ERISA & Fiduciaries: Who is the Prudent Man?

In our latest whitepaper, we dissect and discuss some of the more critical sections of the ERISA regulations on fiduciary duty for the benefit of plan sponsors. The paper highlights the ERISA code broadly, so I’m going to pull out specific language from the regulations in a series of blog posts to help plan sponsors interpret the important parts of the law.

Let’s start with the prudent man standard, because it is central to ERISA regulations and often the subject of lawsuits that plan sponsors face for breach of their fiduciary duty.

What does “prudent” mean?

The “prudent man standard of care” is hotly debated and often misunderstood. What does it mean for a plan fiduciary to be prudent, or to perform duties in a prudent manner? Does an under performing investment in a plan lineup demonstrate a lack of prudence on the part of the investment committee?

ERISA Section 404(a)(1)(A) is the specific section of the code that spells out the scope of the prudent man standard of care. The code states:

…a fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and—

 (A) for the exclusive purpose of:

 (i) providing benefits to participants and their beneficiaries; and

 (ii) defraying reasonable expenses of administering the plan;

These responsibilities are broad, but fairly straightforward. Fiduciaries must act in the best interests of plan participants, in particular in managing the fees plan participants pay to investment managers and service providers.

Section B of the rule goes deeper into what it means to be prudent. The language becomes nebulous here and possibly open to interpretation. But notice the code focuses on action, not results:

[Fiduciaries must act] 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 in the conduct of an enterprise of a like character and with like aims;

Many court rulings have focused on the prudence of the process that plan fiduciaries follow to arrive at their decisions. One opinion—drafted by the late Supreme Court justice Antonin Scalia during his time on a lower circuit court bench—explicitly stated the duties plan fiduciaries are bound to follow in accordance with the ERISA statutes: “to investigate and evaluate investments, and to invest prudently.”

Prudence also factored in the Supreme Court’s unanimous decision from the notable Tibble v. Edison case in 2015. As Justice Stephen Breyer wrote in the Court’s opinion: “[A plan sponsor] has a continuing duty to monitor trust investments and remove imprudent ones. This continuing duty exists separate and apart from the trustee’s duty to exercise prudence in selecting investments at the outset.”

Prudence is measured by the reasonableness of the process that plan fiduciaries use to scrutinize and select investments, and also by how thoroughly the facts are evaluated during the investment selection process.

Prudent care among brokers and advisors

The “prudent man” standard of care is also applied differently by investment advisors and brokers for retirement plans. This article by David Kaleda of the Groom Law Group in Washington D.C. explains how the federal laws that govern broker/dealers and investment advisors distinguish how different standards of care are applied. From page 2 of the article:

The Exchange Act does not create a fiduciary relationship between the [broker/dealer] or an underlying duty of loyalty. Rather, a [broker/dealer] is bound by a standard that requires it to act honorably and fairly in dealings with his or her clients.

The Advisers Act, on the other hand, imposes a fiduciary duty on [registered investment advisers (RIAs)] in dealing with clients and prospective clients… [The] US Supreme Court and the SEC have interpreted Section 206 [of the Advisers Act] to establish a fiduciary relationship between the RIA and its clients and prospective clients. The following duties are derived from that fiduciary relationship:

• Duty of Prudence
• Duty of Loyalty
• Duty to Diversify
• Duty to Follow Plan Documents

Are you practicing prudence?

For a plan sponsor, it’s clear to see why it’s necessary to establish a process of prudence—doing so ensures that fiduciary duties are met. When I’m working with a plan sponsor client, there are specific questions I ask to help them determine if they follow a prudent process with their retirement plan. These questions include:

• When were your plan’s by-laws last updated?
• What process do you follow when adding or removing funds from your plan’s lineup?
• Where do you keep plan records in case you are audited?

These certainly are not the only questions, but they jump-start the thinking around what prudence means and how the plan sponsor can ensure their processes are meeting the prudent standard of care.

The outcomes of a properly constructed process of prudence are informed and reasoned decisions concerning plan investments and service providers. But a prudent process can also give plan sponsors some degree of confidence in managing threats of possible litigation over alleged breaches of fiduciary duty.