This report was produced by the Advisory Council on Employee Welfare and Pension Benefit Plans, which was created by ERISA to provide advice to the Secretary of Labor. The contents of this report do not necessarily represent the position of the Department of Labor.

Executive Summary

This report was produced by the 2006 ERISA Advisory Council’s Working Group on Prudent Investment Process. The ERISA Advisory Council was created by ERISA to provide advice to the Secretary of Labor. The contents of this report do not represent the position of the Department of Labor (DOL). The 2006 ERISA Advisory Council formed a Working Group on a Prudent Investment Process (hereinafter referred to as the “Working Group”) to study numerous issues in managing plan assets. The desired result of the Working Group was to discover and present matters that would enhance the ability of fiduciaries to execute their responsibilities under ERISA.

Testimony to the Working Group was provided on August 9, 2006 and September 21, 2006 by 13 speakers, representing plan sponsors, investment management, organizations that represented multi-stakeholders, lawyers/consultants, and the federal government. After careful debate and analysis of the issues and transcripts, the Working Group submits the following recommendations to the Secretary of Labor for consideration: 

Recommendation 1: The Department of Labor should issue a publication which expresses ‘best practices’ for fiduciaries to consider for use in the investment management of a defined benefit plan.

Recommendation 2: The Department of Labor should publish guidance which expresses the unique features of hedge funds and matters for consideration in their adoption for use by qualified plans as a matter of procedural prudence.

Recommendation 3: The Department of Labor should require that fiduciaries, to the extent appropriate, acknowledge a responsibility to have a working knowledge of investment management and risk management concepts.

Recommendation 4: The Department of Labor should require that the “summary profile” contemplated and discussed in DOL Adv. Op. 2003-11A be provided for all investment vehicles within participant-directed plans, whether or not the plan is covered by ERISA §404(c). Prospectus delivery, where currently required, should be changed to optional upon participant request.

Recommendation 5: The Department of Labor’s electronic delivery standard should be updated from the ‘integral part of the employee’s duties’ standard currently employed to a ‘reasonable access’ standard currently in use by the Internal Revenue Service.

Respectfully Submitted,

Richard D. Landsberg, Chair
Robert M. Archer, Vice-Chair
Charles J. Clark
Lynn L. Franzoi
Neil Gladstein
Kathryn Kennedy
Timothy W. Knopp
Edward Mollahan
Christopher Rouse
Edward A. Schwartz
William L. Scogland
Dennis Simmons
Sherrie E. Grabot, ex-officio
James D. McCool, ex-officio


The Working Group on Prudent Investment Process undertook several issues for study. The balance of this report will address the scope of the Working Group, the questions for witnesses, dates of testimony and list of witnesses, current environment for the issues of inquiry, consensus recommendations to the Secretary of Labor and summary of testimony from the witnesses.

Scope Of The Working Group

This working group made inquiry into current issues regarding prudent investment procedure and process. Specifically, this Working Group studied selected prudent fiduciary procedures by sponsors of the following U.S. tax-qualified pension plans: 

  • Defined benefit pension plans
  • Defined contribution savings plans utilizing the protection of ERISA §404(c)

The study concerning defined benefit arrangements was limited in scope and focused on the unique components of an “accrued benefit obligation” and “actuarial present value of the benefits” as those items relate to investment operations and the funding and actuarial status of a plan. The scope of the study concerning ERISA §404(c) plans sought to determine how plan sponsors and vendors have responded to the regulations since inception. The goal of the defined benefit pension plan portion of the study was to assess and recommend investment implementation and investment monitoring methods to enhance plan operations. The goal of the 404(c) section of the study is to assess those parts of the statute/regulations that are most beneficial to plan sponsors and vendors and to make recommendations for improvement where necessary. The desired results of the Working Group were to determine whether: 

  1. Defined Benefit Pension Plan investment policies, strategies, and monitoring effectively show the timing and distribution of cash flows and the payment of liabilities.
  2. ERISA §404(c) participant directed investment decisions are properly and effectively communicated concerning investment options, participant education as to the investment options and the ability to change the investment options.

Questions for Potential Witnesses

Defined Benefit Pension Plans

What is the definition and function of an investment policy statement for a defined benefit pension plan?

Taking into consideration the accrued benefit obligation and the actuarial present value of the benefits, what time horizon should be used in evaluation of investment performance? Number of years? Market cycles? Long-term/short-term needs to provide benefits?

Should investment returns be stated in absolute terms, i.e. minimum target to match actuarial investment return assumption? Should it be stated in relative terms, i.e. relative to other accounts having similar objectives managed by the manager or relative to indexes? How are investment returns reconciled with the assumptions to determine funding levels? Should it track the pension cost under U.S. GAAP?

Should performance be calculated including the management fee? Excluding the management fee, custodial fees?

Are ‘alternative investments’ appropriate for defined benefit pension plans? By alternative investments we allude to, but are not limited by the following: private equity fund, venture, distressed debt, hedge funds, real estate, timber, oil & gas, LBOs and commodities. Which ‘alternative investments’ are acceptable ERISA investments and why? Are there existing compliance controls for such alternative investments? What steps (due diligence, portfolio diversification and liquidity analysis, bargaining for audit and control rights) should be undertaken in evaluating alternative investments? Are such controls and steps adequate and do they provide complete and transparent valuation?

Defined Contribution Savings Plans under ERISA §404(c)

Whether in-house or out-sourced what due diligence can be done by a plan fiduciary to assure administration of notification and prospectus delivery is compliant? What practices satisfy the §404(c) “sufficient information” requirement and would it be useful for the DOL to issue safe-harbor procedures? Is it practical to use electronic media for §404(c) notifications and prospectus delivery?

Discuss self-directed brokerage accounts in light of the prudent man standards of fiduciary compliance. How should the standards take into account participant demographics such as participant account size, participant investment sophistication and other participant investments?

What problems arise, if any, from investment allocation frequency and ‘blackout periods? Should frequent trading controls and procedures for participant notification, monitoring and modifying such controls be considered?

How can plan fiduciaries mitigate risk for default investments or mapping from discontinued investment and other investments made at the direction of the plan fiduciary?

Are ‘alternative investments’ appropriate for ERISA §404(c) plans? By alternative investments we allude to, but are not limited by the following: private equity fund, venture, distressed debt, hedge funds, real estate, timber, oil & gas, LBOs and commodities. Which ‘alternative investments’ are acceptable ERISA investments and why? Are there existing compliance controls for such alternative investments? Are such controls adequate and do such controls provide complete and transparent valuation? What issues arise concerning ERISA §404(c)’s requirement for “explaining transaction fees and expenses” regarding alternative investments?

The scope of inquiry for the Working Group and the attendant questions were given to all of the witnesses in advance of testimony. The witnesses were told that the questions were merely a starting point to generate thought and discussion of the scope of the Working Group. The questions were not intended to limit the parameters of testimony.

The Working Group solicited testimony of witnesses from a broad cross-section of the qualified retirement plan industry. The witnesses did not answer every question and in many instances, there was not enough information presented to form a consensus as to every inquiry by the Working Group. The witnesses and the dates of their testimony were as follows: 

August 9, 2006

  • Lou Campagna, U.S. Department of Labor
  • Edward Patchett, Independent Fiduciary Services
  • John Szczur, Central Pension Fund International Union of Operating Engineers & Participating Employers
  • Ronald Ryan, Ryan Asset-Liability Management
  • Richard Helmreich, Esq., Porter, Wright, Morris & Arthur
  • Jason Bortz, Esq., Davis & Harman LLP

September 21, 2006

  • Nell Hennessy, Fiduciary Counselors
  • Rhonda Migdail, Milliman Employee Benefits Research Group
  • Elizabeth Krentzman, Investment Company Institute
  • Gerard Mingione, Towers, Perrin
  • Frederic C. Reish, Esq., Reish, Luftman, Reicher & Cohen
  • Douglas Kant, Esq., Fidelity Investments
  • David Lee, CPA, Berdon LLP

Current Environment for the Scope of Inquiry

Before the Employee Retirement Income Security Act (“ERISA”) was adopted, larger retirement plans were using investment counselors and managers to help with the management of plan assets. The coupling of a volatile economy with complex financial markets and instruments and the added fiduciary responsibilities mandated by ERISA make the selection, execution and review of investment advisors even more critical to plan sponsors. ERISA, however, does not differentiate between large qualified retirement plans and small ones. ERISA holds all plans to the same level of fiduciary responsibility.

ERISA Sec. 402(b)(1) states that, “Every employee benefit plan shall provide a procedure for establishing and carrying out a funding policy in a method consistent with the objectives of the plan…” This citation of the statutory mandate references ‘funding policy’ or the detailed assumptions presented by the plan actuary or administrator as those assumptions pertain to present and future retirement obligations. The funding policy supports the asset flow, i.e. funds moving in and out of the plan asset base. Consequently, an integral part of the funding policy is the plan’s investment strategy. This is often referred to as the ‘investment policy statement.’ The investment policy statement is based upon the funding policy assumptions and becomes the very foundation upon which all investment decisions are made. If an investment policy statement has been properly formulated and memorialized, all prudent procedures covered will fall into place. This is predicated upon the fact that liability usually occurs when the fiduciary has failed to act in this area as opposed to acting improperly.

Satisfaction of prudent procedures in managing plan assets depends on diversification of the assets. ERISA is based, in part, on the premise that participants may not benefit from retirement assets if a plan has all of its “eggs in one basket.” The lack of diversification has been the easiest challenge for litigation since: it is easier to prove than specific imprudence and once a plaintiff proves lack of diversification, the burden shifts to the fiduciary to demonstrate that no diversification was prudent under the circumstances. Since ERISA was enacted, “diversification” has evolved to include “asset allocation.” A number of studies have concluded that asset allocation decisions have the greatest impact on the overall long-term performance of a portfolio. Asset allocation is based on the principle that individual asset classes have different investment characteristics and that asset classes can be combined to optimize the objectives of the investment policy statement. For any given expected rate of return, an optimal mix of asset classes can be determined that will yield the expected rate of return with the least amount of volatility or risk. Equally, for any given level of assumed risk, a higher expected return may be obtained by mixing different asset classes than by investing in a single asset class.

There are two references in ERISA that pertain to the use of experts in helping the plan fiduciary shoulder the responsibilities under the plan. The first requires investment decisions be made with the skill and care of a ‘prudent expert.’ ERISA Sec. 404(a)(1)(B) provides that “[A] fiduciary shall discharge his duties with care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.” The other reference is a statutory ‘safe harbor rule.’ This safe harbor is the closest ERISA comes to providing an exculpatory clause. The existence of the safe harbor underscores the critical nature that the Congress placed on having investment decisions made by experienced investment professionals. ERISA Sec. 405(d)(1) provides that “If an investment manager or managers have been appointed no trustee shall be liable for the acts or ommissions of such investment manager or managers, or be under any obligation to invest or otherwise manage any asset of the plan which is subject to the management of such investment manager.” The mere hiring of a money manager does not relieve the fiduciary of responsibility. The fiduciary must still act in a prudent manner in selecting and supervising investment professionals.

Consensus Of Recommendations

Defined Benefit Plans

The Working Group reached a consensus with regard to procedural prudence and the management of a defined benefit investment portfolio. Our consensus recommendation does not ask for a change to any, or new statute, regulation, interpretive bulletin, notice or opinion. Instead, the Working Group would like the Department of Labor to create a publication to stress ‘best practices’ for the execution of fiduciary responsibility as it regards defined benefit plans. In addition, the Working Group would like the Department of Labor to have fiduciaries acknowledge a “working understanding” of investment management and risk management concepts.

The Working Group recognizes that the Department of Labor has the ability to influence plan sponsors short of formally changing the written law. The Working Group believes that plan sponsors need more education relating to ‘best practices’ of portfolio/investment management – not new, more or further regulation relating to fiduciary responsibility or investment management. The Working Group has found that all the pieces of effective regulation are already in place. The Working Group has also found that what seems to be lacking are ‘best practices’ akin to the defined contribution plan world.

The DOL has provided in an earlier bulletin that a “statement of investment policy issued by a named fiduciary authorized to appoint investment managers would be a part of the documents and instruments governing the plan within the meaning of ERISA Sec. 404(a)(1)(D).” Additionally, the DOL has stated that “compliance with ERISA Sec. 404(a)(1)(B) would require maintenance of proper documentation of the activities of the investment manager and of the named fiduciary of the plan in monitoring the activities of the investment manager.”

It is to this end, that the Working Group takes notice that plan sponsors and fiduciaries are increasingly undertaking sophisticated investment strategies and utilizing increasingly sophisticated investment vehicles. It is therefore important that the execution of fiduciary responsibility is undertaken with an understanding of all relevant information necessary to sustain the target funding requirements of a defined benefit arrangement.

The Working Group believes that the goal of defined benefit management is to custom tailor a portfolio strategy that fits the unique circumstances of the plans sponsor while limiting risks to acceptable levels. This has been the goal of Modern Portfolio Theory since its origin in 1954. What has taken place since that time is a number of significant developments: 

  • A host of new financial instruments have been created: options, index funds, synthetic securities and leveraged inverse funds. These products give plan sponsors opportunities to improve performance, control risks and customize their exposure.
  • The rise of investment strategies that broaden a plan sponsor’s universe of opportunities by applying the new securities in novel ways (long-short inverse strategies and ‘hedge funds’).
  • The task of collecting, managing and using financial information has become a major business activity. Databases and trading systems allow investment managers to conduct portfolio strategies at a speed and efficiency that was unheard of a quarter of a century ago.
  • The improvements in econometrics and financial engineering now make it possible to evaluate the ‘fair value’ of many derivative and synthetic securities even in the presence of incomplete markets, thereby allowing for specialized risk mitigation.
  • The enhanced understanding of financial markets. No longer do financial economists subscribe to the theory that all markets are ‘efficient.’ There is now ample evidence that many markets display micro-structures that a careful investor can take advantage of.

The Working Group believes that a prudent investment process for a defined benefit arrangement has as its starting point – an assessment of actuarial liabilities as a way to estimate how much money will be needed, when and for whom. It is this assessment of actuarial liabilities where the plan sponsor encounters the investment time horizon, e.g. ‘planning horizon.’ Asset allocation then follows – taking into account any plan restrictions on allowable securities or trades, authorized trading lines, need for liquidity and perhaps most important – investment styles and how much risk is too much and not acceptable to the plan.

A dynamic, re-balancing portfolio to deliver necessary liquidity as benefits fall due involves two overriding objectives: ‘reward’ or the expected return and ‘risk’ or the volatility of those returns. Determining risk is only the beginning. Knowing how to properly measure risk is the cornerstone of portfolio management. Complicating things by the accelerating innovation of the financial services industry, is the fact that elements of risk today have become interdependent. If a fiduciary gets it wrong at one stage, the error is compounded and affects subsequent outcomes. Also, a secondary issue is that the efficient frontier of MPT moves over time due to changing risk premiums and related economic conditions. Plan sponsors and fiduciaries must be aware of these changes. By way of example, in the late 1990’s, plan sponsors could ‘expect’ returns in the mid-teens for equities. Today, most institutional investors ‘expect’ much lower performance. To this end plan fiduciaries must be educated and understand these plan performance dynamics.

In summary, the Working Group recommends that the DOL in its fiduciary workshops, publications and other educational endeavors adopt the following items as matter of fiduciary ‘best practices methodology’ to encourage plan sponsors to access all available data and information to effectively manage the financial consequences of the defined benefit plan per ERISA Sec. 404(a)(1)(B) and (D), supra ….

  • Perform actuarial projections to evaluate meeting target funding requirements and the plan’s policy for funding plan benefits
  • Model the effect of plan design, contribution and rate changes
  • Conduct cash flow projections to consider future liquidity demands
  • Perform asset-liability projections to assess future funding status
  • Review current investment policy statement for guidelines, objectives and asset allocation
    1. What information is used to change the investment policy statement?
    2. Who has authorization to change the investment policy statement?
    3. Who decides on optimal asset allocation?
    4. How often is the investment policy statement reviewed or changed?
  • Management of risk – evaluation, measurement and management
    1. How does the plan measure risk?
    2. Are returns measured with or without reinvestment assumptions?
    3. Are returns measured on a risk-adjusted basis?
    4. Is the plan diversified effectively – are correlation coefficients updated accurately?
  • Where derivatives or hedge funds are used are their reports understandable?
  • What is the process for changing fiduciaries?
  • Fiduciaries have a ‘working knowledge’ of investment management and risk measurement concepts.

Are Hedge Funds Acceptable Investments?

The Working Group recommends that the Department of Labor publish guidance which expresses the unique features of hedge funds and matters for consideration (“best practices”) in their adoption for use by qualified plans.

Mutual funds employ a more traditional money management philosophy and their portfolio management assume that the markets are efficient. Traditional money management maintains that ‘beating the market’ over time is not possible unless an investor accepts inordinate risk to capital. Hedge funds have a more non-traditional money management philosophy. Hedge funds assume that the market is not efficient and contains numerous revenue-generating opportunities that do not require inordinate capital risks

The Working Group has reached a consensus regarding the use of hedge funds in defined benefit plans. As stated before, our recommendation does not focus on changes to any existing, statute, regulation, interpretive bulletin, notice or advisory opinion. The Working Group finds hedge funds may be an acceptable form of plan investment. The Working Group does, however, believe that certain aspects of hedge funds should be brought to the front of the line in educating trustees, fiduciaries and plan sponsors. The Working Group finds that there are many elements beyond investment strategies that fiduciaries should concern themselves with when executing due diligence regarding plan inclusion of hedge fund investments.

The Working Group believes that the term ‘hedge fund’ is generically used to include a multitude of skill-based investment strategies with a broad range of risk and return objectives. The common thread amongst hedge funds is the use of investment and risk management skills to seek positive returns regardless of market direction. For purposes of this report the term ‘hedge fund’ is understood to be a U.S. private partnership invested primarily in publicly traded securities or financial derivatives. The source of capital for a hedge fund are accredited investors. Some of the more salient features are that hedge funds are unregistered investment companies. They make use of options, futures, swaps and short selling in addition to “long” plays of securities. Hedge funds often employ leverage in that the amount of notional exposure often exceeds the investment capital of the fund. Finally and probably most important, hedge funds have limited liquidity. Typically, investors can only get into funds on certain dates and can only get their money out of the fund on certain dates.

Plan fiduciaries need to know the type of investment they are considering in the hedge fund world does in fact carry unique characteristics not found in other types of portfolio products. Incorporation of inquiry into such matters will assist fiduciaries in discharging their fiduciary responsibility.

The Working Group believes that fiduciaries should be familiar and perform due diligence with regard to hedge fund investment styles. There are many different ‘investment styles’ of hedge funds. Basically they can be broken down into three categories – event driven funds; fund of funds and master-feeder funds. Event driven funds are a style that is dominated by news and events that are seen as special situations or opportunities to capitalize from price fluctuations. Sub-categories of event driven funds can include ‘distressed securities’ (junk bonds and common stock); ‘risk arbitrage’ (simultaneously buying and selling of stock); ‘global-macro’ (opportunistic management profiting wherever value is found – leverage may be used to enhance returns); ‘global international’ (focus on changes outside the U.S. these funds are bottom-up oriented that managers tend to be stock-pickers in markets they like using index derivatives is much less than the macro approach); ‘regional emerging’ (investments in less mature financial markets and specific regions); ‘regional established’ (focus in established markets like Japan, Europe and U.S.); ‘long-only leveraged’ (traditional equity fund structure); ‘market neutral’ (focus on locking out or neutralizing market risk); ‘sector’ (focus on specific economic sectors/industries); ‘short-sellers’ (manager takes position that stock will go down, manager borrows stock and sells it).

A special category of hedge fund is the fund of funds. These funds pool investments from many qualified investors and then place these funds with other hedge funds. The main point of fund of funds investing is that investors will theoretically minimize their risk through hedge fund diversification. Fund of funds investing usually operates under one of two styles – ‘diversified’ or ‘niche.’ The diversified fund of funds approach invests in a broad array of hedge fund types literally covering the much or the entire spectrum of hedge funds. The niche fund of funds approach invests in a number of other hedge funds but all within a single sub-category, i.e. all market neutral.

Still another form is the Master-feeder fund. A fund might consider using separate “feeder” funds to solicit funds from investors in every imaginable tax and legal domain. For example, one feeder for ordinary investors; another for tax-free pensions; another for institutions et. al. The ‘feeder’ funds invest all of their funds into a single master fund. Only the feeder invests into the master fund and the master fund is only available to feeder funds.

Likewise, the Working Group believes that liquidity of hedge funds plays an important role in the defined benefit portfolio. As stated earlier, hedge funds, unlike mutual funds do not stand ready and able to buy and sell shares on any given date. Generically speaking fiduciaries should be informed and understand the two forms of liquidity constraints on plan investment. ‘Liquidity’ dates are pre-specified times of the year when an investor is allowed to redeem shares. Hedge funds typically have quarterly liquidity dates, but yearly dates are not unheard of. Moreover, it is often required that investors give advanced notice of the desire to redeem (which are often required 30 days in advance of redemption). ‘Lockup’ refers to the initial amount of time an investor is required to keep the money in the hedge fund before redemption will be allowed to occur. Lockup therefore represents a commitment to keep initial investment in a hedge fund for a period of time. Once the lockup period is over, the investor is free to redeem shares on any liquidity date. The length of the lockup period represents a cushion to the hedge fund manager. The ability for a hedge fund to demand a long lockup period and still raise a significant amount of money depends a great deal on the quality and reputation of the hedge fund as well as the savvy of the investors.

Key to the fiduciary rules of ERISA and to the execution of ‘best practices’ is ascertaining. whether, and the extent to which, someone is in control of or dealing with “plan assets.” The very definition of a fiduciary under ERISA includes those who have authority over plan assets. Prudence, diversification and if appropriate, avoid large losses are guideposts of fiduciary behavior. Transactions that are prohibited under ERISA relate to certain persons using or obtaining plan assets. There is also a prohibition in ERISA arising from conflicts of interest regarding plan assets. In order to establish rules for what constitutes “plan assets” the DOL published final plan asset regulations in 1986 (DOL Reg. Sec. 2510.3-101). The regulation provided those investments in funds or other entities that were themselves investment vehicles should be subject to fiduciary rules. That is, where investment expertise is relied upon by a plan investing in a fund then the assets of the fund should be considered plan assets, thus implicating ERISA’s fiduciary rules. This has generally been referred to as the “look through” rule. The regulations provide exceptions. The Working Group wants fiduciaries, when investing in hedge funds, to understand that issues of conflict of interest and prohibited transactions can occur in the most mundane investment management scenarios. For example: 

  • Significant participation exception to look through must be tested whenever there is an acquisition of an investment’s equity interests.
  • Do foreign holdings comply with the ownership requirements of ERISA?
  • What is the compensation structure of the managing general partner?
  • How is lending – securities and other leverage – handled? Step by step.

Regardless of the hedge fund’s characterization under ERISA, it is most important for the plan fiduciaries to have a rudimentary understanding of the hedge fund or alternative investment vehicle under consideration and its operation. In addition to a fiduciary understanding of investment styles and liquidity issues – conflicts of interest and prohibited transaction rules must constantly be scrutinized when a hedge fund investment is considered and undertaken. It is a matter of ‘best practice’ for plan fiduciaries.

Defined Contribution Plans

The Working Group recommends to the Department of Labor that the “summary profile” contemplated and discussed in DOL Adv. Op. 2003-11A be required for use by all participant-directed plans, whether or not covered by 404(c). Prospectus delivery, where currently required, should be changed to optional upon participant request. The Working Group also recommends to the Department of Labor that the electronic delivery standard should be relaxed from the ‘integral part of the employee’s duties’ standard currently employed to a ‘reasonable access’ standard currently in use by the Internal Revenue Service.

In selecting a bundled package or utilizing an open-architecture format, the responsible plan fiduciary must analyze the underlying investment alternatives and comply with the general fiduciary standards including the prudent man rule. The Working Group heard testimony from its witnesses and that testimony had a common theme. Section 404(c) seems to say that if a participant in a plan controls the investment of his or her account the plan fiduciaries are not responsible if the investment turns sour. Section 404(c) also says that the DOL has the ability to issue regulations defining the circumstances under which a participant will be deemed to have exercised control over the investment of his or her account. The rather exacting standards prescribed by these regulations have potentially limited the utility of Section 404(c).

Overall, the testimony received told the Working Group that the current disclosure system results in significant gaps in the information that participants receive about some products and can produce information overload with respect to other products. Several witnesses testified that while mutual funds are the easiest investment to understand by participants – mutual funds have the heaviest burden when it comes to disclosure. By the same token less regulated and harder to understand investments might not even provide information regarding fees and performance.

The Working Group would like to recommend to the Department of Labor that the “summary profile” contemplated and discussed in DOL Adv. Op. 2003-11A be required for use by all participant-directed plans, whether or not covered by 404(c). The Working Group questions the utility of the prospectus as a source of investment information. While its delivery is required under SEC rules for investment, it lacks any marginal utility to a plan participant in terms of making an investment decision. Prospectus delivery, where currently required, should be changed to optional upon participant request. The Working Group recommends that such summary profile be required regardless of the type of investment product. The Working Group believes that implementation would provide at least the following as minimal information: 

  • Types of securities/investments
  • Investment objectives
  • Principal risks
  • Annual fees
  • Historical performance
  • Who the investment adviser is

The Working Group would like to recommend to the Department of Labor that the Department should reconsider its rules for electronic transfer of notices and the delivery of ‘sufficient information.’ The Working Group heard extensive testimony regarding the growth of the internet and its use by plan participants. Access to and use of the internet has grown significantly since the DOL first considered electronic delivery. The Working Group recommends that the electronic delivery standard should be relaxed from the ‘integral part of the employee’s duties’ standard currently employed to a ‘reasonable access’ standard.

There were other items to which the Working Group could have easily reached a consensus, but those items are addressed by the Pension Protection Act of 2006 and the Working Group saw fit to make recommendations on only the summary profile and electronic delivery points.

Summary of Testimony

Summary of Mr. Lou Campagna, Chief of the Division of Fiduciary Interpretation & Regulations, Employee Benefit Security Administration, United States Department of Labor, Washington, D.C.

In his capacity as Chief of the Division of Fiduciary Interpretations, Mr. Campagna has responsibility for requests made for advisory opinions from the public under the fiduciary responsibility and prohibited transaction provisions of the Employee Retirement Income Security Act of 1974 (“ERISA”), and to provide technical guidance under those provisions to field offices of the EBSA, including field assistance bulletins made public by the EBSA. Mr. Campagna stated that he was familiar with the issues before the Working Group. He believes that he can provide general background on prudence standards under ERISA and how the DOL has dealt with those issues.

Mr. Campagna provided an introduction to ERISA’s prudence standards as they apply to defined benefit and defined contributions with Plans. He provided some insight into the statutory and regulatory framework underlying those statutes and how they address those standards in the particular situations set forth before the Working Group. According to Mr. Campagna, in a “nutshell,” ERISA’s requirements are that fiduciaries discharge their duties solely in the interest of participants and beneficiaries and for the sole purpose of providing benefits and defraying the expenses of the Plan. Therefore, fiduciaries must discharge those duties with the care, skill, prudence and diligence under circumstances that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of like character and like aim. Prudence standards envision that a fiduciary must engage in a procedurally prudent process in evaluating any decisions it makes on behalf of the trust, including investment decisions.

As to the prudence of monitoring and selecting investments, the Trustees must act prudently in selecting investments for the Plan. ERISA does not speak to the prudence of specific investments nor does it characterize any particular investment as being either prudent or imprudent. Mr. Campagna explained that the idea of procedural prudence is that an ERISA fiduciary should understand the complexity of an investment, its risks, and how it fits into the Plan’s portfolio. If the fiduciary does not understand the complexities of an investment, it should utilize an investment consultant to analyze the investment. On a related point, the Trustees should understand that, in dealing with pooled funds, which are becoming more commonplace, the manager of that pooled fund should comply with the fund’s investment guidelines. Finally, any decision to make investments should not be influenced by non-economic factors (referring specifically to so-called economically targeted or socially responsible investments).

In considering how a fiduciary, like a Trustee, should evaluate potential assets, Mr. Campagna made reference to a letter issued by Olena Berg, of the DOL, transmitted on March 21, 1996 to the Controller of Currency, Eugene A. Ludwig, in connection with addressing the DOL’s views with respect to utilization of derivatives in the management of a portfolio of assets of a pension plan which is subject to ERISA. Therein, the DOL stated that, in the context of derivative investments, when determining whether to invest in a particular derivative, Plan fiduciaries are required, among other things, to engage in the same procedures and to undertake the same type of analysis as they would in making other investment decisions. Such analysis should include, but not be limited to, consideration of how the investment fits in the Plan’s overall investment portfolio, what role a particular derivative plays in the Plan’s portfolio, and the exposure to potential legal issues. In the ensuing discussion, Mr. Campagna suggested that the same evaluation would apply to considering hedge funds and other alternative investments.

Mr. Campagna reviewed the prudence standards under ERISA 404(c). He noted that, even with 404(c) compliance, Plan fiduciaries are still responsible for selecting and monitoring investment providers and it is appropriate for them to offer a broad spectrum of investment options, taking into account the fees and expenses, overall design, liquidity and transactional costs.

In concluding his remarks, Mr. Campagna stated he believes that, in the context of a DOL audit, Plan sponsors must be able to explain to DOL representatives the due diligence approach they followed in selecting an investment, such as an alternative investment vehicle. Trustees and fiduciaries must also evidence an understanding of any transparency issues.

Summary of Mr. Edward Patchett, Senior Vice President and Managing Director, Independent Fiduciary Services, Washington, D.C.

Mr. Patchett generalized that the term “alternative investments” means different things to different investors. These instruments can be complex and often present unique investment and fiduciary risks. However, not all alternative investments are high risk with high leverage, contrary to much of public perception. He noted that many plan fiduciaries are increasingly focusing their attention on alternative investments. The attraction is that alternative investments may increase plan diversification and reduce volatility of total plan investment performance. He advocates possible use of alternative investments, subject to the specific financial and actuarial condition of each plan and the risk tolerance of specific plan fiduciaries.

He sets real estate and commodities aside to define alternative investments as either private equity or hedge funds. While there is no single definition for alternative investments, his firm has chosen to confine the definition to these two broad categories.

Mr. Patchett highlighted two major forms of institutional private equity investments: venture capital funds and buyout funds. Regarding hedge funds, he again noted that public perception is often misguided. His definition of hedge fund boils down to a vehicle where the manager has broad investment discretion, may use leverage to enhance returns, the manager’s fee is weighted heavily toward performance incentives, and the manager has a considerable portion of his/her net worth invested along side the clients.

He emphasized that process is key because the damage of a poor decision can be very high. The process should begin with plan level asset allocation analysis and should include a thorough asset/liability study. Plan fiduciaries must evaluate several key areas before reaching a decision to invest.

Illiquidity is an issue because partnerships that form alternative investment vehicles are usually limited to a certain number of investors. Investment interests are not listed on any exchange, nor publicly traded. The life of a private equity fund may be ten years, and distributions to investors may not be intended to begin until several years into the investment. Lock-up periods for hedge fund investments typically last one or two years. Most hedge funds allow only periodic withdrawals.

Limited regulatory oversight is another issue. Early in 2006, the SEC required certain hedge funds to register, while private equity funds were not required to do so. Later in 2006, the SEC’s requirement was overturned for many managers of hedge funds. It is unclear whether those funds that did register will continue to maintain their registration in the future without being required to do so. Thus, most alternative investments are operated largely outside of any regulatory oversight. Mr. Patchett stressed the importance of plan fiduciaries’ due diligence and ongoing monitoring because of this lack of regulatory oversight.

He pointed to the notion that many alternative investment managers are not ERISA fiduciaries as another critical area that fiduciaries must consider. For private equity funds, vehicles are commonly structured as Venture Capital Operating Companies (“VCOCs”) so managers can avoid responsibility as ERISA fiduciaries. Hedge funds often rely on the “25 percent limit” to avoid the same ERISA responsibilities. Mr. Patchett noted that relaxation of the 25% rule (to say 50%) could likely facilitate greater flows to hedge funds, which may affect certain strategies and strain the capacity of some hedge funds going forward.

Transparency is another issue he highlighted. Transparency, from one alternative investment vehicle to another, can vary greatly. Some hedge fund managers purposely provide limited information regarding underlying holdings for fear that investors may exploit such information to the detriment of the partnership. Mr. Patchett emphasized the need for plan fiduciaries to carefully assess the level of transparency that they feel is necessary in order to effectively monitor a given plan’s investment.

Valuation was noted as another critical area of consideration for plan fiduciaries. For private equity funds, there is no one single, uniform approach to valuation. For hedge funds, while many underlying instruments are publicly traded, many others are not. Mr. Patchett feels that plan fiduciaries must understand and be comfortable with a valuation process in order to properly monitor alternative investments within plans.

The final key area of consideration that Mr. Patchett discussed was leverage. We all saw an example of the danger of leverage with Long Term Capital Management (1998). The amount of leverage used in various alternative investment vehicles varies significantly. Be careful of broad-brush conclusions. Mr. Patchett again underscored the importance of establishing a proper process for fiduciaries to identify a level of leverage that they understand and with which they are comfortable.

Mr. Patchett outlined the advantages of this approach to alternative investment exposure such as broader diversification as well as the potential benefit of more experienced fund-of-fund managers to screen and monitor vehicles. The main disadvantage of this approach is an additional layer of fees, but many plan fiduciaries feel that the advantages outweigh the higher fees.

Mr. Patchett feels the key for fiduciaries is to establish an overall process and follow it. He advocates use of an independent consultant and a clearly written statement of investment policy, which specifies a particular percentage range that is acceptable for alternative investments. Alternative investments are by no means a panacea, but can play a helpful role in a plan’s overall asset allocation strategy.

The main reason why Mr. Patchett sees alternative investments excluded from portfolios is because managers do not want to be considered ERISA fiduciaries. Managers see ERISA exposure as a risk that they wish to avoid.

Mr. Patchett believes that the asset size of a given plan has relevance, regarding suitability of alternative investments. He sees plans as small as $100 million in assets that actively utilize alternative investments. The minimum required investment amount of a given alternative investment vehicle often weeds out plans that are perhaps too small to utilize alternative investments.

He elaborated on the notion that many alternative investments are effectively blind pools for the first few years and that transparency is a critical issue for fiduciaries to consider, prospectively.

Mr. Patchett explained that regarding fees, hedge funds provide audited financial statements, but because peer information is not highly available, meaningful comparisons of fees and fee structures are still difficult for plan fiduciaries. In order to perform their fiduciary duties, plan fiduciaries must do the best job they can, based on the data that is available, which he hopes will be increasingly available. He noted that most advisory fees are charged against plan assets, and he feels justifiably so.

Regarding situations where VCOCs seek to avoid ERISA responsibilities, yet alternative investments are widely used within qualified plans, Mr. Patchett discussed the need for plan fiduciaries to know whether of not their alternative investment managers are acting as ERISA fiduciaries.

Mr. Patchett explained that ongoing education, from alternative investment managers to plan fiduciaries, is important, in order to address situations where “swaps” occur, or any other activity that may abruptly change the underlying mix of holdings within an alternative investment portfolio.

Given the general complexity of alternative investments and common misconceptions, Mr. Patchett encourages further guidance from the DOL on the broad topic, especially on the importance of fiduciaries establishing a proper process.

Summary of Mr. John Szczur, Director of Investments, Central Pension Fund International Union of Operating Engineers & Participating Employers, Washington, D.C.

Mr. Szczur serves as Director of Investments for the Central Pension Fund of the International Union of Operating Engineers and Participating Employers in Washington D.C. This Fund is a defined benefit fund with over 165,000 participants and assets of $8.8 billion. Mr. Szczur has 20 years of experience in the fields of finance and investments, both within defined contribution and defined benefit plans.

Mr. Szczur reviewed the elements of a typical investment policy statement (IPS) which included a summary of investment philosophy, a statement of investment goals and objectives, a delineation of the roles and responsibilities of the various decision making groups (including the Board of Trustees, the staff, investment managers, actuary and investment consultants), the asset allocation and rebalancing policies, eligible asset categories, investment restrictions and description of risk controls, and performance measurement and monitoring. Mr. Szczur provided a brief explanation of each of these elements and stated that it was the responsibility of the Plan’s sponsor, in formulating and monitoring investments, to act consistently with the requirements as detailed in the IPS. Thus, according to Mr. Szczur, the IPS provides the guiding principles to the formation of investment objectives, guidelines, review process and the distribution of responsibilities.

Mr. Szczur noted, that in reviewing investment policy statements for more than fifty defined benefit plans in preparation for his testimony, not surprisingly, very few funds set forth specific funding targets. Moreover, those statements that he reviewed made only general reference to assessing liabilities within the IPS. Mr. Szczur believes that the DOL could be helpful in ensuring that a Plans' sponsor have the IPS include a "point-in-time" snapshot of future liabilities of the Plan.

Mr. Szczur assessed "alternative investments" as an alternative to the traditional asset categories of equities and fixed income. According to Mr. Szczur, the long term nature of the Plan’s investment horizon, coupled with a sourcing of liquidity needs through traditional assets, may permit the Plan to invest in less liquid asset categories. Further, in a risk/return analysis, inclusion of alternative asset categories may permit a higher return for a given level of volatility. Mr. Szczur emphasized that judgments, regarding the adequacy of the investment policy, must consider the changing dynamics of both investment markets on the asset side and interest rate cycles on the liability side. Mr. Szczur noted that an IPS served another purpose: it provided a road map that transcends a turnover in staff and professionals.

Concluding, Mr. Szczur stated he believes that there could be more insight and standardization as to evaluation procedures and transparency issues with respect to hedge funds and the DOL could be helpful in this area.

Summary of Mr. Ronald Ryan, Chief Executive Officer and Chief Financial Architect, Ryan Asset-Liability Management, Inc., New York, New York

Mr. Ryan is the founder and Chief Financial Architect of Ryan ALM, Inc., an asset/liability management firm.

Mr. Ryan stated at the beginning of his remarks that the pension investment policy should be written and policed to best support the attainment of the pension objective. The true pension plan objective is to fund the liabilities at the lowest cost to the plan, taking prudent risk. Cost should be viewed as contributions or the extra payments made to fund the liabilities.

In terms of risk, Mr. Ryan expressed his view that the traditional definition of risk is volatility and that pension risk is best defined as the return behavior and volatility of each asset class compared to the return or growth behavior and volatility of the liability objective it is funding. In order to measure pension risk, Mr. Ryan stressed that the present value of accumulated benefit obligation liabilities must be calculated and that by definition, the low-risk portfolio for a liability-driven objective is a liability index fund. In Mr. Ryan’s view, this requires a custom liability index to build and maintain such a low-risk portfolio.

Mr. Ryan next discussed the difficulty practitioner’s face with discounting ABO cash flow in order to ascertain an accurate measure of the present value of liabilities. Mr. Ryan pointed out that the FASB, IRS, and ASOP 27 have different views and rules that can result in significant differences in the calculation of liabilities. Mr. Ryan also noted that in an October 2004 white paper, the Society of Actuaries made it clear that until pension plans create a set of economic books, namely market value, assets cannot be managed effectively versus the liability valuations currently used.

With regard to the frequency of asset and liability reporting for pension plans, Mr. Ryan noted that the current system where liabilities are reported usually annually with months delinquency, is too infrequent. To correct the situation, Mr. Ryan testified that plan should use a custom liability index or a set of economic books that calculates the market value of liabilities accurately and frequently.

Mr. Ryan discussed his view that with regard to asset allocation under a pension fund, the intent of asset allocation is to create a synergy among asset classes that meets the pension plan objective, and that the objective should be based on a custom index. This would give plans the discipline to shift funds to a less risky asset allocation if there are funding surpluses rather than deficits.

Mr. Ryan testified that with respect to performance measurement today, most pension funds are consumed by the quest for excess return above an index benchmark, and that unfortunately, the finance industry is using the wrong benchmarks for liability-driven objectives. The objective of a pension is to fund the liabilities at the lowest cost to the plan taking prudent risks and it is irrelevant if a pension fund outperforms a generic index like the S&P 500 – since the only thing that matters is performance relative to liabilities.

Mr. Ryan stated that pension investment policies should be designed and enforced similar to the way life insurance companies are regulated. In this regard, Mr. Ryan noted that stringent insurance regulations require an asset-liability management focus using bonds as the matching or funding asset. Any surplus is usually isolated as a distinct portfolio with a distinct objective, most probably a target growth rate, managed as an asset allocation of non-bonds. This would require pension assets to be managed in a way that is in the best interests of the true objective of the pension plan.

In response to questions from the Working Group, Mr. Ryan stated that he believed that in light of the growing level of government agency debt, there is a sufficient market of debt instruments available to enable the matching of assets to liabilities. Mr. Ryan also responded that if a pension plan has a deficit, which the overwhelming majority of plans today have, bonds cannot be used to make up a big deficit effectively.

Consistent with his prepared remarks, Mr. Ryan responded to another question from the Working Group by noting that as a plan’s funded ratio improves, the portfolio should become more conservative and fixed-income oriented and, in his view, when a plan becomes fully funded the plan can get more aggressive – and the key is to get an accurate assessment of he plan’s true value of its liabilities, something that doesn’t happen under the current pension funding rules.

Mr. Ryan noted that he would agree with a recommendation to have DOL bifurcate its approach to providing guidance on investment policy statements: one that factors in liabilities on the defined benefit pension side and a whole different objective on the defined contribution accumulation side. Mr. Ryan reiterated his view that there is a need to require that assets be managed and compared to liabilities, and that until the liabilities are calculated accurately and frequently every time assets are calculated, at the market, it will not be possible for the plan sponsor to know what is going on.

Summary of Mr. Richard Helmreich, Esq., Partner, Porter, Wright, Morris & Arthur, Columbus, Ohio

Richard Helmreich is a partner with Porter, Wright, Morris and Arthur specifically in the tax-qualified retirement plan area. Helmreich has assisted employers in the design and implementation of defined benefit plans, 401(k) plans; DC plans in general, welfare benefit plans, and executive compensation arrangements.

Richard Helmreich testified that the vast majority of employers desire to have protection under 404(c). And most every employer attempts to comply with section 404(c). And almost without exception, every employer fails to comply with section 404(c). And a big part of that is in the detail of how 404(c) and the regulations are set up.

Helmreich went on to say that to make 404(c) more workable the protections net would need to be a little bit broader so that employers could have protection that Congress intended. It would be helpful to have 404(c) and those regulations changed in several respects.

The witness testified that the first area is in the nature of the disclosures that are required. There are some that are very specific in nature, and there are some that are very general in nature. Employers are outsourcing the administration of their defined contribution plans, largely 401(k) plans in today's environment. And so the 404(c) compliance really falls upon the shoulders of the third party administrators. They tend to be investment firms. And the types of disclosures that the participants get are what are prepackaged and already in place. And so for mutual fund types of investments, there are mutual fund prospectuses. And those types of disclosures are typically provided. But the other more general statements that need to be provided and the periodic updates tend to fall through the cracks.

Helmreich also referenced Sarbanes-Oxley that has amended ERISA so that there is a blackout notice required in advance. The witness testified blackouts are necessary. Sometimes when employers change providers there is an acquisition or merger of companies, a planned merger or a planned spin-off. These are normal transactions by plan that require blackout periods. In the era of daily valuation, participants have come to expect to have daily access to their accounts.

The witness stated further that from a 404(c) perspective, the way the regulation is set up is that there is no clear level of compliance. Helmreich thought the Council should consider whether there should be some sort of safe harbor-type protections for employers. The witness offered as an example - for a blackout, if certain conditions are met, where the blackout is reasonable, or certain notice provisions have been put into place, that's all an employer can do. Helmreich doesn’t think that an employer should be held liable being outside of 404(c) simply by going through a blackout period. The threshold question is what is a reasonable period of time? Helmreich believes anything under 30 days is sufficient and would be a starting point of what would be a good safe harbor time period for a blackout.

Helmreich explained another type of transaction in the 404(c) arena is investment mapping. Again, this happens when an employer moves their plan from one TPA to another TPA or from one set of investment funds to another set of investment funds. The question always comes up, "How are we going to transfer those assets?" Helmreich believes there are really two basic choices employers are offered. One is to liquidate the assets and to transfer them in cash. The other is to map, which has become a very popular alternative recently. 404(c) should have a protection for this type of fund mapping or at least within the blackout type of arrangement.

Helmreich also covered alternative investments raised under both defined contribution plans and defined benefit plans. The witness stated that reasonable minds will differ, but alternative investments -- hedge funds in particular -- tend to be investments that carry much higher risk-return profiles. Helmreich stated that within a defined contribution plan, where the risk-return of profiles are being placed upon the participants, alternative investments don't make sense in a defined contribution plan, at least not as a core investment. Retirement funds, he believes, by their nature need to be invested a bit on the conservative side

Helmreich testified about the role of an investment policy statement and how does the time horizon impact investments in a defined benefit plan? He testified that the risk-return profile is really on the employer side what the regulation should emphasize is that the employers need to be investing plan assets, trust assets, as ERISA would indicate, in a prudent fashion and solely for the interest of participants and beneficiaries. Helmreich admitted that it's an awfully broad standard. The investment policy statement is a great idea. Helmreich stated that he regularly counsels clients to put them in place. He stated further that what might surprise the Council is that most employers don't have them. The investment policy statement is a helpful tool to create accountability to put benchmarks in place, to help establish what the goals are for the investments, and to help establish an effective tool to be able to monitor those investments. If nothing else, it forces the employer to stop and think about the investments.

Summary of Mr. Jason Bortz, Esq., Partner, Davis and Harman, LLP, Washington, D.C.

Jason Bortz is partner in the Washington D.C. law firm of Davis and Harman, LLP. Mr. Bortz testified on behalf of the American Benefits Council, a public policy organization representing principally Fortune 500 companies and other organizations that assist employers of all sizes in providing benefits to employees. Mr. Bortz confined his presentation to the 401(k) portion of the Working Group’s charge.

Mr. Bortz made suggestions concerning the regulations under Sec. 404(c). Specifically he focused on four areas – improving disclosure; enhancing delivery of disclosures; the mapping rules and open brokerage windows.

With regard to improving disclosure Mr. Bortz testified that it is important that disclosure not overwhelm plan participants. He questioned the extent to which all of the information in a full blown prospectus is appropriate. He advocated the use of the 2-3 page summary of key investment information regarding each investment option, i.e. the “summary prospectus/profile that was endorsed by the DOL in Advisory Opinion 2003-11A. Likewise, he questions the utility of the prospectus delivery requirement. Mr. Bortz testified that with regard to qualified plans and participants all relevant information is typically known before the first investment decision and therefore, the need for a prospectus after initial investment in the plan is impractical.

Mr. Bortz stated that the regulations to 404(c) should establish a core set of required disclosures that plans must satisfy in order for a plan sponsor to avail itself of the “safe harbor.” He recommends a model format for disclosure that information. Mr. Bortz went on to state that under current regulations, a mere threshold minimum is evident that doesn’t provide the satisfaction that the safe harbor is attained. In fact, he said, the clear implication for meeting the threshold is that ‘more’ is required. Mr. Bortz testified that one of the significant advantages of a uniform set of required disclosures would be to clarify the status of investment options that are not registered under the Securities Act of 1933, as amended. In fact, under current law, bank collective trusts, so-called 81-100 trusts and insurance company separate accounts are not within the purview of Sec. 404(c).

Mr. Bortz testified that electronic delivery of information required under Sec. 404(c) should be enhanced from the current “integral part of an employee’s duties” standard to the more relevant “reasonably accessible” standard utilized by the Internal Revenue Service. Mr. Bortz also pointed out that since plan participants can change investments online, so should fiduciaries be able to disclose information by posting to plan sponsor intranet or secure internet sites.

With regard to “mapping” of investments, Mr. Bortz stated that the Pension Protection Act raises two issues that need to be addressed. First, what are fiduciaries to do when no comparable investment option exists? The best approach according to Bortz is to develop guidance that addresses the intersection of the mapping safe harbor and the soon-to-be-issued guidance on default investment. Second, the issue of ‘what substitute fund is similar’ requires careful clarification so as not to diminish the safe harbor. To this end, Mr. Bortz recommended creating Sec. 404(c) relief for any mapping change determined by using a standard industry assessment created by a third-party, e.g. Morningstar.

In wrapping up his testimony, Bortz spend time discussing the open brokerage window concept. The problem with any regulation of same as Bortz sees it requires an evaluation of the investment acumen of eligible participants by the fiduciary. Consequently, he believes that the general broker suitability rules provide significant protections.

Summary of Ms. Nell Hennessy, President & Chief Executive Officer, Fiduciary Counselors, Inc., Washington, D.C.

Nell Hennessy is the President & CEO of Fiduciary Counselors, Inc.. A lawyer, her career summary includes a partnership (ERISA practitioner) with a Washington, D.C. law firm and government service at the PBGC. Her testimony was focused upon the defined benefit portion of the Working Group’s inquiry.

Ms. Hennessy testified that the long range asset allocation strategy employed by a defined benefit arrangement and memorialized by its investment policy statement, may or may not be tied explicitly to the timing of the benefit cash flows. However, any possible disconnect in an IPS does not mitigate the need to take into account plan liquidity needs by plan fiduciaries.

She went on to state that defined benefit fiduciaries have been shifting from a strategy designed to achieve a particular rate of return from investment portfolios to an investment strategy that takes into account asset – liability modeling to achieve an asset mix that is likely to minimize volatility in funded status. Ms. Hennessy feels that the recently enacted Pension Protection Act of 2006 is likely to create additional pressure to shift assets away from equities to bonds in order to reduce funded volatility. She cautioned that a shift from equities to bonds from similar legislation enacted in the United Kingdom ended up driving bond yields downward. Consequently she advises that any action taken by regulatory agencies should not “force” plan assets into asset liability matching (Liability Driven Investment Strategies, a.k.a. LDI strategies) of LDI strategies that will reduce long-term returns (like the U.K.). In making these cautionary remarks, she referenced that Administration officials indicated during the debate on the Pension Protection Act that pension plan fiduciaries have been ‘gambling’ on equities and perhaps the law should require and proscribe particular investments not unlike the general accounts of insurance companies.

Ms. Hennessy opined that different investment strategies go in and out of favor depending upon different investment cycles and that screening mechanisms based upon quantitative and qualitative measures will allow the universe of investments to remain available. To this end, and regarding hedge funds, she testified that such arrangements are acceptable ERISA investments if managed as part of a diversified portfolio. The outlier dangers with hedge funds from a fiduciary perspective were, and remain, twofold. First, there is a lack of transparency in the hedge fund industry at large. However, a hedge fund that provides access to information about underlying investments would allow fiduciaries to execute their fiduciary responsibility. Second, she mentioned that there might be some risks from investments in unregulated or less regulated markets which might not be understood by plan fiduciaries in the same way that the risks of diversified stock and bond portfolios are understood.

In summary, Ms. Hennessy recognized that modern portfolio theory focuses on maximizing return with low volatility of the portfolio. With the enactment of ERISA and throughout the years has created a “herd mentality” regarding MPT. While defined benefit plans must take into account funding liabilities riskier/potentially more volatile strategies or vehicles require more information than stocks and bond portfolios to maintain the health of the target funding of the plan. While she does not think that the DOL is particularly well situated to regulate investments per se, she believes that DOL could provide encouragement by providing information and education about alternative investments and strategies to fiduciaries.

Summary of Ms. Rhonda Migdail, JD, Director of Employee Benefits Research Group, Milliman, Inc., Washington, D.C.

Rhonda Migdail is a lawyer and serves as Director of Employee Benefits Research Group with the global actuarial and consulting firm of Milliman, Inc.

As to the defined benefit portion of the Working Group’s inquiry Ms. Migdail prefaced her specific comments with the general overview that laws, statutes, rules and regulations codify an underlying assumption that the individuals who undertake fiduciary duties possess the requisite sophistication and knowledge to act as prudent experts. To this end, she testified that an investment policy statement is, by nature, a functional roadmap for an investment committee in making the decisions regarding the funding of the defined benefit arrangement. Ms. Migdail pointed out that executing investment strategies as a fiduciary are an all-inclusive undertaking which requires a statement of goals and objectives for funding; delegation of authority for administration and investment management; selection and evaluation of investment vehicles and strategies; diversification of assets in the plan in order minimize large losses; and changing the asset allocation (rebalancing).

In speaking to the issue of alternative investments (including hedge funds) Ms. Migdail testified that such vehicles may provide an efficient mechanism to diversify systemic/non-diversifiable risk. The basis for her position is that alternative investments include asset classes that are non-correlated with stock or bond markets. Portfolio efficiency and volatility reduction are dependent upon low-correlated assets. She also maintains that complete and transparent valuation should not be made a requirement for the adequacy of an investment. Ms. Migdail testified that in evaluating alternative investments, portfolio investment diversification might better be managed by staging the pension portfolio based on liability duration. To this point, she pointed out that the degree to which a particular plan’s short term liabilities (e.g. 3 to 7 years) are covered either by cash flow or readily liquid assets can then help determine the percentage of longer term liabilities that can be invested in less liquid or more risky/volatile alternative assets. She cautioned that alternative investments must be an undertaking with due weight being given to liquidity, transparency, regulatory status and jeopardy of principal invested.

Ms. Migdail then gave her attention for the balance of her testimony to the defined contribution issues of the Working Group’s charge with an eye towards the impact of certain provisions of the recently enacted Pension Protection Act. In overview to her more specific comments, Ms. Migdail maintains that the purpose of Sec. 404(c) was to make sure that sufficient information is provided to plan participants so that they will have the opportunity to make informed investment decisions. She stated that in light of technological developments and the enactment of the recent law, the time is appropriate to revisit those requirements to determine whether they have adequately served the purpose of providing adequate information and to determine whether there are simpler alternatives available that would enhance and better fulfill the underlying purpose and intent of the statute.

She maintains that a more simple summary communication that contains “key” information related to each investment alternative – mass produced and electronically delivered – within the context of participant education would be much more effective in helping individuals make informed investment decisions. Of course, she stated, the ability to obtain the more detailed information upon request should be preserved. Ms. Migdail offered the suggestion that Advisory Opinion 2003-11A contemplated the use of the summary prospectus/profile approach and that the DOL should consider modifying its regulations permitting the use of the summary and issue a “model document.”

Ms. Migdail believes that it is practical to use electronic media for 404(c) notifications and for compliance with the prospectus delivery requirement. Ms. Migdail testified with regard to self-directed brokerage accounts. She stated that while it is possible to limit the type of investments in such an arrangement, considering the general lack of investment sophistication of participants and beneficiaries in 401(k) plans, it may actually be difficult to justify offering a brokerage account to a plan and claim that it was a “prudent” offering. She provided that instead of putting a focused lineup of high quality investments selected by fiduciaries utilizing high quality tools and benchmarking metrics – a self-directed brokerage account opens up the entire investment world without any real controls to educate participants to the danger of investing in funds that may not be prudent for a qualified retirement plan. She also hypothesized that use of a self-directed brokerage account would require the plan sponsor to judge the relative sophistication of each participant. Finally, she maintains that is would be difficult to objectively and effectively provide “sufficient information” on all the options that such and account would make available.

Ms. Migdail opined on the Pension Protection Act’s Sections 621 and 624 regarding “mapping” of investment choices where a qualified change occurs. She stated that the use of model portfolios, lifestyle funds, or target maturity funds should be among the types of arrangements that would satisfy the new requirement. She views the effectiveness of the new rules on mapping to be focused on the process rather than content. Specifically she offered the view that compliance should be achieved where plan fiduciaries hire and delegate an experienced, independent “fee for service” investment professional to evaluate the appropriate risk/reward characteristics of each investment in the prospective lineups – in function, not unlike a QPAM. She concluded by stating that while legislating mapping scenarios seems cumbersome and overbearing all that ERISA requires is that a prudent process be undertaken in the selection and monitoring of the plan’s options.

Summary of Ms. Elizabeth Krentzman, General Counsel, Investment Company Institute, Washington, D.C.

Elizabeth Krentzman is the General Counsel for the Investment Company Institute.

The witness testified that ICI strongly urges the department to comprehensively evaluate what investment-related information participants should receive and how they should receive it. ICI recommends that participants in all self-directed plans receive a concise summary of each investment option available under the plan. The department should update its electronic delivery rule based on Americans’ increasing access to and use of the internet. They also recommend that the more detailed information about investments products required under the departments rules be available online or in paper copies upon request.

Krentzman suggested the summary include information regarding types of securities held and/or investment objective, principal risks, annual fees and expenses expressed in a ratio or fee table, historical performance and investment adviser.

Summary of Mr. Gerard C. Mingione, FSA, Principal, Retirement Financial Management, Towers Perrin, Philadelphia, Pennsylvania

Mr. Mingione is a Fellow Society of Actuaries and a Principal in the Retirement Financial Management Group of the actuarial and consulting firm of Towers Perrin. He confined his testimony to the defined benefit side of the ledger.

Mr. Mingione began his testimony by providing an overview that covered the differences between a “return based efficient frontier” and a “funding rate efficient frontier” and that the former is the product of modern portfolio theory and the classic method for defined contribution arrangements. Necessarily the later is the dynamic or passive method needed for defined benefit plans. Mr. Mingione provided that the ultimate question for resolution with any defined benefit arrangement is whether the fiduciaries fund to fully secure the liabilities or whether they fund to reasonably secure. Necessarily, because corporate capital is not limitless, he stated that the most prevalent thought is to reasonably secure liabilities. Nevertheless, under either approach employers must maintain plan solvency to pay benefits as they fall due and minimize the long-term cost from a level and volatility of plan contributions perspective.

Mr. Mingione stated that monitoring financial results is best executed using market based funded ratios because they reflect the plan’s ability to pay benefits at any given point in time. He also alluded to ascertaining risk to maximize financial performance but included items for review that heretofore this Council had not heard from another witness. Specifically Mr. Mingione believes that a plan sponsor’s financial strength affects an investment strategy. Likewise the cyclicality of the plan sponsor’s industry. He advocates these items being used in addition to the more classic themes of risk/reward, time horizon, liquidity et. al.

For forecasting, Mr. Mingione believes that assets and liabilities should be modeled dynamically and consistently. However, his checklist for initial and projected normative capital market conditions should take into consideration inflation, productivity increases, bond yields, risk premiums and wage growth. Different time horizons should evaluate the financial implications from short term (1 to 3 years) and long term (5 to 15 years). Mr. Mingione was quick to note that in setting economic assumptions, historical statistics are relevant, but there are factors (such as fundamental market shifts) that may limit the relevance of the historical data.

Mr. Mingione spent time reviewing the asset class characteristics and a sample assumption setting analysis. With regard to hedge funds he stated that the reduced correlation to traditional equity classes can create higher returns. While he sees them as an appropriate investment, he cautions that fiduciaries must seek details in evaluating that they have not had to seek in the past. Specifically he mentioned that hedge funds by and large, have a brief and unreliable return history; that such funds are not benefit responsive (liquidity); have poor transparency. He spent some time describing potential oulier risks from assets contained in a hedge fund – particularly leverage. In essence the problem is that outlier risks exist when the determinants of the model are not borne out in the marketplace. Mr. Mingione believes that two core questions need to be addressed by plan sponsors considering outlier risks. First, does the investment model depend on capital market characteristics that may not be fully realized in the future? Second, what might be the effect of capital market ‘shocks’ that destabilize financial markets?

He finished by addressing the use of over-the-counter derivative strategies. He stated that while investing in fixed income swaps and futures rather than directly investing in long duration bonds has been commonplace, it changes the dynamics of the portfolio and its liability hedging characteristics. While plan sponsors will continue to use these strategies to add interest rate sensitivity without tying up large amounts of plan funds, he noted that such strategies might not be a direct match to liabilities because of different bond quality (credit), different maturity exposures (convexity) and ‘calls’ or ‘collateral’ issues.

Summary of Mr. C. Frederick Reish, Esq., Partner, Reish, Luftman, Reicher & Cohen, Los Angeles, California

Mr. Reish is a practicing lawyer specializing in employee benefits and tax matters. He has over thirty years of experience counseling clients in his area of expertise. He possesses extensive experience in all areas of Sec. 404(c) and his comments were limited to this portion of the Working Group’s charge.

Mr. Reish provided an overview at the beginning of his testimony. He stated that Sec. 404(c) has at its core, the paramount objective of informing participants to properly balance their tolerance for risk and their need for investment returns. He stated that before there was a 404(c) this very concept was actually based on ERISA’s adoption of Modern Portfolio Theory (“MPT”) and other generally accepted investment theories. However, Mr. Reish testified, it is now obvious to the most casual observer that most participants lack the knowledge to develop appropriate portfolios.

Mr. Reish testified that the benefits of Sec. 404(c) are significant and he supplied footnoted data that shows that many employers do not fully comprehend the statute. He testified that in his experience the most common failures to comply with Sec. 404(c) can be grouped under five different categories. First, the prospectus delivery requirement is either misunderstood or executed improperly. Second, failure to notify the participant of the identity of the 404(c) fiduciary. Third, participant information notification is either misunderstood or executed improperly. Fourth, plans often fail to notify the participants that the plan even intends to comply with 404(c). Finally, Mr. Reish testified that the confidentiality procedures for pass-through voting of company stock are often not developed and communicated. These five areas nothwithstanding, Mr. Reish stated that the good news is that for the most part, plan sponsors and providers are furnishing participants with the balance of the information required in the statute.

Mr. Reish recommended that the 404(c) regulation be improved by the following: 

  • Addition of a participant education element;
  • Clarification on what information must be furnished to participants;
  • Elimination of the prospectus delivery requirement;
  • Disclosure of all expenses, revenue and conflicts of interest;
  • Addition of disclosures regarding company stock;
  • Notifications that the summary plan description transfers liability;
  • Representation in the SPD concerning fiduciary liability and participant responsibilities;
  • Facilitation of use of default investments;
  • Clarifications of responsibilities concerning brokerage accounts;
  • Modification of definition of “broad range”;
  • Facilitation of electronic delivery

With regard to investment education, Mr. Reish stated that for the vast majority of the plans in existence, basic investment education is already offered to participants. To the extent that additional investment education is codified, the burden and expense of providing that education would most likely be absorbed by vendors rather than plan sponsors.

Mr. Reish also feels that clarification on what information must be furnished to participants is required. The main focus of his argument is that 404(c) notice requirements are best understood when they are realized in light of mutual funds and similar investment vehicles. He claims that a weakness in the regulation is revealed when one applies the regulation to illiquid or non-diversified or non-publicly traded investments. According to Mr. Reish, 404(c) appears to place the greatest disclosure requirements on diversified mutual funds which may be the easiest of the different types of investments to evaluate. In his opinion, the disclosure requirements should be just the opposite, that is to say, the greatest disclosure burden should attach to the investments that are most risky and that are the most difficult to evaluate.

He testified that the SPD is the most effective instrument for informing the participants that the plan intends to satisfy the 404(c) conditions and to obtain the relief provided by the statute. In essence the SPD is the perfect disclosure to inform participants that the fiduciaries are relieved of any losses which are a direct and necessary result of investment instructions and directions by participants and beneficiaries. Mr. Reish believes that it is the one document that is almost certainly provided to all participants and that there is little risk that the information will be mislaid or not delivered. Likewise Mr. Reish testified that the SPD should be the document to disclose the representation concerning fiduciary responsibility and participant responsibilities. In his opinion, the participants should be aware of the ongoing duties of fiduciaries of 404(c) plans as well as their own duties with respect to the plan. Mr. Reish testified that the SPD would heighten the awareness of the duties of fiduciaries to prudently select and monitor the investment choices offered by the plan and for participants to combine prudently selected funds in a manner which develop portfolios in their accounts that properly balance risk and reward.

Summary of Mr. David C. Lee, CPA, Partner, Berdon LLP, New York, New York

David Lee is a CPA and a partner at Berdon LLP where he heads up the Firm’s ERISA practice. He spoke on valuation of alternative investments in plans, loosely defined as anything not quoted on an exchange or other public market. Approximately 1/3 of the 75 or so plans David serves have alternative investments, compared to about 10% of plans just 5 years ago. However, the amount of AI is not a significant part of total investments. While generally accepted accounting principles requires AI’s to be valued at fair value, fair values are hard to come by. Usually the outside investment manager, the custodian or the issuer of the AI, a hedge fund eg, ends up determining AI fair value, and no one at the plan looks at it. There is no DOL requirement for the sponsor to have an independent valuation performed. David said he believes DOL needs to emphasize the plan’s fiduciary responsibility to determine fair value.

The Independent Qualified Public Accountant (IQPA) is precluded by the DOL independence rules from determining the fair value. However, the IQPA is required to look at how fair value is determined, but if it’s a limited scope audit the DOL lets the auditor accept the fair value the custodian puts on the AI. In a full scope audit the IQPA has to test the model for determining fair value. There is checklist the IQPA is supposed to complete when testing the fair value that is determined by the plan administrator. The important thing is to see that those coming up with the fair value go through a proper process. However, David said many less sophisticated IQPAs do not adequately test the fair value model, and he referred to a recent DOL report that found there has been no improvement in plan audits. The American Institute of CPAs had a Risk Alert recently regarding valuation of AIs, which put IQPAs on notice to perform proper procedures when testing the fair value of AIs. The auditor’s professional judgment is important in making sure the fair value is correct.

The 5500 will display AIs if they are properly classified, and the footnotes to plan financial statements are supposed to disclose the existence of significant amounts of AIs and how their fair value is determined, including assumed rates of return, etc.

Summary of Mr. Douglas O. Kant, Esq., Senior Vice President & Deputy General Counsel, Fidelity Investments, Boston, Massachusetts

Douglas Kant is Senior Vice President and Deputy General Counsel of FMR Corporation. FMR’s subsidiaries include a group of financial service companies known as Fidelity Investments. Fidelity provide record keeping, investment management, and trustee or custodial services to thousands of 401(k) and 403(b) programs, and millions of individual retirement accounts (“IRAs”) and Roth individual retirement accounts (“Roth IRAs”).

He described how the Pension Protection Act (PPA) provides two alternative rules for a fiduciary adviser to qualify for prohibited transaction exemption relief when providing investment advice. One rule is for the use of computers. Any investment based on the computer’s advice must occur solely at the direction of the participant or beneficiary. The computer model must be certified by an independent third party and it must be able to accommodate a wide range of investment options. Alternatively, if no computer model is used, the advisor’s fees cannot vary based on the investment options selected.

Mr. Kant also described some of the findings in Fidelity latest version of “Building Futures,” its annual report that looks at defined contribution plans. They report that most plan participants allocate their savings in only a relatively small number of investment options. Slightly more than two-thirds of participants allocated account assets among less than five (5) investment options. Because of this limit allocation; Mr. Kant stated that investment advice may play an important role in supporting broader account diversification.

One role that Mr. Kant sees for the Department of Labor (DOL) is to issue regulations on what happens when they advises a participant to sell investments in employer stock but the participant wants to retain the employer stock position. He argued that they should be able to either exclude the employer stock position entirely or seek to “counterbalance” the employer stock. Under the counterbalance approach, they could give advice on how to invest the remainder of the account in a manner that increases allocation to other asset classes. Unless this is addressed, Mr. Kant believes that Fidelity will be foreclosed from offering advice on that participant’s account.

He sees a similar problem when a participant has some of the investments in a brokerage account or allocation funds (including life-cycle funds). Mr. Kant testified that the advisor should be able to exclude these funds when determining an investment strategy. That the adviser should be able to construct portfolios based on its reasonable judgment, choosing between any investments options currently available to all plan participants.

The Council and Mr. Kant discussed these and other issues.