Oct 30, 2009


Investment issues are among the most complex and significant issues relating to employee benefit plans, involving the fiduciary relationship of plan sponsors to participants and beneficiaries, as well as larger issues of public policy. In this section, some basic rules and some of the more frequently occurring investment issues are discussed.

Fiduciary Requirements of ERISA and the Internal Revenue Code

A relationship in which one person holds and administers money or property belonging to another is legally described as a fiduciary relationship. A funded employee benefit plan, therefore, involves fiduciary relationships—plan assets are held by a trustee or insurance company, under the direction of the employer, on behalf of plan participants and beneficiaries. The rules governing fiduciary relationships are generally a subject of state law; however, in the case of qualified plans and other employee benefit plans, federal law (primarily ERISA) has superimposed specific federal fiduciary requirements that supersede state law where applicable. The federal requirements are usually stricter than the superseded state law requirements. While these rules are applicable to most employee benefit plans, they have their greatest impact on qualified pension and profit-sharing plans because welfare-benefit plans are typically insured or unfunded, although the use of funded welfare-benefit plans is increasing.

The fiduciary requirements were not intended as a helpful guide for employers and trustees in administering qualified plans. They do not spell out the specific responsibilities of each person involved in designing and maintaining the plan. Rather, the rules are intended to spread a net of liability over various persons involved with the plan, aimed at maximizing the protection of participants and beneficiaries. Thus, there are not always simple rules explaining how employers, trustees, and other persons should act with regard to qualified plans; rather, they must be aware of their fiduciary responsibilities and do their best to comply with them or avoid them.

The definition of fiduciary is broad enough to include the employer, the plan administrator, and the trustee. It also includes a wide variety of other possible targets. However, the government has stated that an attorney, accountant, actuary, or consultant who renders legal, accounting, actuarial, or consulting services to the plan will not be considered a fiduciary solely as a result of performing those services. Also, labor regulations exclude broker/dealers, banks, and reporting dealers from being treated as fiduciaries simply as a result of receiving and executing buy-sell instructions from the plan. Furthermore, a person giving investment advice will be considered a fiduciary only with respect to the assets covered by that investment advice.

Every plan must specify a named fiduciary in the plan document. The purpose of this requirement is not to limit liability to named persons, but rather to provide participants and the government with an easy target in case they decide to take legal action against the plan. Of course, other unnamed fiduciaries can also be included in the legal action.

The duties of fiduciaries specified in the law are primarily of an investment nature. According to ERISA Section 404, a fiduciary must do the following:

  • Discharge duties with respect to a plan solely in the interest of the participants and the beneficiaries

  • Act for the exclusive purpose of providing benefits to participants and their beneficiaries and defraying the reasonable expenses of administering the plan.

  • Act with the care, skill, prudence, and diligence under the prevailing circumstances 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

  • Diversify the investments of the plan to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so.

  • Follow the provisions of the documents and instruments governing the plan, unless inconsistent with ERISA provisions

In interpreting the prudent-man requirement, labor regulations indicate that the fiduciary must, in making an investment, determine that the particular investment is reasonably designed as part of the plan's portfolio to further the purposes of the plan. The fiduciary must consider (1) the composition of the portfolio with regard to diversification, (2) the liquidity and current return of the portfolio relative to the anticipated cash flow requirements of the plan, and (3) the projected return of the portfolio relative to the funding objectives of the plan.

A major exception to the diversification requirement applies to holdings of employer securities and employer real property. An eligible individual account plan (a profit-sharing, stock bonus, or employee stock ownership plan that specifically permits the holding of employer real property or qualifying employer securities) may hold such property in any amount, and may even hold such property as the exclusive assets of the plan. Other plans can hold such property only up to the extent of 10 percent of the fair market value of the plan assets. The purpose of this exception is, of course, to encourage the adoption of employer stock plans of the type. A qualifying employer security means employer stock or marketable debt obligations meeting the various requirements of ERISA Section 407. Employer real property is real property owned by the plan and leased to the employer, again under limitations set out in ERISA Section 407.

Fiduciaries can delegate fiduciary responsibilities and, therefore, avoid direct responsibility for performing the duty delegated. For example, the employer can delegate duties relating to the handling and investment of plan assets to a trustee, and investment management duties can be delegated to an appointed investment manager. The plan must provide a definite procedure for delegating these duties. The delegation of a fiduciary duty does not remove all fiduciary responsibility. A fiduciary will be liable for a breach of fiduciary responsibility of any other fiduciary under certain circumstances.

The broad scope of the fiduciary liabilities indicates that, in addition to careful delegation of fiduciary duties to well-chosen trustees and advisers, the employer should take care that its liability insurance coverage adequately covers any liabilities that might arise out of the fiduciary responsibility provisions. ERISA specifically prohibits a plan from excusing or exculpating any person from fiduciary liability, but individuals and employers are permitted to have appropriate insurance and employers can indemnify plan fiduciaries.

Prohibited Transactions

In addition to the general fiduciary requirements already described, both Code Section 4975 and ERISA Section 406 include a specific list of "don'ts" for employee benefit plans, including qualified plans. Under-these rules, a party-in-interest is forbidden to do any of the following, with a number of exceptions described later:

  • Sale or exchange, or leasing, of any property between the plan and a party-in-interest

  • Lending of money or other extension of credit between the plan and a party-in-interest

  • Furnishing of goods, services, or facilities between the plan and a party-in-interest

  • Transfer to, or use by or for the benefit of, a party-in-interest of any assets of the plan

  • Acquisition, on behalf of the plan, of any employer security or employer real property in excess of the limits described previously in this chapter

A party-in-interestthe Code uses instead the term disqualified personis defined very broadly, again to bring the largest possible number of persons into the net to provide the maximum protection for plan participants. A party-in-interest includes the following:

  • Any fiduciary, counsel, or employee of the plan

  • A person providing services to the plan

  • An employer, if any of its employees are covered by the plan

  • An employee organization, any of whose members are covered by the plan

  • An owner, direct or indirect, of a 50 percent or more interest in an employer or employee organization

  • Various individuals and organizations related to those on this list, under specific rules given in Code Section 4975 and ERISA Section 406

Because of the breadth of the prohibited transaction rules, certain specific exclusions are provided in the law, and the IRS and Department of Labor are also given the authority to waive the prohibited transaction rules in certain circumstances.

First, the specific statutory exemptions: Loans to participants or beneficiaries are permitted under the rules. A loan to an ESOP by a party-in-interest is also permitted under certain circumstances to permit the ESOP to function. Similar provisions permit such a plan to acquire employer securities or real property without violating the prohibited transaction rules. Also, the plan is allowed to pay a reasonable fee for legal, accounting, or other services performed by a party-in-interest. There are provisions permitting various financial services to the plan by a bank or insurance company that is a party-in-interest. Other provisions exempt normal benefit distributions from any possible conflict with the prohibited transaction rules.

In addition to the specific statutory exemptions, the Department of Labor has broad authority to grant an exemption to the prohibited transaction rules for a transaction or a class of transactions, after finding that the exemption is administratively feasible, in the interest of the plan and its participants and beneficiaries, and protective of their rights. There are specific administrative procedures for obtaining such exemptions. Pursuant to this authority, the Department of Labor has granted, among others, a class exemption permitting the sale of life insurance policies by participants to the plan or by the plan to participants. Another exemption, PTE84-14, permits a wide variety of transactions by qualified plan asset managers (QPAMs) such as banks and insurance companies. Individual exemptions have been granted for a variety of transactions, usually involving a sale to the plan by a party-in-interest of property that represents a particularly favorable investment opportunity for the plan.


A violation of the prohibited transaction rules can result in a two-step penalty under the Internal Revenue Code, with the initial penalty equal to 15 percent of the amount involved, and an additional 100 percent penalty if the transaction is not corrected within a certain period of time. A violation of the prohibited transaction rules can also result in penalties for breach of fiduciary liability.

Unrelated Business Income

The trust fund under a qualified plan and trust funds used in some other self-insured employee benefit plans, such as Section 501(c)(9) trusts, are given a broad exemption from federal income tax similar to that granted to a variety of other institutions and organizations, such as churches, schools, and charities. However, such tax-exempt organizations are subject to federal income tax on unrelated business taxable income according to Code Sections 511-514. Unrelated business taxable income is income of a tax-exempt organization from a trade or business that is not related to the function that is the basis for the tax exemption. For example, if a charitable organization operates a full-time shoe store in a shopping center, the shoe store income would be taxable to the charity. However, the charity's tax exemption for its other income probably would not be jeopardized unless the effect of operating the shoe store was to shift the focus of the organization totally away from its exempt function.

The basic function of an employee benefit plan trust is to receive, invest, and distribute plan funds to participants and beneficiaries. Thus, passive investment income of the plan trust is usually not unrelated business income unless the investment is debt-financed, as described in the next paragraph. Problems sometimes arise in distinguishing passive investments from activities that might be considered a trade or business. The law specifically exempts dividends, interest, annuities, and royalties, as well as rents from real property and from personal property leased with real property. However, the wide variety of possible leasing arrangements indicates that each rental arrangement must be looked at on the basis of its own facts and circumstances. For example, a number of revenue rulings have held that investments in manufacturing or railroad equipment for leasing constituted an unrelated trade or business, even though these leasing arrangements are usually looked on by investors as strictly investment activities. Another revenue ruling, however, allows a qualified plan trust to hold shares in a real estate investment trust without incurring unrelated business taxable income. In short, the possible impact of unrelated business taxable income is an additional factor that must be taken into account by the investment advisers of a benefit plan trust.

Code Section 514 specifies that income from debt-financed property is to be treated by a tax-exempt organization as unrelated business taxable income. However, there is an exception in Section 514(c)(9) for qualified plans holding certain real estate investments that typically are highly leveraged or debt-financed. Therefore, such investments may still be advantageous to a qualified plan, particularly if they provide long-term growth or other benefits.

Investment Policy

The policy baseline for the investment of qualified plan funds is set by the rules previously discussed—the exclusive-benefit rule, the prudent-expert rule, the diversification requirement, liquidity requirements, the plan document itself, and the additional limitations imposed by the prohibited transaction and unrelated business income provisions. Within these constraints, however, a broad range of investment strategies is possible.

Growth-Oriented Strategies

Trustees governed by fiduciary rules aimed primarily at the preservation of principal generally do not follow aggressive, growth-oriented investment strategies, and pension trustees are no exception. However, qualified plan design offers a number of opportunities for incorporating growth-oriented investment strategies without running into fiduciary problems.

Defined-contribution plans can provide that part or all of each participant's account be put in a participant-directed account, with the participant then choosing the investment strategy. This relieves the trustee of liability for that choice if the plan meets requirements of Department of Labor regulations under ERISA Section 404c. Also, defined-contribution plan funds can be invested in pooled accounts of a bank or insurance company that offer participants choices of investment strategies—an equity fund, a fixed-income fund, and so on.

For defined-benefit plans, there is no provision for participant direction of investment; defined-benefit plan funds can be invested in insurance company funds utilizing separate account funding, with a choice by the employer of investment strategies such as equity or fixed income. It is also possible to structure the trust agreement to allow the employer to recommend investments, and the employer can pursue a growth-oriented strategy. In such a case, of course, the employer is still responsible for the adequacy of the pension fund and is subject to full fiduciary liability for its investment recommendations. Finally, there is the possibility of designing a plan to invest primarily in employer securities, which can be viewed as a type of growth-oriented investment strategy.


Most of the ERISA investment rules can be seen as prescriptions for avoiding risk, particularly the risk of large losses; for example, the requirement for diversification of investments. Within the ERISA limits, however, the qualified plan investment manager, like any investor, must balance risk and return.

Social Effects

According to the Employee Benefit Research Institute,[1] at the end of 1992, private pension funds (trusted and insured) in the United States totaled about $2.8 trillion, with government-employee funds comprising an additional $1.3 trillion. This is a sizable portion of the nation's capital. If there is any pattern to the investment strategies of qualified plan investment managers, such a pattern is likely to have an effect on the economy and on society. Because so much pension money is held and invested by large institutions such as banks and insurance companies, current pension investment policies largely reflect the views of these organizations. In general, such organizations will tend to invest in conventional ways that support the status quo. The question is often raised whether there is a role in pension investing for active attempts to support a particular social result not dictated merely by market conditions.

Existing legislation and other laws relating to qualified plan investments focus primarily on fiduciary aspects of the relationship between plan managers and participants; they do not address issues of social policy. That is, they encourage investment managers to invest so as to prevent direct losses to participants and beneficiaries, but they do not deal with possible indirect losses that may accrue to participants and beneficiaries as a result of trends in overall pension investment policy that may be contrary to the social and economic interests of plan participants.

Social Investing

In recent years, objections to prevailing pension investment policies have been raised, particularly on behalf of unionized employees in large manufacturing industries. Although these objections are not always clearly stated, four types of arguments can be distinguished. First, it is stated that the usual pension investment policies contribute to the disinvestment in basic manufacturing industries that has been occurring, particularly in certain geographic areas such as the Midwest. This results in the loss of jobs for persons covered under the pension plans, with the attendant economic and social costs, and also in disinvestment in housing and other facilities in communities where plan participants live. Second, it is stated that pension investors can undercut the union movement by investing in nonunionized corporations. Third, pension investment policies allegedly can affect the welfare of workers adversely by investing in corporations that violate health, safety, or nondiscrimination principles. Finally, some object to investing in certain corporations on moral or political grounds (not directly related to the interests of plan participants), such as environmental pollution or weapons production. Although advocates of social investment for union pension funds sometimes make common cause with religious and academic groups who advocate social investment policies for church or university endowment funds, it is clear that on this issue the interests of unionized employees are quite distinct.

A decision by a pension investment manager to pursue a social investment strategy that attempts to avoid one or more of these objections raises a number of issues. The first relates to fiduciary responsibility. Does a social investment strategy result in a lower return on the fund? There are some studies indicating that an investment portfolio of "good guy" investments has a lower return. However, such studies usually choose the "good" investments using a broad range of criteria, so they do not indicate the effects of narrower targeting such as simply excluding nonunion employers. The "efficient markets" theory proposed by some economists would suggest that in the long run an investment strategy based on social investing should have no effect on investment return, so long as investments are sufficiently diversified and the market includes other investors who do not use the same social criteria.

Some social investment advocates suggest that even if the return is lower, the indirect social and economic benefits to plan participants are a compensating factor. However, under current fiduciary law, both state and federal, this argument probably could not protect an investment manager in the event of a lawsuit by a plan participant injured directly by a low return on the fund. Suggestions have been made in Congress to amend federal legislation to permit social investment of various types, but no such provision has yet been enacted. The Department of Labor is reportedly studying the issue, but no regulations or rulings in this area have been issued.

A second problem is, assuming a social investment strategy has been chosen, how does the investment manager evaluate possible investments to determine their compliance with the chosen social criteria? It is currently difficult to identify corporations that meet even such simple criteria as compliance with health and safety legislation. There are various social investment indices available, but these are generally inadequate as guidance in any specific program of social investing. Because of these difficulties, social investing usually involves additional administrative costs.

The pension investment community has generally reacted with some hostility to social investing, with most pension advisers taking the view that any considerations other than the traditional ones of risk and return have no part in pension investment decisions, and that it would be a violation of fiduciary responsibility to use other criteria.


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