1. Adviceware

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FIDUCIARY RESPONSIBILITY
EXECUTIVE SUMMARY
The objective of ERISA’s fiduciary provisions for investments is to provide secure
and meaningful retirement benefits for participants. The key to accomplishing
that objective is for each participant’s account to be well invested. That is, each
participant’s account should hold a portfolio of quality and moderately priced
investment funds that is appropriate for that participant’s risk tolerance and return
needs. As explained in this White Paper, plan fiduciaries are ultimately
responsible for the prudence of the participant investment decisions. To manage
that risk, fiduciaries should acknowledge the need of many participants for help
with their investments and should design the plan’s investment menu and
services in a manner that supports prudent investment decisions by participants.
One alternative for such a design is to offer only well-balanced portfolios
(sometimes called asset allocation models or lifestyle funds) for participant
choice. Combined with help for selecting the appropriate portfolio, this
arrangement has a high probability of resulting in participants being prudently
invested and, therefore, in fiduciaries satisfying their duties under ERISA.
INTRODUCTION AND LEGAL PRINCIPLES
The purpose of this “White Paper” is:
• to provide an overview of the legal requirements for investments in
participant-directed plans, such as 401(k) plans;
• to highlight areas of exposure to officers of plan sponsors who serve as
fiduciaries; and
• to evaluate the use of professionally designed investment vehicles (“asset
allocation models”) as a method of managing that exposure.
Investment Fiduciaries and Their Duties
The Employee Retirement Income Security Act (ERISA) is the federal law that
governs investments in almost all U.S. private sector retirement plans. (The most
notable exceptions are one-person owner-only plans and church plans.)
ERISA accomplishes its regulatory objective by classifying investment decision-
makers as “fiduciaries,” by imposing specific duties on those fiduciaries, and by
establishing a high standard for measuring their conduct.

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The definition of fiduciary is found in ERISA section 3(21)(A). Fiduciary activities
include, for example, the management of plan assets, the operation of the plan,
and the appointment of other fiduciaries.
A person may become a fiduciary by:
• being named as such in the plan document;
• being appointed as such by another fiduciary,; or
• making fiduciary decisions, even if not named or appointed (a “functional”
or “de facto” fiduciary).
For most plan sponsors, the primary fiduciaries for plan investments are either
the committee members (who are appointed, usually by the Board of Directors)
or officers who make investment decisions on behalf of the plan sponsor. If the
Board is responsible for appointing the committee, the Board members are
considered ERISA fiduciaries for that purpose.
ERISA section 409(a) imposes personal liability on fiduciaries who breach their
duties. The significance of that provision was recently illustrated by the Enron
settlement where the outside members of the Board of Directors and the chair of
the plan committee contributed to the settlement from their personal assets.
ERISA section 404(a)(1) requires that fiduciaries conduct themselves according
to specified standards. Fiduciaries must act in the sole interest of participants
and:
• for the exclusive purpose of providing retirement benefits (and defraying
reasonable expenses);
• according to the prudent man rule (see below);
• to diversify investments; and
• in accordance with the plan documents (unless it would be imprudent to
do so).
The prudent man rule mandates that fiduciaries 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; . . .”
Surprisingly, the prudent man rule does not mention “investments” or “participant
direction.” As a result, the broad provisions of the prudent man rule must be
interpreted through government guidance and court decisions. In that regard, the
Department of Labor and the courts have concluded that:

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• Fiduciaries must prudently select, monitor, remove and replace the
investment options offered to participants. (See, e.g., the Preamble to the
Final 404(c) Regulation, 57 F.R. 46906, 46924, footnote 27.)
• ERISA’s investment provisions are based on the principles of modern
portfolio theory. (See Tittle v. Enron, 284 F.Supp. 2d 511 (S.D. Texas
2003).)
• In applying the prudent man rule to investment decisions, fiduciaries
should use generally accepted investment theories and prevailing industry
practices. (See, e.g., DOL Interpretive Bulletin 96-1 and its Preamble.)
• Fiduciaries must select investments which are suitable and appropriate for
the participants, taking into account the needs of the plan and the
participants. (See the Preamble to the Final 404(c) Regulation, 57 F.R.
46906.)
• Fiduciaries must seek expert advice where they lack the skill to
adequately perform their job. (See Liss v. Smith, 991 F. Supp. 278, 297
(S.D.N.Y. 1998).)
Participant Direction and Fiduciary Responsibility
While plan sponsors and fiduciaries generally accept their responsibility for
selecting and monitoring 401(k) investment options, most are unaware that
fiduciaries are also responsible for the prudence of investment decisions made
by participants. That is, if a participant invests imprudently, the fiduciaries may be
liable for any losses (which would include insufficient gains).
This unexpected result is due to the structure of ERISA’s fiduciary provisions.
Sections 403(a) and 404(a) put investment responsibility squarely on the backs
of the fiduciaries. As a result, even if participants direct their investments, the
fiduciaries remain responsible for both the prudency of the investment options
and for their appropriate selection by the participants. However, if the plan
sponsor and the fiduciaries want to transfer part of that legal responsibility to the
participants, they can do so--by complying with ERISA section 404(c) and the 20
to 25 requirements in the 404(c) regulation. As the judge said in the September
30, 2003 Enron decision:
“If the plan does not qualify as a § 404(c) [plan], the fiduciaries
retain liability for all investment decisions made, including decisions
by the plan participants.”
(Tittle v. Enron, 284 F.Supp. 2d 511, 578 (S.D. Texas 2003).)
While the apparent answer may be to comply with the 20 to 25 detailed
requirements of the regulation, that is easier said than done. In fact, few plans
comply with all of the 404(c) conditions. My law firm audits plans for 404(c)

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compliance, and we seldom find that a plan has satisfied all the rules. In the
Enron case (where you would assume that the committee was advised by
competent ERISA counsel), the defendants (i.e., the fiduciaries) asserted that
they were protected by 404(c). In its brief, the DOL pointed out that it had
reviewed the plan records and did not find evidence of satisfaction for a number
of the requirements.
Beyond the issue of 404(c) protection, there are other fiduciary threats caused by
imprudent participant investments. For example, fiduciaries are protected in
404(c)-compliant plans only if the investments offered to participants are prudent,
suitable and appropriate. In last year’s Enron decision, the court explained:
“Even if the Savings Plan were to qualify as a § 404(c) plan,
relating to the Savings Plan and the ESOP in the Department of
Labor’s Final Regulation Regarding Participant Directed Individual
Account plans, Preamble, 57 Fed. Reg. 46,906,924 n. 27(1992),
the agency emphasized, [T]he act of designation investment
alternatives ... is a fiduciary function ... [and] [a]ll of the fiduciary
provisions of ERISA remain applicable to both the initial
designation of investment alternatives and investment managers
and the ongoing determination that such alternatives and managers
remain suitable and prudent investment alternatives for the plan
[emphasis added].”
As a result, even those few plans that satisfy 404(c) are left with the issue of
whether they remain liable for participant investments because of the issue of
whether the investment choices are “suitable and prudent” for their plan and their
group of participants. Unfortunately, these terms are not well defined. There is a
growing body of evidence that the average participant may have difficulty
understanding and investing in a 401(k) menu of more than a few individual
funds (perhaps three to six). (See, e.g., Agnew, Julie and Szykman, Lisa R.
(2004), Asset Allocation and Information Overload: The Influence of Information
Display, Asset Choice and Investor Experience, Center for Retirement Research
at Boston College; and Iyengar, S., Jiang, W. and Huberman, G. (2003), How
Much Choice is Too Much?: Contributions to 401(k) Retirement Plans; Working
Paper 2003-10, the Wharton School, Pension Research Council.) Is it prudent,
then, to offer more than that number of funds? That question has not been
answered.
There are surveys and studies that show that many participants lack basic
investment knowledge, for example, don’t understand the difference between
growth and value styles; don’t realize that, when in interest rates go up, bonds go
down. (See, e.g., the annual surveys performed by The John Hancock.) While it
seems inconceivable that it would be inappropriate to offer growth and value
equity funds, or to offer bond funds, a prudent fiduciary should arguably offer
services to assist participants in properly using those funds. Going beyond the

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basic funds, though, there remains the question of whether it is prudent to offer
emerging market funds, high yield bond funds, or other non-basic funds, to
participants who lack the investment abilities to properly use those options in
building portfolios in their accounts? That is also an unanswered question.
The purpose of raising these issues is to point out that there are unanswered
questions about what are prudent, suitable and appropriate investments for
many, and perhaps most, participants. In light of this uncertainty, the best
course--and perhaps the only course that is safe--is for fiduciaries to assume a
higher level of responsibility for the prudence of participant investments.
MANAGING THE RESPONSIBILITY
Overview: A plan’s investment fiduciaries may decide to manage their risk for
participant investments in order to minimize their legal exposure, or because they
accept a general responsibility to help employees who lack investment skills, or
both. In that case, the goal is to place each participant in a well-constructed
investment portfolio based on information reasonably available to the fiduciaries
(such as the participant’s age).
Unfortunately, as discussed earlier in this paper, many participants lack the basic
investment knowledge and skills necessary to successfully use typical 401(k)
investment lineups. That is, they do not know how to properly combine different
types of mutual funds to produce a portfolio that is appropriate for their needs. As
a result, the odds of a well-invested account are slim. To further complicate
matters, many participants are not investing in a manner that would support a
well-balanced portfolio. The 2003 Hewitt study, “How Well Are Employees Saving
and Investing in 401(k) Plans,” notes that 14% of the participants were invested
in one asset class (e.g., type of investment) and another 20% were invested in
only two. The study notes that lifestyle funds (i.e., professionally designed asset
allocation vehicles) are assumed to invest in five--and many invest in more than
that. Thus, investment professionals seek to manage and balance risk and return
by combining five or more asset classes, while many participants either take
unnecessary risk or accept low returns by using only one or two asset classes.
(See, also, Building Futures IV, Fidelity Institutional Retirement Services
Company, 2003.)
Those participants have little, if any, chance of developing prudent portfolios in
their accounts. This places investment fiduciaries in the awkward position of
being at risk for the participants’ investment inadequacies. To manage this risk,
the fiduciaries should design their plan’s investment structure to minimize the
possibility of improperly invested accounts.
While ERISA does not offer detailed guidance about the definition of a prudent
portfolio, it does provide general guidance. For example, both the DOL and the

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courts have noted that ERISA’s investment provisions are based on Modern
Portfolio Theory. (See, e.g., DOL Interpretive Bulletin 96-1, and Laborers Nat.
Pension Fund v. Northern Trust Quantitative Advisors, Inc., 173 F.3d 313 (5th
Cir. 1999).) And both have commented on the need to adhere to generally
accepted investment principles and prevailing investment industry practices.
Thus, in effect, ERISA points fiduciaries to the practices of competent
professional investors, consultants and advisors.
As a result, to satisfy 404(a)’s fiduciary standards, fiduciaries should manage
their plan’s investment activities in a manner that results, to the greatest possible
extent, in their participants being invested in portfolios that adhere to those
standards. Since most participants lack the level of investment knowledge
needed to assemble a portfolio of funds that is appropriate for their needs and
risk tolerances, fiduciaries would be well-advised to offer professionally designed
vehicles, such as asset allocation models and lifestyle funds. When a participant
is invested in an appropriate portfolio, the fiduciary’s investment duties under
ERISA section 404(a) are satisfied, regardless of whether the plan meets the
404(c) conditions.
The lack of participant investment abilities has been known for some time, but
was “concealed” for most of the early years of 401(k) plans because of the bull
market for both stocks and bonds for most of the 1990s. Even then, though, plan
providers and consultants delivered investment education programs to most
401(k) participants. In the latter half of the 1990s, internet investment advice
services began to appear. Unfortunately, studies now show that investment
education has had little effect on most participants. And, the actual utilization of
internet investment advice has not been significant. Interestingly, the primary
users of investment advice have been the more knowledgeable participants who,
at least in theory, needed to the least amount of help.
Use of Asset Allocation Models
Overview: To increase the likelihood of participants being invested in prudent
portfolio, some have suggested offering only asset allocation models to
participants. In that way, the participants could only choose among professionally
designed investment vehicles. Their choice would be limited to selecting the
option which best reflected their personal circumstances. Such an offering raises
two ERISA issues: Is it prudent under ERISA section 404(a)? Does it satisfy the
conditions of ERISA section 404(c), should the fiduciaries seek that additional
protection?
ERISA’s fiduciary responsibility rules do not mandate the number or types of
investment options that must be offered in participant-directed plans. However,

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many industry commentators look to the DOL’s 404(c) regulation, and its “broad
range” proviso, for guidance. In relevant part, that regulation states:
“(3) Broad range of investment alternatives.
(i) A plan offers a broad range of investment alternatives
only if the available investment alternatives are sufficient to
provide the participant or beneficiary with a reasonable
opportunity to:
(A) Materially affect the potential return on amounts in
his individual account with respect to which he is
permitted to exercise control and the degree of risk to
which such amounts are subject;
(B) Choose from at least three investment
alternatives:
(1) each of which is diversified;
(2) each of which has materially different risk
and return characteristics;
(3) which in the aggregate enable the
participant or beneficiary by choosing among
them to achieve a portfolio with aggregate risk
and return characteristics at any point within
the range normally appropriate for the
participant or beneficiary; and
(4) each of which when combined with
investments in the other alternatives tends to
minimize through diversification the overall risk
of a participant’s or beneficiary’s portfolio;
(C) Diversify the investment of that portion of his
individual account with respect to which he is
permitted to exercise control so as to minimize the
risk of large losses, taking into account the nature of
the plan and the size of participants’ or beneficiaries’
accounts.”
The objectives of that provision are:
• The opportunity for a participant to affect the likely investment result;
• The opportunity for a participant to balance risk and return; and
• The use of diversification to minimize the risk of large losses.
As a general statement, asset allocation models are portfolios that are designed
by investment professionals to accomplish those purposes. As a result, they
appear to accomplish the objectives of the 404(c) regulation. Similarly, well-
designed asset allocation models would satisfy the literal terms of the regulation.

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For most of the provisions, that conclusion is clear, e.g., diversification and
materially different risk-and return characteristics. In fact, the only two provisions
that warrant discussion are (B)(3) and (4). That is because they suggest that
participants would combine plan options to achieve the goal of balancing risk
tolerance and investment returns, while asset allocation models are each
designed to be used as the sole vehicle for a participant’s account. Having said
that, though, the regulation does not preclude a participant from investing in only
one option and, of course, the regulation does not preclude an investment option,
standing alone, from satisfying a participant’s needs. Because the use of asset
allocation models are designed to satisfy 404(c)’s broad range provisions, the
protections of that section should be available to the investment fiduciaries, if the
plan satisfies the remaining requirements of the regulation.
Turning to the responsibilities under 404(a), the fiduciaries will also have satisfied
the duty to offer participants a reasonable set of investment alternatives to be
used by the participants to accomplish their investment goals--in terms of the
number and types of funds. While it is the province of investment experts, rather
than ERISA attorneys, to determine the right number of asset allocation models
(and the appropriate combination of investments within each model), the
objective of both the investment experts and ERISA is to allow participants to
select a portfolio which would reasonably allow each participant to place himself
at the appropriate point on the risk-and-reward spectrum. When combined with
appropriate services (e.g., a well-designed questionnaire and guidance
materials), the use of an investment menu consisting solely of asset allocation
models will provide participants with an investment structure that they use to
invest prudently. Finally, the fiduciaries must engage in a prudent process to
select and monitor the provider of the asset allocation models and to select and
monitor the mutual funds underlying the models.
Selection and Monitoring
Overview: Fiduciaries have a duty to prudently select and monitor the plan’s
investments and providers. That does not require that the fiduciaries become
investment experts, but instead that they engage in a prudent process, that they
obtain at least a basic understanding of the services provided and that they
periodically evaluate their quality, cost and effectiveness. This portion of the
White Paper discusses key issues for fiduciaries to consider when engaging in
that process.
In evaluating the selection of asset allocation models, fiduciaries should take the
following steps:
• Obtain and review information about the provider of the asset allocation
models, including:

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the credentials of the key personnel at the organization. They (or
their consultants or providers) should have the education and
experience to competently design the models.
the methodology used to design the models. It should be based
primarily on modern portfolio theory, and should use generally
accepted investment theories.
the resources used by the organization to design the models. This
would include databases, software, consultants and providers.
These resources should be from sources highly regarded in the
investment industry.
obtain references and contact those references to learn about
participant satisfaction, delivery of the service, investment
performance (e.g., have the conservative options performed more
conservatively that the growth or moderate options) and risk
management.
For additional information on the selection of investment
professionals, see, the court decision of Whitfield v. Cohen, 682
F.Supp. 188 (S.D.N.Y. 1988).
In addition to determining that the providers has the competency to design the
asset allocation models, the fiduciaries should evaluate the method used for
delivery of the models to the participants. For example, are conservative
participants being properly placed in options consistent with their objectives? The
key is whether the process (often a questionnaire) for directing participants to the
appropriate option was designed according to modern concepts of behavioral
finance. The fiduciaries should satisfy themselves that it was and that the
credentials of the investment professional who did that work are appropriate. The
second step is for the fiduciaries to understand how the participant response is
implemented.
Next the fiduciaries need to obtain a sense of the effectiveness in terms of the
utilization by participants. Initially, this can be done by contacting references
given by the provider and asking about their experiences. Once the arrangement
is in place, the regular (perhaps annual) monitoring of the program should
include an evaluation of the performance, of the models and of their appropriate
usage by the participants.
In addition to evaluating the models, fiduciaries need to prudently select and
monitor the underlying funds--or to work with an investment advisor or manager
(“advisor”) who will perform that task. If the advisor agrees to serve as an ERISA
fiduciary for that purpose, it reduces the exposure of the primary plan fiduciaries.
Even then, though, the primary fiduciaries must prudently select and monitor the
advisor, using a process similar to the one described earlier in this paper.
Fiduciaries should make sure that the advisor has a well-defined process for the
selection, monitoring and removal of the investment funds. In addition, the

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fiduciaries should review that process to evaluate whether it uses generally
accepted investment principles and is consistent with prevailing industry
practices. Most quality providers will give the fiduciaries descriptions of their
process and its underpinnings in conventional investment practices.
CONCLUSION
As explained in this paper, ERISA fiduciaries are responsible for both the
selection of a 401(k) plan’s investment options and for the use of those options
by the participants. Many fiduciaries believe they are protected from participant
decisions by ERISA section 404(c). However, as discussed in this paper, that
protection is illusory because:
• few plans comply with the 20 to 25 requirements in the 404(c) regulation;
and
• even for those that do, there is no protection if the investments are not
prudent and suitable for the participants in a given plan (and many--
perhaps half or more--of the participants in the typical plan lack basic
investment knowledge).
Fiduciaries should consider actively managing their risk, rather than relying on a
legal “shield” that may not be available. The key to managing the risk is to have
as many participants as possible invest in professionally designed portfolios that
are appropriate for the participant.
One method of accomplishing that goal is for a 401(k) plan to offer only asset
allocation models. As explained in this paper, such models may be offered in a
way that satisfies the requirements of ERISA section 404(a) (e.g., the prudent
man rules) and that meets the broad range requirement of 404(c).