Fiduciary Issues Associated with Life Cycle Funds in Individual Account Plans

by Marcia S. Wagner, Esq.

March 2005

Footnotes in [ ] appear at the end of this article.

This Article describes certain fiduciary issues under ERISA Title I concerning the use of life cycle funds in individual account or defined contribution plans from a critical perspective. This analysis is useful because persons who have the greatest familiarity with these issues rarely, if ever, take this position. This Article initially explores the nature of life cycle funds and mutual funds. It will then analyze specific issues particular to the use of life cycle funds in individual account plans. [1]

A. What is a Life Cycle Fund?

A life cycle fund is a mutual fund consisting of shares of other mutual funds, otherwise known as a "fund of funds", in which the assets are allocated amongst the underlying mutual funds in a manner which reflects the life cycle stage of individuals. Thus, life cycle funds for younger individuals typically have a higher concentration of equities than will life cycle funds for older individuals.

A "dynamic life cycle" fund is a life cycle fund which changes its allocation over time to reflect the aging of the individuals who invest in it. For example, a fund that commenced operations with an allocation of 80% equity-intensive mutual funds could alter gradually its allocation so that it invests 30% of its assets in equity-intensive mutual funds twenty-five years later. The advantage of this type of life cycle fund is that it does not require any action ­e.g., shifting to a different life cycle fund due to aging by the investors in such funds.

B. Mutual Funds.

Mutual funds are collectively managed investment vehicles registered under the Investment Company Act of 1940. Technically, mutual funds are separate corporations each with their own board of directors, charged with protecting the interests of shareholders. The reality, however, has been in too many instances that the advisor of the funds, who receive fees for managing the funds assets, tends to dominate the board of directors.

The most typical structure for a mutual fund life cycle fund provides that a mutual fund advisor will determine the appropriate mix of mutual funds that constitute the life cycle fund. The mutual fund advisor collects the management fees associated with the underlying mutual funds and then collects an additional fee for the life cycle fund itself. The management fees of the underlying mutual funds usually vary widely so that the allocation decisions by the mutual fund advisor may have a significant affect on the advisor's fees and profits.

Professor Nicolaj Siggelkow of the Wharton School has demonstrated a systemic and pervasive tendency for mutual fund advisors to maximize their own fee income or profits. [2] It follows that there is the potentiality for life cycle mutual fund advisors to maximize their fees and profits by modifying the underlying asset allocations. Professor Siggelkow's research indicates that mutual fund advisors will generally seek to maximize their profits; there is no reason to believe that tendency could not or might not affect asset allocation in a life cycle fund, which could corrupt the asset allocation process. Further, the actions of mutual fund advisors in determining asset allocation would be strictly prohibited under ERISA Section 406(b) as self dealing except for the fact that the allocation occurs within mutual funds and ERISA provides that mutual fund shares do not constitute plan assets. [3]

In other words, if the financial service provider, which is affiliated with the life cycle mutual fund family, creates the algorithm for asset allocation applicable to the life cycle fund, then the issue of self dealing arises, as the provider might skew the allocation to where the group's profits, fees or margins are the greatest. Although this conflict of interest does not give rise to a prohibited transaction because mutual funds themselves are not plan assets, this puts pressure and significant fiduciary responsibility for monitoring on the plan sponsor for hiring an entity that might have an incentive to render conflicted management.

Fiduciary exposure may be particularly acute given that available research seems to demonstrate that the value provided by asset allocation greatly exceeds that provided by money management. [4] Given the importance of asset allocation for participants, the potential impact of self-interested decisions that affect asset allocations could have a negative affect on participants that exceeds that of abuses of mutual fund providers recently reported by the press. Therefore, plan fiduciaries should be particularly attentive to these potential abuses.

The above argues that plan fiduciaries who are responsible for selecting a life cycle mutual fund, which operates as described above, may be at risk. This exposure could arise in a variety of contexts. For example, a disgruntled former employee of a mutual fund could attest to the difference in allocation that was due to the consideration of fees and/or profits paid to the mutual fund advisors. A plan fiduciary that included such a life cycle mutual fund in a plan could be faced with a lawsuit alleging imprudence in the selection and/or monitoring of the life cycle fund. The lawsuit could seek damages equal to the difference between the investment returns with and without the skewing of the investment allocation. Given the above evidence of mutual fund advisors' propensity to increase their fees and the lack of ERISA regulation preventing them from doing so in a life cycle fund, it could be difficult to defend such a lawsuit, particularly where a plan suffered a loss. In this regard, plan fiduciaries should consider the application of a letter from Ann L. Combs, Deputy Assistant Secretary of the Labor, to Jonathon Katz, Secretary of the SEC, dated March 15, 1988, as well as a letter from Secretary of Labor, Alexis M. Herman dated July 19, 2000, to the Honorable William F. Goodling, Chairman of the Committee on Education and Workforce of the U.S. House of Representatives. In both letters, the Department of Labor cautioned that plan sponsors could have significant ERISA liability with respect to the decision to invest in financial products if critical protections are lacking. Such proposition clearly holds in the context of life cycle mutual funds, as they are typically operated. In fact, the conflicts addressed in the Secretary of Labor's letter are less severe than those that may arise in the life cycle funds arena. This is because the conflicted investment advice discussed in the Secretary's letter is provided on a transaction-by-transaction basis and may or may not be followed by a plan participant; this is to be contrasted with life cycle funds, as they are typically operated, where there is a continual stream of transactions that are automatically effectuated, with each potentially being influenced by a conflict of interest.

C. No Fiduciary Relief if Life Cycle Fund is Default Option.

There has been discussion concerning whether a life cycle fund might be the best default option where participants fail to self-direct their account balances. ERISA Section 402 enables a named fiduciary to appoint an investment manager, who must on a timely basis acknowledge its fiduciary status in writing. Thereafter, the named fiduciary, typically the employer, is only fiduciarily responsible for retention and monitoring in a duly diligent manner. This is routine in the defined benefit context and most employers are comfortable with and know how to satisfy these requirements. However, under a life cycle fund, there is no investment manager responsible under ERISA for investment management, which is a critical requirement in order to gain the protections available if one follows the procedures specified under Section 402 of ERISA.[6] In fact, there is no accountability whatsoever under ERISA with respect to an advisor's allocations under a life cycle fund. Therefore, there is no fiduciary relief for the plan sponsor available under ERISA Section 402 if a life cycle fund is the default investment option.

D. Failure to Disclose.

A growing body of case law deals with the fiduciary duty to disclose relevant information to plan participants and beneficiaries. A preeminent text regarding Title I issues, ERISA Fiduciary Law ,[7] has added a chapter in its supplement (Chapter 16) which addresses this topic, in recognition of its growing importance. A number of cases cited in this Chapter take the position that fiduciaries are required to disclose facts that are material to a participant's decision that are typically not known to participants. In this connection, plan fiduciaries who select a life cycle fund may be required under ERISA to disclosure the conflicts of interests inherent in such vehicles. Fiduciaries may also be required to disclose that these life cycle funds will typically result in inappropriate asset allocation if a participant has substantial assets outside the plan (see Section E, below).

Attorneys who advise plan fiduciaries should consider the possible application of Shea v. Esensten.[8] In that case, the Eighth Circuit held that ERISA requires disclosure of a physician compensation scheme that discourages referrals of patients to specialists. The reasoning of this case appears to be applicable to requiring disclosure of the incentive for, or propensity of mutual fund advisors to, maximize their profits by skewing asset allocations in life cycle funds, since mutual fund advisors are no less susceptible to financial incentives than are physicians. In this connection, it is important to note that securities law does not currently require any disclosure of these conflicts.[9] As a policy matter, it seems the SEC should at least consider whether it would be appropriate to require disclosure of the conflicts that may be present in this context. Alternatively, Congress might consider amending the law so that entities that operate life cycle funds are clearly governed by the ERISA prohibited transaction rules.[10]

E. Failure to Consider Outside Assets.

A life cycle fund does not generally consider relevant facts and circumstances of a particular individual other than age or years of service until retirement. Consequently, the asset allocation provided by even a properly operated life cycle fund will be inappropriate for at least some individuals, particularly those with substantial assets outside of the plan. While these individuals may comprise a minority of plan participants, their accounts will generally be the largest in the plan and their total account balances will constitute a significant portion of the total assets under the plan. Where an employer also sponsors a defined benefit plan, such individuals will also tend to have the largest accrued benefits thereunder, which benefits are not considered in assigning them to a life cycle fund. Consequently, a plan sponsor should consider, based on the demographics of the participants and beneficiaries under its plans, how frequently a life cycle fund may or could result in an inappropriate asset allocation. Moreover, such allocations would likely be imprudent if the person performing the allocations were subject to ERISA.

This issue could potentially require and/or be addressed by appropriate and adequate disclosure. For example, plan sponsors could disclose to participants that a life cycle fund may result in inappropriate asset allocations, if, for example, a plan participant has a significant accrued benefit under a defined benefit plan and/or significant assets outside of the plan. However, the issue of such disclosure may affect the incentives a plan sponsor/fiduciary could have for permitting life cycle funds in the plans it sponsors.

F. Mechanisms for Addressing the Conflicts.

One clear manner in which these issues may be addressed would be to allocate assets inside a life cycle fund based on formulae provided by an independent third party. The Department of Labor has ruled that this approach is permissible under ERISA, as the conflicts of interest are mitigated thereby. [11] Therefore, the use of this approach under a life cycle fund would provide a great deal of comfort to a plan fiduciary that selects a fund so managed. The marketing advantages to be gained by providing such comfort would seem to exceed the relatively nominal costs of licensing the formulae.

Another way to address conflicts would be for the life cycle mutual fund provider to charge the same management fee regardless of the allocation amongst the underlying mutual funds. While this appears to address conflicts due to the receipt of different fees depending on allocation, conflicts may continue to exist due to the fact that some of the underlying funds may have lower operating expenses. Therefore, it may be more profitable to increase allocations to funds with lower operating expenses and the inherent conflicts between investing assets and receiving variable profits (if not fees) on such investments would remain. Such a construct is, however, inconsistent with the manner in which most money managers currently operate and, consequently, would be likely to meet resistance from at least some of them.

G. Conclusion.

The manner in which most mutual fund advisors currently operate life cycle mutual funds raises significant fiduciary issues under ERISA. However, safeguards could be added that could reduce or eliminate at least the concerns related to potential conflicts of interest. Adoption of safeguards would encourage plan sponsors and fiduciaries to consider life cycle funds as an investment alternative for the individual account plans they sponsor.

Footnotes:

[1] Marcia S. Wagner, Esq., is an ERISA/employee benefits attorney and principal of The Wagner Law Group, a Professional Corporation based in Boston, Massachusetts. She is a frequent author and lecturer on ERISA/employee benefits issues. Ms. Wagner expresses her sincere appreciation to Andrew Oringer, Esq. of Clifford Chance US LLP for his advice, comments and insights.

[2] Siggelkow, Nicolaj, "Caught Between Two Principals," Wharton School, 2004

[3] ERISA Section 401(b)(1). Furthermore, the author notes that some have argued that self-dealing could be permitted under one or more prohibited transaction exemptions (e.g., Matta, Richard "Managed Accounts May be An Answer, but not Necessarily the Answer", Tax Management Compensation Planning Journal, November 2003); however, as noted in the following articles, these arguments are less than compelling: Wagner, Marcia S., "Managed Accounts: Still the Best, Least Risky Solution Yet Developed," Tax Management Compensation Planning Journal, November 2003; Wagner, Marcia S., "Managed Accounts: Are They the Answer?," Tax Management Compensation Planning Journal, August 2003.

[4] Ibbotson, Roger G. and Kaplan, Paul D., "Does Asset Allocation Policy Explain 40%, 90%, or 100% of Performance?," Financial Analysts Journal, January/February 2000.

[5] Tax Policy Center Forum, "Improving 401(k) Asset Choices: Avoiding the Next Enron," June 10, 2004, The Brookings Institution.

[6] For the specific protections provided, see Section 405(c)(2) and (d) of ERISA and DOL Regulation Section 2509.75-8, Q/A 15 and 17.

[7] Serota, Susan P., ERISA Fiduciary Law, Bureau of National Affairs (1995).

[8] 107 F. 3d 625 (8th Cir.) cert. denied 118 SCt 139 (1997).

[9] Note, however, that the SEC has proposed in connection with fund-to-funds that the fee table required in the prospectus include a description of the fees charged by the underlying funds (see SEC Release Number 33-8297, October 2, 2003 Amendments to Forms N-1A, N-2, N-3, N-4 and N-6). The author gratefully acknowledges the assistance of Ethan D. Corey, Esq. regarding issues concerning the Investment Company Act of 1940.

[10] At a minimum, Congress might consider some sort of regulation in the case where entities that operate life cycle funds or their affiliates have engaged in wrong doing, which could be evidenced, for example, by paying one million or more dollars to settle any matter concerning or involving improper conduct related to investments.

[11] Advisory Opinion 2001-09A issued to SunAmerica.