DOL and SEC Issue Guidance For Plan Fiduciaries in Evaluating Investment Consultants

On June 1, 2005, the Department of Labor (“DOL”) and the Securities and Exchange Commission (“SEC”) jointly released tips to help ERISA plan fiduciaries in selecting and monitoring “pension consultants.” These recommendations were made in response to a May 16, 2005 report issued by the SEC, which raised concerns as to whether pension consultants were fully disclosing potential conflicts of interest to their plan clients. Pension consultants, more frequently called investment consultants, assist plan trustees and other fiduciaries in overseeing the investments of retirement and other employee benefit plans. Services provided by investment consultants include developing investment objectives, preparing investment policy statements, recommending asset allocations, reviewing and recommending money managers, recommending investment options for participant directed plans, monitoring and reporting on investment performance, recommending brokerage and custodial practices, and advising a plan on other aspects of its investment program.

The SEC undertook a study of investment consultants because it was specifically concerned about allegations of “pay-to-play” schemes, where investment consultants’ recommendations of money managers to clients might be based on financial incentives from the managers instead of on the quality of the managers’ performance. Some members of the pension industry have long questioned certain financial arrangements between investment consultants and money management firms. News reports of underfunded pension plans have also recently led to increased scrutiny of investment consultants’ relationships with money managers. In the report following its investigation, the SEC stated that many investment consultants may be breaching the fiduciary duty to clients required by federal statute if they fail to disclose conflicts of interest.

Fiduciary Status of Investment Consultants under ERISA
ERISA requires that employee benefit plan fiduciaries administer and manage plans prudently, and solely in the interest of the plan’s participants and beneficiaries. If plan fiduciaries lack investment expertise, they should consider hiring advisers with the requisite knowledge to assist them in carrying out their investment duties. Some plan fiduciaries rely heavily on investment consultants for guidance in making investment decisions.

The question of whether an investment consultant has fiduciary status under ERISA is not settled, and the DOL has stated that it depends upon the particular facts and circumstances of each case. Some investment consultants consider themselves to be ERISA fiduciaries to their plan clients and expressly state so in their engagement agreements, whereas other investment consultants explicitly state that they are not fiduciaries.

ERISA section 3(21)(A)(ii) provides that a person is a fiduciary under ERISA to the extent “he renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of[a] plan, or has any authority or responsibility to do so.” Additional guidance is contained in DOL Regulation §2510.3–21(c) which provides, in part, as follows:

A person shall be deemed to be rendering “investment advice” to an employee benefit plan, within the meaning of section 3(21)(A)(ii) of the Employee Retirement Income Security Act of 1974 (the Act) and this paragraph, only if: (i) Such person renders advice to the plan as to the value of securities or other property, or makes recommendations as to the advisability of investing in, purchasing, or selling securities or other property; and (ii) Such person either directly or indirectly (e.g., through or together with any affiliate)…. (B) renders any advice described in paragraph (c)(1)(i) of this section on a regular basis to the plan pursuant to a mutual agreement, arrangement or understanding, written or otherwise, between such person and the plan or a fiduciary with respect to the plan, that such services will serve as a primary basis for investment decisions with respect to plan assets, and that such person will render individualized investment advice to the plan based on the particular needs of the plan regarding such matters as, among other things, investment policies or strategy, overall portfolio composition, or diversification of plan investments.

In Advisory Opinions 84–03A and 84–04A, the DOL reviewed two situations where investment consultants assisted plan fiduciaries in formulating investment strategy, implementing the strategy to maximize the plan’s investment performance and analyzing the performance of the plan’s investment managers. In these Opinions, the DOL assumed, but expressly did not hold, that the investment consultants were rendering investment advice as a fiduciary within the meaning of the ERISA definition. The DOL reasoned that, even if the investment consultants did not make specific recommendations to a plan in terms of acquiring or retaining a particular investment manager or investment vehicle, the advice provided to a plan on a regular basis would be relied upon as a “primary basis for either the longer range strategic decisions or the more immediate allocation decisions that are made by the plan or by the plan’s fiduciary.”

An investment consultant’s fiduciary status under ERISA is important in assessing potential claims that a plan may bring against the investment consultant. In the recent case of Toledo Blade Newspaper Unions — Blade Pension Plan v. Investment Performance Services, LLC, 2005 U.S. Dist. LEXIS 11542, the issue was whether a plan could plead state law claims of professional negligence against an investment consultant in the alternative to ERISA breach-of-fiduciary-duty claims. The court held that the plan was permitted to plead its claims in the alternative because it was unclear at the motion to dismiss stage whether some or all of the defendants were fiduciaries under ERISA. The court held that if an investment consultant is found to be an ERISA fiduciary, ERISA pre-empts state law causes of action. If an investment consultant is found not to be an ERISA fiduciary, the court further held, the plan could assert state law claims without preemption under ERISA.

In addition to the overall issues of fiduciary responsibility and potential liability, determining an investment consultant’s fiduciary status under ERISA is also important for application of the ERISA prohibited transaction rules including, particularly, the “self-dealing” restrictions under ERISA section 406(b).

The SEC Report
In its report, “Staff Report Concerning Examinations of Select Pension Consultants,” the SEC states that, under the Investment Advisers Act of 1940, investment advisers providing consulting services have a fiduciary duty to provide disinterested advice and disclose any material conflicts of interest to their clients. Investment advisers registered with the SEC must file ADV forms, which contain disclosure information about investment advisers and their businesses. In addition, the SEC states that all investment advisors are expected to inform clients of any material conflicts of interest. Recently issued Rule 206(4)–7 under the 1940 Act, the “Chief Compliance Officer” rule, requires advisers registered with the SEC to designate a Chief Compliance Officer and to adopt and maintain written policies and procedures designed to assure compliance with the 1940 Act.

The SEC was concerned about “the independence of the advice that pension consultants provide in light of the fact that many pension consulting firms provide services both to pension plans who are their advisory clients and to money managers.” The SEC viewed the dual customer base of investment consultants as problematic because consultants might encourage clients to use certain money managers and other vendors based on their business relationships and fees collected, instead of on the client’s needs. The SEC is concerned that these arrangements can compromise the objectivity of an investment consultant’s recommendations and can lead to a breach of the fiduciary duty owed by investment advisers to their clients.

The SEC studied 24 pension consultants who are registered investment advisers over a period of 22 months. Through a twelve-page letter to firms, the agency sought detailed information about the consulting practices, compensation and disclosure of the consultants under investigation. The consultants varied in size and type of products and services offered. Approximately half the consultants examined were from the largest consulting firms. The SEC did not release the names of the consultants that were investigated, but news reports indicate that the following firms confirmed they were examined by the agency: Mercer Investment Consulting Inc. and Segal Advisors Inc., New York; Watson Wyatt Investment Consulting, Chicago; Wilshire Associates, Inc., Santa Monica; Frank Russell Co., Tacoma; Strategic Investment Solutions Inc. and Callan Associates, San Francisco; and Summit Strategies Group, St. Louis. In addition, the activities of several money managers were examined by the SEC for a view of the activities of investment consultants from the vantage point of those companies who may be engaged by plans based on the consultants’ recommendations.

Findings of the SEC Report
The SEC report sets out the following findings:

  • More than half of the pension consultants studied regularly provide products and services to both pension plan advisory clients and money managers and mutual funds. Payments from money managers comprise a “significant” portion of some firms’ annual revenue.
  • Over 50% of the consulting firms host investment conferences where money managers and pension consultant clients are both present. The money managers pay a fee to attend the conferences, while plan sponsors attend for free. Fees paid by money managers go towards either the cost of producing the conference or the travel costs of pension plan trustees attending the conference.
  • Ten of 24 consultants sell software programs to money managers analyzing the performance of clients’ accounts at costs as high as $70,000 per year.
  • 58% of pension consultants studied have affiliated broker-dealers or relationships with unaffiliated brokerdealers.
    • A relationship with an affiliated broker-dealer allows the pension consultant to collect compensation through brokerage “commission recapture” programs. Recapture programs may be used either to provide a rebate of brokerage commissions to the pension plan or to pay the pension consultant’s fee. The SEC expressed concern that these arrangements are not well documented and may not result in the best execution of trades. The SEC is also concerned that these arrangements may result in recommendations for an unnecessarily active trading strategy or result in overpayment for the consultant’s services.
    • Two of the pension consultants studied have brokerage referral arrangements with unaffiliated broker- dealers. Under these programs, the pension consultant refers clients to the broker-dealer to execute brokerage transactions. In turn, the brokerdealer compensates the consultant based on the amount of commission the broker-dealer receives from the plan. The consultants did not disclose to clients that they received payment based on their referrals.
  • Over one-third of the pension consultants and their affiliates acted as both pension advisers and brokerdealer representatives. These affiliates are usually compensated with commissions from trades placed by the pension plan client through the consultant’s affiliated broker-dealer firm. Not all consultants disclosed that their affiliates receive payment based on the number of transactions the plan client executes. The SEC concluded that the relationships between the pension consultants and their “dual-hatted” employees create disclosure and conflict of interest issues.
  • 16% of consultants or affiliates that provide products or services to money managers failed to disclose these services to their clients, and 84% of consultants provided only limited disclosure. In the SEC’s view, those consultants who did disclose the relationship did not indicate the possible conflict clearly enough or specifically enough for the pension plan clients to assess the potential harm of the consultant’s possible conflict of interest.
  • Many pension consultants do not consider themselves to be ERISA fiduciaries to their clients and either ignore or are unaware of their fiduciary obligations under the Advisers Act. Further, many of the pension consultants studied did not maintain policies and procedures governing how they prevent or manage conflicts of interest in their activities or disclose conflicts of interest to clients.
  • Many money managers also have failed to disclose their relationships with consultants who recommended them to their pension plan. These money managers may have relationships with multiple consultants and buy overlapping products from more than one consultant.

Conclusion of SEC Report
The SEC concluded in its report that consultants should have “policies and procedures that will ensure that the adviser is fulfilling its fiduciary obligations to its advisory clients.” To that end, the SEC urges investment consultants to adopt policies and procedures to ensure that a firm’s advisory activities are insulated from its other business activities, to ensure that disclosures required by fiduciary rules are provided to prospective and existing clients, and to prevent or disclose material conflicts of interests when brokerage commissions, gifts, or other compensation are paid to clients or received from money managers.

DOL and SEC Issue Ten Questions Plan Fiduciaries Should Ask
In the recently issued “Selecting and Monitoring Pension Consultants: Tips for Plan Fiduciaries,” the DOL and SEC provide a set of ten questions (followed by brief explanations) that pension plan fiduciaries should ask prospective investment consultants to help evaluate the objectivity of their recommendations and to ascertain potential conflicts of interest:

  • Are you registered with the SEC or a state securities regulator as an investment adviser? If so, have you provided me with all the disclosures required under those laws (including Part II of Form ADV)?
    • You can check yourself—and view the firm’s Form ADV—by searching the SEC’s Investment Adviser Public Disclosure website. At present, the IAPD database contains Forms ADV only for investment adviser firms that register electronically using the Investment Adviser Registration Depository. In the future, the database will expand to encompass all registered investment advisers—individuals as well as firms—in every state. If you can’t locate an investment adviser in IAPD, be sure to contact your state securities regulator or the SEC’s Public Reference Branch.
  • Do you or a related company have relationships with money managers that you recommend, consider for recommendation, or otherwise mention to the plan? If so, describe those relationships.
    • When pension consultants have alliances or financial or other relationships with money managers or other service providers, the potential for material conflicts of interest increases depending on the extent of the relationships. Knowing what relationships, if any, your pension consultant has with money managers may help you assess the objectivity of the advice the consultant provides.
  • Do you or a related company receive any payments from money managers you recommend, consider for recommendation, or otherwise mention to the plan for our consideration? If so, what is the extent of these payments in relation to your other income (revenue)?
    • Payments from money managers to pension consultants could create material conflicts of interests. You may wish to assess the extent of potential conflicts.
  • Do you have any policies or procedures to address conflicts of interest or to prevent these payments or relationships from being a factor when you provide advice to your clients?
    • Probing how the consultant addresses these potential conflicts may help you determine whether the consultant is right for your plan.
  • If you allow plans to pay your consulting fees using the plan’s brokerage commissions, do you monitor the amount of commissions paid and alert plans when consulting fees have been paid in full? If not, how can a plan make sure it does not over-pay its consulting fees?
    • You may wish to avoid any payment arrangements that could cause the plan to pay more than it should in pension consultant fees.
  • If you allow plans to pay your consulting fees using the plan’s brokerage commissions, what steps do you take to ensure that the plan receives best execution for its securities trades?
    • Where and how brokerage orders are executed can impact the overall costs of the transaction, including the price the plan pays for the securities it purchases.
  • Do you have any arrangements with broker-dealers under which you or a related company will benefit if money managers place trades for their clients with such broker-dealers?
    • As noted above, you may wish to explore the consultant’s relationships with other service providers to weigh the extent of any potential conflicts of interest.
  • If you are hired, will you acknowledge in writing that you have a fiduciary obligation as an investment adviser to the plan while providing the consulting services we are seeking?
    • All investment advisers (whether registered with the SEC or not) owe their advisory clients a fiduciary duty. Among other things, this means that advisers must disclose to their clients information about material conflicts of interest.
  • Do you consider yourself a fiduciary under ERISA with respect to the recommendations you provide the plan?
    • If the consultant is a fiduciary under ERISA and receives fees from third parties as a result of their recommendations, a prohibited transaction under ERISA occurs unless the fees are used for the benefit of the plan (e.g., offset against the consulting fees charged the plan) or there is a relevant exemption.
  • What percentage of your plan clients utilize money managers, investment funds, brokerage services or other service providers from whom you receive fees?
    • The answer may help in evaluating the objectivity of the recommendations or the fiduciary status of the consultant under ERISA.

Issuance of the DOL/SEC tips puts the onus on plan fiduciaries to use the questions or similar ones in selecting and monitoring investment consultants. Some consultants have already posted responses to the DOL/SEC questions on their websites. Other firms have posted comments in response to the SEC report but have not provided specific answers to the questions. Plan fiduciaries are responsible for prudently selecting investment consultants and monitoring their performance. Asking the right questions when hiring and monitoring investment consultants and evaluating the information received will help plan trustees fulfill their fiduciary duty to plan participants and beneficiaries.