record-keeper for a retirement plan and a plan sponsor has chosen not to select many Fidelity mutual funds, Fidelity can still extract sufficient (and sometimes even excessive) revenue-sharing payments from non-Fidelity funds. A bundled plan makes it more likely that any excessive revenue-sharing--whether paid by a Fidelity fund or a non-Fidelity fund--can be disguised in the sense that it won't be monitored by a plan sponsor, as Judge Laughrey found in Tussey.

When Fidelity (or any other such provider) bids to provide a bundled retirement plan, it offers its own proprietary mutual funds on the plan's platform plus a number of non-proprietary funds provided by other mutual fund companies. Each fund family has its own contract with Fidelity as to how much revenue-sharing each fund will pay to Fidelity. Fidelity's contract with ABB allowed that, if the amount of revenue-sharing in a particular period of time wasn't sufficient to fully cover Fidelity's required fees, Fidelity reserved the right to charge the plan sponsor for any shortfall.

Reciprocally, though, when the amount of revenue-sharing in a particular period of time more than fully covered Fidelity's required fees, Fidelity had no duty to rebate the excess to the plan sponsor. The ABB-Fidelity contract also allowed this. Many plan sponsors fail to keep track of any such excessive revenue-sharing, which is just what happened in Tussey. Indeed, the ABB human resources department had the responsibility to "sign off" on (i.e., consent to) invoiced, hard-dollar recordkeeping fees, but it had no such duty when recordkeeping fees were paid through revenue-sharing. In offering a bundled retirement plan, the investment product provider really doesn't care which investment options plan participants select from the plan's menu, because it will get what it needs to cover its required fees one way or the other (and sometimes a lot more than that).

The real money-makers in a bundled retirement plan are the default funds that a provider makes available to plan participants once a plan sponsor has selected them. (These are funds that participants get if they don't make investment elections.) In Tussey, the expensive retail versions of the Fidelity Freedom Funds were default options. As Judge Laughrey noted in her decision in Tussey: "Revenue sharing was paid to Fidelity Trust based on each of the retail funds that comprised the Freedom Funds. Fidelity charged an additional fee for deciding how to allocate additional funds coming into the Freedom Funds." So not only were participants in two 401(k) plans with more than a billion dollars of assets paying retail prices to invest in the Fidelity Freedom Funds (and non-Fidelity funds), Fidelity also charged them an asset allocation fee on top of that when they invested in the Freedom Funds.

A Directed Trustee Has No Discretionary Authority
ERISA section 403(a) provides, in part, that all assets (except insurance contracts) of an employee benefit plan (e.g., a 401(k) plan) must be held in trust by one or more trustees. ERISA section 403(a) further provides for two kinds of trustees: (1) directed and (2) discretionary.

When a plan document expressly provides that a trustee is subject to the directions of a named fiduciary who is not a trustee (or an investment manager) (pursuant to ERISA section 402(a)), that would be a "directed" trustee. Fidelity, as noted, is the directed trustee in Tussey holding in trust for safe-keeping the billion dollar-plus assets of the PRISM Plans. The Pension Review Committee of ABB, Inc. (PR Committee) is the named fiduciary of the PRISM Plans. The PR Committee gives directions to Fidelity Trust, but such directions must be prudent--that is, in accordance with the terms of the plan and not contrary to ERISA.

The other kind of trustee--not present in Tussey--is a "discretionary" trustee, which is named in a plan or trust document as "having exclusive authority and discretion over the management and control of plan assets" (i.e., a plan's menu of investment options). Although Fidelity Trust made available to the PR Committee a menu of investment options that we may assume was shaped largely (if not entirely) by Fidelity's overriding need to receive sufficient revenue-sharing payments, under ERISA (and under the Fidelity-drafted contracts with ABB) the PR Committee still retained the ultimate authority to select, monitor, and replace the investment options made available to participants in the PRISM Plans. Of course, as the named fiduciary of the PRISM Plans, the PR Committee had the option to delegate (in writing) its responsibilities and liabilities for selecting, monitoring, and replacing the investment options in the PRISM Plans to an ERISA section 3(38)-defined "investment manager." The PR Committee could have been relieved of such responsibilities and liabilities had it made such delegation (while retaining a continuing monitoring duty over the 3(38)).

As a directed trustee, Fidelity Trust has no discretionary authority to make decisions, only to follow prudent directions from a discretionary decision-maker. This central characteristic of many bundled retirement plans creates two problems for plan sponsors and plan participants (and their beneficiaries): (1) Fidelity doesn't ordinarily mitigate risk for plan fiduciaries, and (2) Fidelity is indifferent to making available to plan participants institutionally priced investment options.

While these two problems, as noted, significantly harm both plan fiduciaries and plan participants, reciprocally, they also significantly help Fidelity in maximizing the profits it generates in bundled retirement plans. Financial product providers can compound the first problem by sometimes implying (whether in oral and written communications in sales presentations to plan sponsors or in advertising costing millions of dollars) that they so mitigate risk for plan fiduciaries.

A Directed Trustee Doesn't Mitigate Risk for Plan Fiduciaries
Any unabashed capitalist seeks to minimize the risks that threaten its fundamental, underlying goal of generating maximum profits. One such risk for Fidelity in the retirement plan marketplace is if Fidelity were to provide fiduciaries of qualified retirement plans with legally meaningful risk mitigation. Fidelity doesn't ordinarily provide plan sponsors with such protection because to do so would pose an unacceptably large risk in realizing its full profit potential. There's absolutely nothing wrong with that business decision on the part of Fidelity in an ERISA legal sense.

But it can be wrong in a business sense when a financial product provider appears to imply otherwise: that it does provide legally meaningful risk mitigation. In such cases, such providers can sometimes create the impression in sales presentations made to plan sponsors that the providers will stand in fiduciary (or "co-fiduciary") solidarity with them to share in any liability when attorneys for plan participants come a-knockin'. This gives sponsors a warm fuzzy feeling that the provider "will be there to take care of us if we get into trouble." As a result, a sponsor's decision to retain a large and reputable plan service provider would appear to be a very easy one. (In a past version of this belief, it was often said: "No one was ever fired for doing business with IBM.")

That kind of feeling is a false one. In the first place, financial product providers are rarely sued because they make crystal clear in their contracts with plan sponsors that it is the sponsors--not the product providers--that are ultimately responsible and liable for the prudence of a plan's menu of investment options. Second, even when product providers are sued, they almost always escape any significant liability for the same reason because, after all, judges can read contracts, too. Tussey is a perfect illustration showing plan sponsors why product providers, in reality, "will not be there to take care of us."

An ERISA Investment Advisor Doesn't Mitigate Risk for Plan Fiduciaries
Fidelity Research is not, as noted, an ERISA section 3(21)(A)(ii) fiduciary (i.e., one rendering investment advice for a fee) in Tussey. But suppose it was. Even then, Fidelity Research couldn't claim that, as the investment advisor to ABB, it's providing legally meaningful risk mitigation to the ABB fiduciaries anymore than Fidelity Trust could claim that, as the directed trustee of the PRISM Plans, it's providing legally meaningful risk mitigation to the ABB fiduciaries. Even if both these Fidelity units in Tussey were ERISA fiduciaries (concerning the investment options in the PRISM Plans), neither would have any discretionary decision-making authority under the law of ERISA or under the terms of the Fidelity-ABB contracts. That lack of discretion renders them powerless to legally protect ABB fiduciaries.

The fiduciary responsibilities (and liabilities) of Fidelity Research--even if it were the investment advisor to ABB--are limited to providing only non-discretionary advice to ABB, such as the composition of the menu of investment options in the PRISM Plans. While Fidelity's giving of such advice might be helpful to ABB in a business sense, it's not binding on Fidelity in a legal sense. That's because a 3(21)(A)(ii) investment advisor is a non-discretionary "advice-giver" (i.e., one rendering investment advice for a fee) that can provide only legally nonbinding advice to a 3(21)(A)(i) discretionary "decision-maker" (i.e., one exercising any discretionary authority or control in the management of a plan or disposition of a plan's assets).

A Directed Trustee Is Indifferent to Providing Institutionally Priced Investment Options
As the directed trustee in Tussey, Fidelity Trust is indifferent to making available to plan participants institutionally priced investment options. On the contrary, because Fidelity is an unabashed capitalist seeking to maximize its profits (as in Tussey), ordinarily many (or even all) investment options made available by such service providers in their bundled plans are retail-priced that pay revenue-sharing.

Sometimes a directed trustee can wear a fiduciary hat and at other times a corporate hat. (This "two-hatted" doctrine is usually discussed in the context of a plan sponsor.) This allows a directed trustee to act as a fiduciary at times and at times as a non-fiduciary--often at the expense of plan sponsors and plan participants.

The essential problem facing many plan sponsors (and therefore plan participants) is that they have no idea which hat is being worn at what times. Judge Laughrey nails this critical issue beautifully in her opinion where she notes how, when Fidelity is discussing its recordkeeping fees, Fidelity isn't wearing its fiduciary hat but its corporate hat: "As a 'directed trustee,' Fidelity Trust wears the 'hat' of a fiduciary only when carrying out its delegated duties as the Plan trustee and recordkeeper...[But] Fidelity Trust did not act under the direction of the Trust Agreement when [it] communicated with [ABB officials] regarding a reduction in recordkeeping fees [which would be dependent] on the PRISM Plans' fund line-up. Thus, Fidelity Trust did not wear the fiduciary 'hat' in [those fee discussions]; [Fidelity] simply represented Fidelity Trust's own [corporate] interests in [the] discussions with [ABB officials]. These interests were to increase Fidelity Trust's compensation for the recordkeeping and administrative services to the Plan." (Emphasis added.)

Once it began negotiating its own recordkeeping fees in Tussey, Fidelity essentially morphed from an ERISA directed trustee for the PRISM Plans into a fiduciary for Fidelity's shareholders. Fidelity, of course, is legally permitted to profit from unbridled revenue-sharing when wearing its corporate hat, as it did in Tussey. Plan sponsors (and their advisors) must be particularly on guard in such situations, though, because many of them just assume that Fidelity is always wearing its fiduciary hat with their sole interests at heart.

This won't change with the new ERISA section 408(b)(2) regulations, either. As has always been the case under ERISA section 404(a)(1)(B), under section 408(b)(2) it is only a plan sponsor that has the duty to determine if the costs of the plan it sponsors are "reasonable." As of July 1, Fidelity (and other such providers) is under the obligation to disclose its fees and what services it provides in exchange for those fees. But Fidelity has no duty to determine if those fees are unreasonable, such as the excessive revenue-sharing that Judge Laughrey found in Tussey. On the contrary, Fidelity's only fiduciary duty (when negotiating its own recordkeeping fees with ABB, for example) is to its corporate shareholders to maximize profits, and the failure to carry out such a duty could be a breach of duty--vis-à-vis its own shareholders.

If the goals of a plan sponsor are to mitigate the risk of its fiduciaries and/or to offer plan participants institutionally priced investment options, Tussey shows that the sponsor may find it more difficult to achieve those goals with a product-driven bundled plan solution.

Particularly alert plan sponsors will readily see the value of effectively eliminating conflicts of interest by adopting a fiduciary-centric solution with an independent advisor in which fiduciary advisors (1) provide legally meaningful risk mitigation for plan fiduciaries and (2) provide plan participants with institutionally priced investment options.

Having real fiduciary skin in the game, such providers have an incentive to provide low-cost and broadly and deeply diversified investment options, the combined effect of which is to leave more money in the pockets of plan participants, thereby allowing them a better chance to achieve improved long-term compounding of wealth to generate enhanced retirement income. This fiduciary-centric solution will be described in next month's column.

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 Understandingis 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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