prepared by drinker biddle & reath llp the erisa ......the erisa fiduciary investment process...

THE ERISA FIDUCIARYINVESTMENT PROCESS:

INVESTMENT PRODUCTS: NOT FDIC INSURED • NO BANK GUARANTEE • MAY LOSE VALUE

Prepared by Drinker Biddle & Reath LLP

Hon. Bradford P. Campbell, Esq., Drinker Biddle & Reath LLP

Historical Returns and Back-Testing as Relevant Factors to Evaluate Prudence

What’s inside

For institutional investor, broker-dealer or financial professional use only. Not for use with the public. IMPORTANT NOTE: This white papers has been prepared on behalf of Franklin Templeton, Inc. by Mr. Campbell. This paper includes suggested practices that plan sponsors, and the financial

professionals who work with plan sponsors, may wish to consider in connection with the evaluation of plan investments. It is important to note that the suggested practices are not the exclusive means of evaluating plan investments. Other combinations of practices also may be effective. Plan sponsors and other

fiduciaries should consult with their own legal counsel concerning their responsibilities under ERISA in the administration and management of their respective plans. Future legislative or regulatory developments may significantly impact these suggested practices and the related matters discussed in this paper. Please be sure to consult with your own legal

counsel concerning the application of ERISA to the selection of plan investments and your other fiduciary obligations under ERISA. This white paper is intended for general informational purposes only, and it does not constitute legal, tax or investment advice on the part of Drinker Biddle & Reath LLP or Franklin Templeton,

Inc. and its affiliates. Plan sponsors and other fiduciaries should consult with their own legal counsel to understand the nature and scope of their responsibilities under ERISA and other applicable law.

The content of this whitepaper was updated in September 2019 and is subject to change.

Introduction 2

ERISA Doesn’t Discriminate Against Products and Services

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Fiduciary Consideration of All Relevant Factors May Include Historical Performance and/or Back-Testing

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Additional Relevant Factors for Target Date Investments

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Conclusion 7

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INTRODUCTIONThe investment world never stands still—there are new and innovative products and services available to investors every year. This reality is no different for retirement plans subject to the Employee Retirement Income Security Act (“ERISA”). ERISA plan fiduciaries, who are charged with making prudent investment decisions for their plans, have an ongoing obligation to monitor the investments they select for their plans, and to make changes in those investments as appropriate. Put simply, ERISA’s fiduciary standard is not a “set it and forget it” obligation—it is a dynamic standard that requires plan fiduciaries to adapt to changing circumstances to best serve their participants’ needs.

ERISA’s fiduciary standard is not a “set it and forget it” obligation—it is a dynamic standard that requires plan fiduciares to adapt to changing circumstances to best serve their participants’ needs.

Recent years have seen quite a few changes as fiduciaries adopted new types of investment products and new investment strategies to meet participant needs while reducing costs and risks.

For example, the use of collective investment funds, or “CIFs” (also known as collective investment trusts), in 401(k) plans has been steadily increasing as plan fiduciaries seek to reduce costs associated with different types of investment options. According to a report by the Investment Company Institute, the percentage of large plan 401(k) assets in these collective investments increased from just 6% in 2000 to 13% in 2013 and to 22% in 2017.1

Further, one of the longest-running bull markets in American history has caused many plan fiduciaries to consider whether their current plan investment portfolio is prudently positioned for potential market downturns. As a result of these desires to better control costs and risks, actively managed collective investment funds that seek to limit downside risk (many of which are established as target date or target risk investments) have garnered greater interest among plan fiduciaries.

1 “2019 Investment Company Fact Book,” Investment Company Institute, April 30, 2019, pg. 75 (Fig. 3.16 showing percentage of assets in 401(k) plans with 100 participants or more, excluding Direct Filing Entity assets that are reinvested in collective investment trusts).

For institutional investor, broker-dealer or financial professional use only. Not for use with the public.

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ERISA DOESN’T DISCRIMINATE AGAINST NEW PRODUCTS AND SERVICESWhile ERISA’s fiduciary duties have been described by courts as “the highest known to law,”2 that does not mean ERISA is a backward-looking statute that stifles innovation. In fact, ERISA requires plan fiduciaries to periodically review plan investments to ensure they remain prudent in light of changing plan and market conditions.3 This includes taking into account new investment options that become available that might better serve the interests of plan participants.

Target date investment options are a good example of these product developments. Plan fiduciaries have become more sophisticated consumers of target date investments over the past 15 years, and participants have benefited from cost-effective access to investments offering professional management of investment allocations. Continued innovation in target date offerings has resulted in a wide array of target date products and investment services, including combining diversified active and passive investments in CIFs incorporating strategies that provide tactical investment allocations, retirement income generation, and downside volatility management. These new products are intended to address a variety of risks and needs of plan participants, such as inflation risk, longevity risk and sequence of return risk, all of which can significantly erode the value of retirement savings for workers.

2 Donovan v. Bierwirth, 680 F.2d 263, 272 n.8, (2d Cir. 1982). 3 See, Tibble V. Edison Int’l, 135 S. Ct. 1823. (2015).

“... continued innovation in target date offerings…includes combining diversified active and passive investments in CIFs incorporating strategies that provide tactical investment allocations, retirement income generation, and downside volatility management.”These new innovations for ERISA plan investments may serve participants well, but some plan fiduciaries question whether they can prudently consider investments that do not have three or more years of investment returns. Does their fiduciary duty bar them from selecting investments lacking historical investment performance?

The answer is no, it does not. While historical returns may be a relevant factor to consider, investments lacking a performance history are not disqualified as permissible plan investments. Further, fiduciaries may consider additional relevant factors about such investments, including hypothetical “back-testing” (an illustration of how the investment option’s underlying investment strategy might have performed in prior market conditions).


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FIDUCIARY CONSIDERATION OF ALL RELEVANT FACTORS MAY INCLUDE HISTORICAL PERFORMANCE AND/OR BACK-TESTINGTo make a prudent investment decision, the plan fiduciary must employ a thorough process that takes into account all of the relevant factors—the prudence of the decision is judged on the process by which it is made, not whether investments ultimately experience gains or losses.

Specifically, ERISA’s prudent fiduciary process requires fiduciaries to act “solely in the interest of the participants and beneficiaries” of the plan “for the exclusive purpose” of providing benefits, and defraying reasonable expenses of administering the plan.4 Fiduciaries must act in accordance with the law and “the documents and instruments governing the plan.”5 Fiduciaries must carry out their responsibilities “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 with like character and like aims.”6

U.S. Department of Labor (“DOL”) fiduciary regulations further explain that the fiduciary must give “appropriate consideration to those facts and circumstances that ... the fiduciary knows or should know are relevant to the particular investment or investment course of action involved ... [and act] accordingly.”7

Thus, the ERISA fiduciary standard of care requires an evaluation of all relevant factors, but it does not elevate any one of those factors to be the sole determining factor regarding an investment’s prudence. For example, while fees are clearly a relevant factor, they are not the only factor, and must be considered in light of the totality of the facts and circumstances. As the U.S. Department of Labor explained in an educational guide for plan fiduciaries, “Fees are just one of several factors fiduciaries need to consider in deciding on service providers and plan investments.”⁸ The fiduciary duty to pay a “reasonable” fee does not mean a fiduciary must select the cheapest fee—it simply means that what is reasonable is based on the totality of the factors relevant to the decision.

The same is true of the past performance of investments. While some fiduciaries have been concerned that new investment products don’t have a three or more year track history of actual performance to take into account, its absence is not disqualifying. Further, back-testing that fully discloses the parameters and assumptions used in the analysis can provide similar information and fulfill a similar purpose as prior investment returns. Both factors aid fiduciaries in understanding and evaluating the underlying investment strategy.

4 ERISA § 404(a)(1)(A).5 ERISA § 404(a)(1)(D).6 ERISA § 404(a)(1)(B) (Note that the statute, adopted in 1974, does not employ gender neutral terminology).7 29 C.F.R. §2550.404a-1(b). 8 “Meeting Your Fiduciary Responsibilities,” U.S. Department of Labor’s Employee Benefits Security Administration, September 2017, pg. 5.


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There are a number of reasons why a prudent fiduciary process does not require historical performance data and may appropriately consider back-testing:

• Past Performance Does Not Predict the Future: What is the purpose of considering past performance? As every investor is warned when making investment decisions, past performance is not a guarantee of future returns. When an ERISA fiduciary reviews the past performance of an investment, she is doing so to understand how the investment managers and the underlying investment strategy addressed past market conditions. This provides insight into how the investment strategy works, and suggests how it might respond to similar conditions in the future. The same is true of back-testing—it serves to illustrate how the investment strategy works, and suggests how it might respond to future conditions resembling those of the past. Neither guarantees future performance, but both provide useful analytical information.

• Past Performance Doesn’t Address Recent Changes: Just because an investment has a track record doesn’t mean it offers an apples-to-apples comparison. To the extent an investment’s underlying strategy or its investment managers have changed, past performance may bear little or no relationship to its current goals, objectives and methods. If such changes have occurred, the existence of a 3-, 5-, or 10-year period of historical returns would be of little use in evaluating the prudence of the same investment today. Back-testing may provide a more meaningful analysis than consideration of unrelated past performance.

• There Is No Basis for a “Waiting Period” for Plan Investments: ERISA intentionally places very few restrictions on the types of investments that a plan may hold other than “collectibles” and special rules for precious metals.9 To view the fiduciary process and its consideration of relevant factors as barring investment by plans in new investment vehicles for an unspecified

“waiting period” of years to develop investment performance data is simply inconsistent with the statute and DOL regulations.

• However, it is important for ERISA fiduciaries to be mindful of their obligation to act in accordance with the documents and instruments governing the plan. ERISA fiduciaries should review their plan documents and any investment policy statement (“IPS”) to determine if there are any relevant restrictions regarding the type of plan investment being contemplated. For example, an investment policy statement may discuss the relevant factors a fiduciary may consider in making plan investments. If the IPS language specifically requires consideration of past performance, or if it prohibits consideration of back-testing, the plan fiduciaries are obligated to follow these requirements. Fiduciaries should periodically review and modify these documents as necessary.

9 See 26 USC 408(m).

“…some plan fiduciaries question whether…their fiduciary duty bars them from selecting investments lacking historical investment performance? The answer is no, it does not…[such] investments…are not disqualified as permissible plan investments…[and] fiduciaries may consider additional relevant factors including hypothetical “back-testing…”


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ADDITIONAL RELEVANTFACTORS FOR TARGETDATE INVESTMENTS

• Considering the demographics of the plan and “how well the [target date vehicle’s] characteristics align with eligible employees’ ages and likely retirement dates…[and] other characteristics of the participant population, such as participation in a traditional defined benefit pension plan offered by the employer, salary levels, turnover rates, contribution rates and withdrawal patterns”;11

• Understanding how the fees and expenses differ between types of target date vehicles under consideration;

• Considering whether a custom target date model incorporating the plan’s existing core funds is available; and

• Considering whether non-proprietary funds of the vendor of the investment vehicle are available.

Finally, plan fiduciaries considering CIFs and other investments structured as target date vehicles should be aware that the DOL issued informal guidance identifying additional relevant factors that fiduciaries should consider when selecting target date investments.10 While this informal guidance does not have the legal force of a regulation, it nonetheless is worth reviewing and understanding to ensure a prudent fiduciary process. These additional relevant factors for target date vehicles include:

• Understanding the underlying investments in the target date vehicle;

• Understanding the fund’s “glide path” and whether the fund will reach its most conservative allocation before or after the target date;

10 “Target Date Retirement Funds, Tips for ERISA Plan Fiduciaries” U.S. Department of Labor’s Employee Benefits Security Administration, February 2013.11 Id. at 2.


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CONCLUSION

ERISA fiduciaries have a duty to periodically review their plan investments and to consider new investment options available to the plan. In doing so, fiduciaries should employ a thorough, prudent and well-documented process that takes into account all relevant factors. These factors can include past investment performance as well as hypothetical back-testing, provided the assumptions and methodologies are clearly disclosed and understood by the fiduciary. The absence of historical investment performance data alone does not eliminate an investment from being prudent for an ERISA plan. Ultimately, selecting an investment option for a particular plan is an individualized decision. The information provided here is intended to help fiduciaries better understand that process, but it is not intended to be, and should not be relied on, as legal, financial or investment advice. Fiduciaries should seek appropriate counsel for specific matters.


All investments involve risk, including loss of principal. For institutional investor, broker-dealer or financial professional use only. Not for use with the public. Investments in securities are subject to certain inherent risks, and the value of securities may fluctuate in response to activity of individual companies and to general economic and market

conditions. Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and

should not be construed as, investment advice, forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.

Franklin Templeton, Inc., its affiliates and its employees are not in the business of providing tax or legal advice to taxpayers. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon by any such taxpayer for the purpose of avoiding tax penalties or complying with any applicable tax laws or regulations. Tax-related statements, if any, may have been written in connection with the "promotion or marketing" of the transaction(s) or matter(s) addressed by these materials to the extent allowed by applicable law. Any such taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor.

Franklin Templeton, Inc. and Drinker Biddle & Reath LLP are not affiliated companies. ©2020 Legg Mason Investor Services, LLC, member FINRA, SIPC. Legg Mason Investor Services, LLC is a wholly-owned subsidiary of Franklin Resources, Inc. 972213 RETX549542 9/20

About the AuthorThe Hon. Bradford P. Campbell is a nationally recognized figure in employer-sponsored retirement plans. From 2006 to 2009, he served as the Assistant Secretary of Labor for Employee Benefits, the head of the Employee Benefits Security Administration (EBSA). As ERISA’s former “top cop” and primary federal regulator, Mr. Campbell provides his clients at Drinker Biddle with insight and knowledge across a broad range of ERISA plan-related issues.

During Mr. Campbell’s tenure, EBSA’s investigations garnered $2.6 billion in monetary results on behalf of plans and participants and led to more than 200 criminal indictments. The plans under his agency’s jurisdiction provided benefits to more than 150 million Americans and held as much as $6 trillion in assets.

While in public service, Mr. Campbell played a key role in significant ERISA retirement plan reforms, and his regulatory and policy decisions had a fundamental impact on the structure and operation of ERISA plans. Mr. Campbell implemented final regulations establishing Qualified Default Investment Alternatives (QDIAs) to

facilitate automatic enrollment in defined contribution plans; electronic disclosure of more transparent plan expense and fee information; and improving participant access to professional investment advice. Mr. Campbell also promulgated proposed regulations requiring plans to disclose concise fee and investment information to participants and requiring service providers to disclose direct and indirect fees to plan fiduciaries pursuant to ERISA §408(b)(2).

Mr. Campbell is a frequent keynote speaker at business, professional and trade association events, and he has testified extensively on employee benefits issues before Congress. Mr. Campbell held a number of other senior positions in the government, including Deputy Assistant Secretary of Labor for Employee Benefits, Senior Legislative Officer for the Department of Labor and Senior Legislative Assistant for then-Congressman, later SEC Chairman, Christopher Cox.

He received his JD, cum laude, from Georgetown, and his AB from Harvard. He resides in Alexandria, Virginia, with his wife, Kerry, and their three children.

Hon. Bradford P. Campbell, Esq.Drinker Biddle & Reath LLP

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