The Employee Retirement Income Security Act (ERISA) requires that a fiduciary diversify plan investments to minimize plan participants’ risk. Plan fiduciaries must act cautiously and solely in the best interest of the plan’s participants and beneficiaries. Who’s a fiduciary, and what are his or her responsibilities in a defined contribution (DC) retirement plan that allows participants or beneficiaries to direct their investments? Let’s take a closer look.
Defining a fiduciary. A fiduciary is anyone who has discretionary control over the management or administration of a plan, or who holds control over the management or disposition of assets. Fiduciary status is based on the tasks performed rather than a person’s title. The plan document must name at least one fiduciary (individual or an entity) as having control over the plan’s operation.
A plan’s fiduciaries generally include the plan trustee, all people exercising discretion in the plan, members of any administrative committee, those who appoint the committee and investment advisors. The law holds fiduciaries to a higher standard of conduct because their actions affect participants and their beneficiaries. Generally, the law doesn’t consider attorneys, accountants and actuaries to be fiduciaries when acting only in their professional roles. Plan fiduciaries make many decisions that aren’t fiduciary actions, but are strictly business decisions made by an employer. This includes establishing a plan, creating a benefits package, and amending or terminating a plan. ERISA doesn’t govern these decisions. In these instances, an employer is acting on behalf of its business, not the plan.
Diversifying plan investments. ERISA requires fiduciaries to diversify a plan’s investments to attempt to minimize the risk of large losses, unless under the circumstances it’s clearly prudent not to do so. Federal regulations implementing this requirement require plans to offer a broad range of investment alternatives. Such investment alternatives must provide participants a reasonable opportunity to materially affect both the potential return on amounts in their individually directed account and the degree of risk to which such amounts are subject. Plans must make at least three investment options available that meet the following requirements:
The plan must diversify each available core investment. Core investments have consistent performance year after year and are the foundation of an investment portfolio. Some examples of core investments are intermediate bonds, gold and silver.
Each core investment must have different risk or return features. The collection of potential investments must offer varying levels of risk.
Core investment choices must allow participants to realize appropriate risk and return. When combined, the core investment choices must permit participants to realize a portfolio with combined risk and return features at any point in a range appropriate for them. The available choices must provide the individual participants with an opportunity to choose the potential level of monetary return and the degree of risk they’re comfortable with.
Overall risk must be minimal. Each core investment choice, when combined with investments in other alternatives, must minimize through diversification the overall risk of the participant’s investments.
Plan sponsors should choose investments with a broad range of choices so participants can diversify their portfolio to suit their needs. They must explain the options, describe the investment objectives and disclose the potential risk and return. Make sure participants understand fees or expenses and how to communicate investment directions so that participants make informed decisions regarding their choices.
Keep in mind that participants bear the risk in a DC plan. Plan fiduciaries must consider each investment option’s risk and give participants a meaningful way to balance that risk among the offered investment options. To avoid fiduciary liability, plan sponsors must show they prudently determined the risk of each investment option offered and provided diverse options with varying degrees of risk. In determining whether a plan provides the participant with a reasonable opportunity to diversify his or her investments, the plan fiduciary must consider the nature of the plan’s investment alternatives and the portion of the participant’s account over which the participant exercises control.
Diversity and fiduciaries
Fiduciaries aren’t required to make participants completely avoid risk. However, the plan must provide investment alternatives with varying degrees of risk so participants can diversify if they choose. Understanding the diversity rules for DC plans goes hand in hand with fiduciary duties. Make sure you understand both before entering into these types of plans. If you already offer a DC plan that allows participants to direct their own investments, now is the time to review the rules to make sure you’re in compliance.