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How is Prudence Defined Under ERISA?
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How is Prudence Defined Under ERISA?
What is Prudence Definition in ERISA Standard?
Prudence serves as the keystone for the ERISA standard of fiduciary conduct. The rule requires a fiduciary to 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. The language is drawn in part from the common law of trusts, which judges prudence exclusively in terms of the twin objectives of preserving the estate and attaining adequate return.
Under the Department of Labor regulations, a fiduciary may satisfy the ERISA prudence requirements by giving “appropriate consideration” to the facts and circumstances that, given the scope of the fiduciary’s investment duties, the fiduciary knows or should know are relevant to the particular investment or investment course of action involved, including the role it plays in the plan’s investment portfolio, and acting accordingly.
“Appropriate consideration” includes determination by the fiduciary that the particular investment is reasonably designed, as part of the portfolio, to further the purposes of the plan, taking into consideration the risk of loss and the opportunity for gain and such factors as:
(a) the composition of the portfolio with regard to diversification;
(b) the liquidity of the portfolio; and
(c) the projected return of the portfolio.
Prudence is measured, therefore, in terms of the anticipated total performance of the portfolio, and not in terms of the actual performance of any particular investment. The ultimate outcome of an investment is not proof of imprudence. The fiduciary duty of care requires prudence, not prescience. The risk level of an investment does not alone make the investment either per se prudent or per se imprudent.
Prudent Investor Rule
The investment losses and trustee experiences of the 1970s was the beginning of the end for the traditional prudent person rule in American trust investment law. This time period showed that long-term bonds were not a financial asset that could be held in portfolios without regard to risk; so-called “one-decision” stocks were not immune from severe price corrections; and inflation and losses in purchasing power were important considerations in long-term investing.
Even professional money managers and bank trust departments reported alarming losses. Many portfolio managers had been seduced by the idea that certain stocks were immune to severe declines in prices, and could be held in their portfolios on a long-term basis because of their growth fundamentals and value. Following this investment strategy, professional and individual investors rode the disastrous 1973-1974 bear market down with virtually fully invested positions.
THE BASIC LAW OF THE PRUDENT INVESTMENT RULE
The Uniform Prudent Investor Act requires trustees to comply with the highest standard of care in making and monitoring investments for their trusts. The Prefatory Note to the UPIA states that “the trade off in all investing between risk and return is identified as the fiduciary’s central consideration.” The “heart of the Act,” UPIA, Section 2, Probate Code § 16047, directs trustees to consider specific circumstances that “commonly bear on risk/return preferences in fiduciary investing.” Official Text of UPIA, Comment, Section 2. And the Restatement Third makes it clear that portfolio return expectations are related to risk; the expected return from an investment or investment strategy must be adequate for the risk of loss; and trustees must determine an appropriate level of portfolio risk for the purposes and circumstances of their trusts.
Compliance with the prudent investor rule is determined in light of the facts and circumstances existing at the time of the trustee’s decision or action and not by hindsight. UPIA, Section 8, Probate Code 16051. Several practical considerations immediately stand out for trustees with respect to this compliance standard.
First, trustees must consider all facts and circumstances in their decisions or actions that a prudent investor would consider. This is an objective and not a subjective standard, which tells trustees that there are compliance risks if they ignore relevant information. Thus, in an information economy dominated by the media, the Internet, and Federal Reserve Board transparency, attorneys for beneficiaries can always argue that information or circumstances the trustee overlooked or ignored were relevant to the investment management of trust assets, and could have prevented or limited investment losses if included in the trustee’s decision or action.
Second, trustees must avoid making errors in analyzing the facts and circumstances under their duty of skill. Their analytic approach must be reasonably supported in concept, and they should view information on risk and return from different perspectives and sources to account for all outcomes. In prudent investing, trustees are required to make sound judgments for all of their duties to comply with the prudent investor rule.
Third, trustees should recognize that a permanent record of facts and circumstances, including historical facts and real-time information on the price of assets, always exists on the trustee’s ongoing compliance timeline for judging their conduct and performance. Trustees, therefore, cannot claim judgment by hindsight when the record indicates that relevant information they had a duty to consider with care and skill existed before the event or loss.
Finally, new information and changed circumstances that affect the suitability of investments, the trade off between risk and return in investments, and the trust’s risk management strategies, will force trustee to reexamine their assumptions and make new decisions or take actions to buy, retain, or sell trust assets. In an evolving global economy dominated by risk, information, and asset price speculation, the modern trustee must be an active portfolio manager or closely monitor the activities of agents or advisers to manage breach of trust and liability risks.
Prudent Effect on Smaller Trusts
Trustees of smaller trusts should be concerned with the disproportionate burden placed upon them to comply with the prudent investor rule over the longer term. Under the Restatement Third and the UPIA, the prudent person rule was updated to accommodate the growth and capital appreciation objectives of professional and corporate trustees of large diversified portfolios. “Thus, the objectives of the ‘prudent investor rule’ of this Restatement Third range from that of liberating expert trustees to pursue challenging, rewarding, non-traditional strategies when appropriate to the particular trust, to that of providing other trustees with reasonably clear guidance to safe harbors that are practical, adaptable, readily identifiable and unexpectedly rewarding.”
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 the 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:
- Defined Benefit Pension Plan investment policies, strategies, and monitoring effectively show the timing and distribution of cash flows and the payment of liabilities.
- 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.
Duty of Prudence:
Section 2(a) of the Uniform Prudent Investor Act directs, “A trustee shall administer the trust as a prudent person would…” But how is one to know how a prudent trustee would act? There are three sources that inform what “prudence” means. These are (1) the instruction in the trust document itself; (2) the statutory language of the Prudent Investor Act; and (3) the court’s historical interpretation of what the statute means. A prudent trustee will consider these sources and develop a series of policies and procedures that, if followed, ensure compliance with this “prudent person” standard of care. A “Fiduciary Governance Statement” would reasonably be the first document in the trustee’s compliance library.
Curating the Compliance Library:
Once these policies and procedures have been memorialized, administering the trust consistent with the “prudent person” standard is a matter of having a compliance calendar and following the procedures that a prudent trustee would employ. As each governance procedure is completed a record is created and stored within the compliance library. In this way, the trustee creates an evidentiary record that demonstrates they have acted prudently and in good faith. If the day comes when an attorney representing a disgruntled beneficiary argues that the trustee acted imprudently and in bad faith, the trustee will have a robust document set to rebut this claim.
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