December 1, 2009

Removal Spot: The duty to remove investments

It is commonly accepted that fiduci­aries of participant- directed plans, such as 401(k) plans, have a duty to select, monitor, and remove investments prudently.

The threshold question is whether a fiduciary’s duty to remove investments applies to individual investments or whether the decisions are judged on the basis of the investments in the aggregate. The trial court in DeFelice v. US Airways, Inc., applied an aggregate test. Based on that court’s reasoning, there is no need to remove an investment option, regardless of its individual merits, so long as there is an adequate number of investments to satisfy modern portfolio theory and to balance the risk and return characteristics of the portfolio. Put another way, if prudence is judged solely on the basis of the investment options in the aggregate, there is no need for a fiduciary to consider the prudence of an individual investment.

The court was wrong. The duty of fiduciaries is to select, monitor, and remove individual investments prudently, in addition to considering the portfolio as a whole. It is not an “either-or” scenario; both requirements must be satisfied.

The DOL made it clear in the preamble of a regulation that its view is that the prudent selection of investments incorporates both a consideration of the individual investments and the portfolio.

The regulation, however, is not intended to suggest either that any relevant or material attributes of a contemplated investment may properly be ignored or disregarded, or that a particular plan investment should be deemed to be prudent solely by reason of the propriety of the aggregate risk/return characteristics of the plan’s portfolio. Rather, it is the Department’s view that an investment reasonably designed—as part of the portfolio—to further the purposes of the plan, and that is made upon appropriate consideration of the surrounding facts and circumstances, should not be deemed to be imprudent merely because the investment, standing alone, would have, for example, a relatively high degree of risk.

To appreciate the importance of the DOL guidance, consider the unique characteristics of participant-directed plans. While participants can decide which of the offered investments to use, they cannot decide which investments are offered—that job belongs to the fiduciaries. In fulfilling that responsibility, ERISA requires, in effect, that the fiduciaries make a legal “promise” to the participants that each of the investment options is selected and monitored prudently (and removed, if it is no longer a prudent choice) and that the lineup of options offered to the participants is prudent in the aggregate.

Why is this the case? Unless a participant’s account is professionally managed, the participant must put together a portfolio in his account that is allocated among different categories of investments to create an appropriate blend of risk and return. If the investment choices are not prudent in the aggregate (for example, if the investments do not constitute a broad range that allows participants to balance risk and reward by selecting among them), the participants could not construct portfolios according to their needs. On the other hand, if some or even all of the investments were individually imprudent, then even a well-constructed portfolio would likely underperform. Thus, each investment must be prudent and suitable on a stand-alone basis, and the lineup of investments must be prudent in the aggregate. In describing the obligations of fiduciaries, one court said that, “[o]nce an investment has been made, a fiduciary has an ongoing duty to monitor investments with reasonable diligence and remove plan assets from an investment that is improper.”

Returning to my earlier statement that “the court was wrong,” it was not as brazen as it may have seemed. The 4th Circuit Court of Appeals subsequently reversed the trial court saying:

“[A] fiduciary must initially determine, and continue to monitor, the prudence of each investment option available to plan participants.”

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