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Yes, Separately Managed 401k Account Pose Risks to Plan Sponsors, But These Steps Can Reduce Their Fiduciary Liability

Yes, Separately Managed 401k Account Pose Risks to Plan Sponsors, But These Steps Can Reduce Their Fiduciary Liability
May 30
00:03 2018

As more employees’ 401k accounts approach or exceed seven figures, there’s increasing interest in moving away from mutual fund options and towards with individually managed portfolios of stocks and bonds. Switching from mutual funds, including asset allocation model portfolios that contain mutual funds, to individual stocks and bonds becomes more important as the employee nears retirement age. Such customized portfolios help soon-to-be retirees better manage their anticipated cash flow. It also gives them more precise control of their downside risk.

These “separately managed accounts” or “separate brokerage windows” certainly provide measurable benefits for employees. For plan sponsors, especially those not familiar with anything other than mutual funds, such options present a clear and present danger when it comes to fiduciary liability. “The biggest risk is the selection of investment managers for the separately managed accounts,” says John E. Schembari, Chair of the Corporate Finance Department at Kutak Rock, LLP in Omaha, Nebraska. “The fiduciaries of the plan must prudently retain managers to help participants manage their separate accounts.”

Failing to engage in a prudent process for selecting the manager presents a major risk to plan sponsors. For one thing, unlike mutual funds, RIAs have no strict reporting requirements. As a result, there’s no reliably consistent database of investment advisers. “Publicly traded products are easier to evaluate given the performance history, says Patrick DiCarlo, who serves as Compensation, Benefits & ERISA Litigation Counsel in Alston & Bird’s Atlanta office. “Getting truly comparable performance history for a separately managed account – particularly an actively managed one – is likely more difficult. Evaluating things like style drift and performance in various market conditions would likely be more challenging for separately managed accounts. Procedural diligence is critical for ERISA fiduciaries, and will likely be more difficult for managed accounts. Ongoing benchmarking may also be more challenging.”

In addition, plan sponsors may find separately managed accounts present a compliance challenge. “While ERISA Section 404(c) provides fiduciary protection for fiduciaries creating a menu of diverse investment alternatives,” says Schembari, “that protection will not apply to a fiduciaries decision to hire investment manager(s) to manage separate accounts. While this is not a new risk for fiduciaries of defined benefit plans, it may be a new risk for fiduciaries of defined contribution plans. These fiduciaries, and their advisors, may not be as experienced in interviewing, hiring, and monitoring individual investment managers.”

Unfortunately, this lack of experience is all too common when it comes to 401k plan sponsors. They may not be fully prepared to conduct the necessary due diligence when it comes to selecting and monitoring investment advisers. “Plan fiduciaries must vet the managers for separately managed accounts otherwise they risk violating their fiduciary duties under ERISA,” says Schembari. “Given the lack of experience of many fiduciaries in hiring investment managers as opposed to selecting individual investment options, this process may create more risk for many fiduciaries. In addition, given the loss of ERISA Section 404(c) protection, it is arguably a more significant fiduciary decision to hire an investment manager than an individual investment option.”

As an alternative to selecting investment advisers for employees, plan sponsors might consider allowing employees to bring in their own RIA. This, though, doesn’t fully remove fiduciary liability. “This is an acceptable option if the plan fiduciaries have an appropriate structure in place to delegate responsibilities to individual participants to make these decisions,” says Schembari. “Most plan sponsors interested in this approach offer a separate brokerage window that allows participants to buy and sell investment alternatives that are not included in the main menu. Participants always have the right to seek their own investment advice from advisers outside of the plan. If the plan sponsor is going to allow a participant’s investment adviser to have control over the participant’s assets, the plan’s fiduciaries need to insure proper governance as well as checks and balances are in place between the plan’s fiduciaries, the participant, the custodian, the recordkeeper, and the participant’s investment manager.”

Do This to Reduce Fiduciary Liability:

Plan sponsors want to offer the best benefits to their employees. Still, they need to avoid offering options that clearly far exceed the actually needs of their specific workforce demographic. Employees who can best take advantage of separately managed accounts generally are near retirement and have in excess of $500,000 in retirement assets. “Plan fiduciaries should consider whether a separately managed accounts make sense for their participants and beneficiaries,” says Schembari. “Separately managed accounts are very much in the minority of defined contribution plans. Further, the number of participants in plans that have separately managed accounts is usually a very small percentage of all participants. As a result, those plans that establish separately managed accounts usually do so because of a small minority of very vocal participants who ask for this feature. Plans without these vocal participants do not usually establish the accounts.”

To reduce liability, selecting and monitoring individual investment advisers for separately managed accounts should be undertaken in the same manner plan sponsors address all their fiduciary functions. “Engaging in a robust, and well documented, process for picking a particular manager, and style, is the best way to mitigate risk,” says DiCarlo. “For many fiduciaries, that likely means doing a formal Request for Proposal and hiring outside expertise to design the RFP and evaluate the responses.”

Additionally, plan sponsors can reduce their liability by placing the bulk of this selection process on the shoulders of the employees. “The key distinction is whether the plan fiduciaries are allowing brokerage accounts or whether the fiduciaries are hiring investment managers to manage separately managed accounts,” says Schembari. “If the idea is to establish brokerage accounts, the Department of Labor has provided helpful guidance for plan fiduciaries in creating and monitoring these accounts. If the fiduciaries are looking to hire individual investment managers, they must insure that they have the expertise to prudently investigate, hire and monitor these investment managers.” [Editor’s Note: The DOL guidelines referenced may no longer be current.]

As more employees find their 401k accounts growing to more than one million dollars, there will be a greater need for self-directed options – managed by professional investment advisers – to be included in the 401k menu. These options can both benefit employees nearing retirement as well as increase plan sponsor fiduciary liability. Plan sponsors should become more aware of the consequences of providing these kinds of options and how best to mitigate the liability risk associated with them.

Christopher Carosa is a keynote speaker, journalist, and the author of  401(k) Fiduciary SolutionsHey! What’s My Number? How to Improve the Odds You Will Retire in Comfort and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on Twitter, Facebook, and LinkedIn.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

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