Investment Policy Statements: A Practical Guide to Procedural Prudence

A firestorm of qualified plan litigation has risen up in the past few years, much of which focuses on the steps taken—or not taken—by fiduciaries with respect to various aspects of the plans’ investment line-ups, such as the costs associated with and performance of the investment options. In many cases, but not all, the courts have reached decisions favorable to the fiduciaries. So, what can a fiduciary do to increase the likelihood of ending up on the favorable side of a decision? A common theme to the outcomes of these cases has been the extent to which the fiduciaries were able to demonstrate to the court’s satisfaction that they exercised procedural prudence in making decisions with respect to plan investments.

What Is an Investment Policy Statement?

In general, an investment policy statement functions as a guide for plan sponsors’ decisions with respect to the funding or investment options applicable to their defined benefit or defined contribution plans, respectively, and in regard to the ongoing evaluation of those investments.

The concept of an investment policy statement originates with the Employee Retirement Income Security Act, which sets forth the requirement that every employee benefit plan “shall provide a procedure for carrying out a funding policy and method consistent with the objectives of the plan.” ¹ERISA §402(b)(1). In selecting plan investments, a fiduciary is expected to fulfill his or her duties “with the 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,” ²ERISA §404(a)(1)(B). typically referred to as the “prudent man standard of care.” The Department of Labor (DOL), which has the power to enforce ERISA, has further commented that having an investment policy statement would be “consistent” with the fiduciary obligations under the prudent man standard of care. ³Interpretive Bulletin 94-2, 29 C.F.R. §2509.94-2.

Why Have a Written Investment Policy Statement?

The DOL defines a “statement of investment policy” as a “written statement that provides the fiduciaries that are responsible for plan investments with guidelines or general instructions concerning … investment management decisions,” ⁴Id. although ERISA itself does not contain an express requirement for a written investment policy statement, or for an investment policy statement at all. So, must a fiduciary have an investment policy statement, and, if it does have one, must it be in writing? Strictly speaking, no. However, when it comes to litigation, the absence of a written investment policy statement may be significantly detrimental, as it may be difficult to demonstrate that you have an investment policy if the policy isn’t written.

In Liss v. Smith, ⁵Liss v. Smith, 991 F. Supp. 278 (S.D.N.Y. 1998) the plaintiffs brought allegations, among other things, of a fiduciary breach related to the fiduciaries’ investment decisions. The fiduciaries acknowledged that there was no written policy guideline, and the question that the court considered was whether the absence of a written policy and the “ad hoc nature of the Funds’ investment decisions” violated their fiduciary duties under ERISA. The court found that the trustees’ failure to provide a written policy guideline, and their failure to implement any investment policy and guidelines for investment of fund assets, constituted a breach of their fiduciary duties. ⁶The opinion stated that “ERISA does not contain a specific requirement that a written investment policy be maintained by the trustees. I find, at least in this instance, that such a policy is necessary to insure that the plan investments are performing adequately and meeting the actuarial, liquidity and other needs of the Funds. Support for this proposition is found in Department of Labor regulations. … While this regulation states only that a written investment plan is “consistent” with ERISA’s fiduciary duty requirements, in the circumstances here, absence of any [investment] plan constitutes a breach of fiduciary duty.” Liss v. Smith, 991 F. Supp. 278, 296.

Checklist of Criteria for an IPS

The regulations interpreting the prudence requirements of ERISA state that, in selecting and monitoring investments, fiduciaries are to give appropriate consideration to relevant factors, such as diversification, liquidity and the risk/return characteristics of plan investments. ⁷29 C.F.R. 2550.404a-1(b). This would include consideration of the expected returns on alternate investments with similar risk qualities, as the DOL does not consider an investment prudent if it is expected to provide a lower rate of return than investments with comparable risk factors, or a higher risk than investments with comparable returns. ⁸Interpretive Bulletin 94-2.

Checklist.

Based on this framework, an investment policy statement should, generally, address the following questions:

• □ Does the investment policy statement clearly state the roles and responsibilities of the parties involved in making decisions related to the plan’s investments? For example:
  • — Whether the fiduciaries will utilize an outside investment adviser, manager and/or consultant.
  • — Whether investment decisions will be made by the plan’s general committee, by an investment subcommittee, by an outside adviser, manager, or consultant, or by some combination of the foregoing.
  • — Who will be on the committee or subcommittee that makes the plan’s investment decisions or recommendations, and what level(s) of investment expertise will be represented.
  • — How frequently will the committee or subcommittee meet (for example, quarterly).
• □ Does the investment policy statement provide clear funding or investment objectives, as applicable, for the plan? For example:
  • — For defined benefit plans, whether the objectives address the company’s acceptable level of risk while considering the return required to meet the plan’s funding obligations.
  • — For defined contribution plans, whether the objectives provide specific criteria for fiduciaries to follow in fund selection, such as offering participants a diversified range of investments across multiple asset classes.
• □ Does the investment policy statement set forth clear standards for fund selection? For example:
  • — Whether the fund satisfies a specific diversification criteria or asset class need.
  • — Whether the fund’s fees and expenses are reasonable compared to other funds with a similar risk/reward profile and management style (e.g., actively managed or indexed).
  • — Whether all available share classes for a particular fund have been properly considered.
  • — Whether the fund’s historic performance is consistent with its risk profile.
  • — Whether the fund’s composition is consistent with its investment objective.
• □ Does the investment policy statement describe the factors for monitoring the ongoing performance of selected funds? For example:
  • — Whether the fund remains consistent with the initial selection criteria.
  • — How does the fund’s ongoing performance compare to its benchmarks and peer funds.
  • — Whether the fund is consistent with its own investment objective(s) or whether it experiences style drift.
  • — Whether there have been any changes in the fund’s management.
  • — What method(s) will the fiduciaries use to track under-performing funds (e.g., use of a watch list).
• □ Does the investment policy statement address certain considerations typically relevant to participant-directed defined contribution plans (e.g., 401(k) and profit sharing plans)? For example:
  • □ Whether the plan will utilize the protections of ERISA Section 404(c) and, if so, whether the steps that will be taken to maintain 404(c) compliance are identified.
  • — Whether the plan will offer a tiered (core/non-core) line-up.
  • — Whether the plan will offer a qualified default investment arrangement (QDIA).
  • — Whether the plan will offer target date funds and, if so, whether the philosophy with respect to those funds is clear (e.g., whether the glide path will be “to” retirement or “through” retirement).
  • — Whether the plan will offer self-directed brokerage accounts.
  • — Whether the plan will offer employer securities and, if so, whether proxy voting has been addressed. There is a further discussion on employer securities below.

Investment Policy Statement Pitfalls

The DOL has taken the position that an investment policy statement will be considered to be a part of the documents and instruments governing the plan. ⁹Id. Consequently, once an investment policy statement has been adopted, fiduciaries will have exposure if they fail to follow it. Similarly, since an investment policy statement need only provide “guidelines” and “general instructions,” ¹⁰Interpretive Bulletin 94-2. putting too much detail into the statement may also be problematic to the extent that the level of detail cannot be adhered to. Automatic triggers, such as those that require removal of funds upon certain situations (e.g., “x” quarters of below-benchmark performance), also pose a risk when they preclude the exercise of fiduciary judgment, and the failure to adhere to such triggers may create liability. Finally, as with all plan documents, fiduciaries should take care to periodically review and, as needed, update their investment policy statement.

The Special Situation of Employer Securities

Does an investment policy statement need to address employer securities? Up until very recently, a “presumption of prudence” had applied with respect to employer securities, which served to remove some, if not all, of the fiduciary risk associated with including employer securities as an investment option. As a result, to the extent that fiduciaries relied upon this presumption, or upon the terms of plan documents that mandate investment in employer securities, many investment policy statements did not address employer securities. However, the Supreme Court has now held, in Fifth Third v. Dudenhoeffer, that there is no presumption of prudence applicable to fiduciaries with respect to investment in employer securities. ¹¹Fifth Third v. Dudenhoeffer, 134 S. Ct. 2459, 58 EBC 1405 (2014)(123 PBD, 6/26/14; 41 BPR 1360, 7/1/14).

In light of the Fifth Third decision, provisions within plan documents that mandate investment in employer securities will no longer serve to eliminate the duty of fiduciary prudence with respect to continued investment in those securities. Instead, if challenged in court, fiduciaries will need to be able to demonstrate that offering, or continuing to offer (or no longer offering), employer securities as a plan investment was prudent. A properly constructed investment policy statement will help to accomplish this.

Addressing Employer Securities in an IPS

In the Fifth Third decision, the Supreme Court provided somewhat of a roadmap to fiduciaries when it took the position that only complaints that state a plausible claim for relief will survive a motion to dismiss. ¹²Id. The Court found that, absent special circumstances, if a stock is publicly traded, allegations that a fiduciary should have recognized, from public information alone, that the marketplace was either over- or under-valuing employer stock are “implausible as a general rule.” It also found that a claim for the breach of the duty of prudence on the basis of inside information will not withstand a motion to dismiss unless the plaintiffs can plausibly allege another course of action that the fiduciary could have taken.

In this regard, for plans that offer employer securities, investment policy statements should be revised to reflect the position that the Court has taken in Fifth Third. This would include providing procedures around (1) the manner in which the employer securities are valued, (2) the manner in which the performance of the employer securities is evaluated, and (3) the steps fiduciaries will take if they are in a position of conflict as it relates to employer securities.

Any acquisition of employer securities must be for adequate consideration ¹³ERISA. §408(e)(1)., which is defined as the fair market value of the securities. ¹⁴Hood v. Smith’s Transfer Corp., 762 F. Supp. 1274, 13 EBC 2113 (W.D. Ky. 1991). ERISA fiduciaries may, as a general matter, prudently rely on the market price ¹⁵In Re: UBS ERISA Litigation, No. 1:08-cv-06696-RJS, FN11, 58 EBC 2958 (S.D.N.Y. September 29, 2014)(190 PBD, 10/1/14; 41 BPR 2085, 10/7/14). of employer securities, and the investment policy statement should reflect this. For publicly traded securities, this will, under normal circumstances, be the value of the securities on the exchange on which they are traded. In situations where the employer securities are not publicly traded, fiduciaries will need to determine how best to evaluate the value of employer stock.

Unlike mutual funds, there is no ready benchmark against which to assess the performance of employer securities. And, there is neither definitive guidance nor binding case law to guide fiduciaries in this regard. Consequently, fiduciaries will need to give some thought to how best to accomplish this for their particular set of circumstances, and use the IPS to reflect this thinking, at least in general terms. For example, overall market conditions could be of general relevance, as might any employer-specific economic considerations deemed applicable to evaluating the overall long term performance of the employer securities. Fiduciaries may also be able to enlist the assistance of an investment adviser or consultant in providing guidance in this regard.

In addition to a quantitative analysis, fiduciaries may also take into account the intangible benefits associated with ongoing employee stock ownership, such as capital growth and stock ownership of the employees in the company. ¹⁶Fifth Third at p. 2469 (“Congress intended ESOPs to help ‘secur[e] capital funds for necessary capital growth and … brin[g] about stock ownership by all corporate employees’”). The potential value of intangible benefits should, however, be evaluated in the context of the objective criteria. Where the two pull in opposite directions (such as a “stock drop” scenario), it is not clear how much weight can be placed on qualitative factors. In these situations, fiduciaries should take particular care to thoroughly document their evaluation process(es) when making decisions with respect to retaining employer securities, as either a frozen or active investment option, in the plan.

Where fiduciaries are conflicted, the prudent man standard requires that they make an impartial evaluation of the merits of continuing to offer employer securities as an investment, and courts will look to see if, at the time of any challenged transactions, fiduciaries employed appropriate methods to do this, such as appointing an independent, non-conflicted fiduciary. ¹⁷DiFelice v. U.S. Airways Inc., 497 F.3d 410, 41 EBC 1321 (4th Cir. 2007)(148 PBD, 8/2/07; 34 BPR 1845, 8/7/07). Accordingly, the investment policy statement should reflect the steps that fiduciaries may or shall take should this type of situation arise, which would likely include obtaining impartial guidance from a disinterested outside adviser to the plan. ¹⁸Moench v. Robertson, 62 F.3d 553, 19 EBC 1713 (3d Cir. 1995).

Putting It All Together

A written investment policy statement that identifies the processes fiduciaries will follow in prudently selecting and monitoring plan investments is an important first step in demonstrating procedural prudence with respect to plan investments. However, an investment policy statement is of little value if it is not followed, or if it is so detailed that it cannot be readily adhered to. It should be periodically reviewed and updated as needed.

For plans that offer employer securities as an investment, it should be revised to include provisions that will address how the value and performance of the employer securities will be determined and the measures that will apply in the case of conflicted fiduciaries. Ultimately, process, and the documentation of adherence to that process, will provide the best protection to fiduciaries if the outcome of fiduciary investment decisions is ever challenged.