On May 18, in Tibble v. Edison International, the United States Supreme Court sent a strong message to 401k Plan Sponsors in a unanimous ruling stating that ERISA fiduciaries “must examine periodically the prudence of existing investments” and “remove imprudent” ones. The Ninth Circuit must now determine the meaning of “prudency” and could determine that Plan Sponsors have an ongoing duty to make sure investment options are appropriate and that fees represent the lowest cost option given a certain product. Historically, Plan Sponsors had gotten by with ensuring that the upfront process to select investment options was sound, and anything that happened after the initial selection was the burden of the participant. Not anymore. This is a wakeup call for all Plan Sponsors who select investment options for plan participants.
In this case, Edison International offered six mutual funds with higher fees than identical institutional funds that were available but not offered to participants in Edison’s retirement plan. Edison’s defense was that too much time had passed between the initial inclusion of the funds in the 401k offerings and Tibble bringing the case (statute of limitations) for Edison to be held responsible. The Court disagreed and ruled that Edison has an ongoing “continuing duty – separate and apart from the duty to exercise prudence in selecting investments at the outset – to monitor and remove imprudent investments.”
While this particular case centered on fees, the heightened sense of responsibility of Plan Sponsors for regular and “prudent” oversight introduces several potential issues including:
- Should Plan Sponsors simply offer the cheapest fee investment options or do they have a duty to participants to consider the appropriateness of an investment given future risk and return expectations?
- Could a participant have recourse to a Plan Sponsor for not offering a wider array of uncorrelated investment options, especially if commonly-offered equity and fixed income solutions struggle at the same time?
- What tools and systems are available to Plan Sponsors to regularly monitor exposures and risks that their participants are selecting, especially with respect to alternative asset classes like real estate, private equity and hedge funds?
- What level of investment transparency will Plan Sponsors be required to monitor on an ongoing basis across all asset classes?
Impact on Hedge Funds
The knee-jerk reaction to the Edison case brings to light the scrutiny that Plan Sponsors may face with higher cost investment options like hedge funds or private equity. In our view that misses the mark. What this case really calls into question is the Plan Sponsor’s responsibility to perform necessary ongoing monitoring and present appropriate, not just cheap, investment options to plan participants in order to protect the participants’ best interests.
In the Defined Benefit (DB) plan arena, alternative assets have played a critical role in protecting the best interests of retirees with pensions by introducing diversifying exposures to traditional equity and fixed income investments. Are diversifying exposures like private equity, commodities, hedge funds, real estate, and currencies not also similarly appropriate to serve the best interests of retirees with Defined Contribution (DC) plans? We believe that retirees in both DB and DC plans are best served when a thorough menu of investment options are available to them as they build a well-rounded asset allocation. Further, we think it is clear that this case will create a heightened awareness among Plan Sponsors regarding the need to discharge their ERISA fiduciary responsibility with “care, skill, prudence and diligence” (as mandated by the Trust Law Standard). Sharpening this responsibility will likely result in a review of the risk/return characteristics of all asset classes, not just those in the current 401k menu, and could potentially mean the inclusion of more alternative assets in defined contribution plans.
Not Your Grandmother’s Hedge Funds
DC Plan Sponsors have traditionally not offered hedge funds as investment choices to 401k plan participants for a variety of reasons. Cost, liquidity and transparency are chief among them. Hedge funds that charge 2/20, offer only locked-up/commingled investment options, and provide little to no transparency of the underlying positions make it almost impossible for Plan Sponsors to consider them in a DC context. In addition, Plan Sponsors have traditionally not had access to monitoring tools that capture the risks and exposures of hedge funds.
Today, however, a significant evolution is being driven by investors that make hedge funds cheaper, more accessible, and more monitorable than ever before.
- Separate Accounts: Sophisticated hedge fund investors with scale are now investing in managers via separate accounts (e.g., managed accounts, funds of one, etc.) that put the investor, not the manager, in the driver’s seat on many key control issues.
- Fees: Allocators with extensive sourcing capabilities are finding access to high quality, talented managers and actively negotiating fees approaching 1/10, a significant savings from the 2/20 of the past.
- Position-Level Transparency: There are more managers than ever before that are willing to provide 100% position-level access to underlying holdings. This removes much of the “black box” mystique of hedge funds and allows their exposures and risks to be appropriately analyzed and monitored.
- Daily Risk Interface: Given heightened transparency, Plan Sponsors now have access to technologies and tools that can feed hedge fund positions to them on a daily basis. This makes regular risk monitoring and P&L reporting more timely and accurate.
We are moving towards a world where, in order to fulfill one’s ERISA fiduciary duty to DC participants, Plan Sponsors must be more dialed-in. They must be more aware of the types of investments, strategies, and fees being utilized in the marketplace, and constantly be on the prowl for better, net-of-fee, risk-adjusted investment options to offer to their plan. While hedge fund investments might not be appropriate for some 401k investors, for others they can be an important component of a well-diversified portfolio. Given the evolution among hedge funds on factors that were hurdles to investment in the past, Plan Sponsors would be remiss to continue to ignore them. These recent trends could be the key to unlocking alternative assets, like hedge funds, as a valuable tool for Plan Sponsors to consider as they focus on their prudent and ongoing fiduciary responsibility to their DC plans.
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