The Employee Retirement Income Security Act of 1974 (ERISA) is aimed at safeguarding the interests of participants in employer-sponsored retirement plans. One crucial aspect of being an ERISA fiduciary is understanding the duty to diversify to minimize the risk of large losses. In this article, we review ERISA’s duty to diversify, its rationale, applications to address modern challenges, and best practices for compliance.
Overview
ERISA’s duty to diversify is outlined in Section 404(a)(1)(C), which states that fiduciaries must “diversify the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so.” This duty is grounded in the principle of prudence, with diversification widely recognized as a fundamental risk management strategy, aiming to spread investment assets across various asset classes to reduce exposure to any single risk or investment. Section 404(c) of ERISA requires Plan Sponsors offer participants at least three types of investments to satisfy the requirements of diversification: a money market or cash-like vehicle (i.e., stable value), a bond fund, and an equity fund.
Modern Challenges and the Duty to Diversify in the Context of Retirement Plan Oversight
Mutual fund companies are not ERISA fiduciaries to your retirement plan, which is important to consider when selecting and monitoring investment options for your participants. For example, under the Investment Advisors Act of 1940, investment advisors managing funds under a “diversified” status mitigate concentration risks by limiting position sizes individually (typically 5%) and in aggregate at the industry level. While many mutual fund options may be prudently managed in this manner, there are instances when mutual fund mandates can operate in ways that present challenges to Plan Sponsors. For instance, some large-cap growth funds have amended their status from “diversified” to “non-diversified” to avoid violating the concentration requirements they must adhere to while being “diversified.” Microsoft, one of the Magnificent Seven, represents 12% of the Russell 1000 Growth Index, with some active managers having even more exposure in their portfolio.
Oversight of Non-Diversified Funds in a Retirement Plan
Having non-diversified funds in your investment menu is permissible if you demonstrate a reasonable and adequate basis for their initial selection and perform ongoing monitoring. While non-diversified funds can have individual positions exceeding 5% of their net assets, which does not violate any regulations under the Investment Company Act of 1940, Plan Sponsors nevertheless have an ongoing duty to consider the risks of such concentration and take steps to mitigate worst-case scenarios. While modern portfolio theory (MPT) posits that investors can maximize returns while minimizing risks by investing in different asset classes, the most important objective as it relates to ERISA is to minimize the risk of large losses. It is possible that by having strategies offered in non-diversified mutual funds, Plan Sponsors can aid participant diversification efforts such as via a commodities fund alternative.
Conclusion
ERISA’s duty to diversify is a critical component of fiduciary responsibility meant to safeguard the retirement assets of plan participants. By adhering to the principles of prudence and diversification, fiduciaries can enhance the long-term sustainability of employer-sponsored retirement plans while fulfilling their obligations under ERISA and to that end, we offer the following best practices for Plan Sponsors to satisfy this duty.
Steps to Ensure Plan Sponsors are Fulfilling ERISA’s Duty to Diversify
- Develop an Investment Policy Statement (IPS): Outline investment objectives, risk metrics, and guidelines for the prudent selection and de-selection of investments, diversification and establishment of monitoring procedures.
- Offer a Broad Range of Investment Options: We recommend Plan Sponsors offer 12-15 options to their participants designed to address various economic environments, including options which are inflation sensitive.
- Document Decision-Making Processes: Fiduciaries should maintain thorough documentation of their investment decisions, rationale, and the factors considered in diversifying the plan’s investments.
- Adopt 404(c) provisions and regularly confirm adherence to requirements to relieve plan sponsors from liabilities associated with participant decisions which are injurious such as the participant who invests all savings into one volatile fund like a small-cap offering which subsequently declines 50%.
- Identify non-diversified mutual funds in your Plan’s investment menu and apply monitoring criteria to affirm that the product continues to be appropriate for participant utilization.
The information contained herein is provided for informational purposes only. The information provided is from sources we believe to be reliable, but we cannot guarantee its accuracy or completeness. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Francis LLC does not offer personal legal advice.
