Why 401(k) plan sponsors should consider a discretionary trustee

Business owners must tackle many important decisions when establishing a 401(k) plan for their employees. Many of these choices are unfamiliar, and perhaps the most pivotal is also the least understood — whether to be the plan’s trustee themselves (self-trusteed) or designate a corporate trustee, which could be directed or discretionary.

Since 401(k) plans originated in the Internal Revenue Code (IRC) in 1978, the vast majority have been self-trusteed plans, in which the plan owner or an internal committee assumes the role. Business owners were often told that the self-trusteed model is cheaper, easier and entails little risk.

But that’s not really the case, particularly in the litigious world we live in. Internal Revenue Service plan audits happen, Department of Labor investigations happen and yes, occasionally employee-driven lawsuits happen.

In the past, a plan sponsor might have been able to select a certain investment platform and simply plug in all its mutual funds without any process for how those funds were selected. But the absence of a prudent process creates a problem with the Employee Retirement Income Security Act of 1974. It violates the prudent expert rule of ERISA, which indicates that all fiduciary decisions must follow a process that is prudent and would adhere to the standards of an expert.

As a result, business owners become vulnerable to litigation from employees who believe their 401(k) plan hasn’t properly prepared them for retirement, whether due to inappropriate or inadequate choices, ineffective allocations, higher expenses or worse share class options. Conversely, substantial data supports why a plan following a prudent process would include institutional shares, as well as potentially both passively and actively managed investments.

How a directed trustee and a discretionary trustee are different

I believe business owners are becoming more aware that different trustee options exist, but they may not be familiar with the distinctions between them:

• A directed trustee provides some benefits beyond the self-trusteed model and offers the business owner a certain level of protection.
• A discretionary trustee, meanwhile, provides more comprehensive benefits and essentially all the protections allowed to business owners by the DOL and ERISA.

Some of the differences between directed, discretionary and self-trusteed models are outlined in greater detail below:

1. A discretionary trustee is responsible for “everything the money touches.” In Disney’s “The Lion King,” Mufasa tells his son Simba, “Everything the sun touches is our kingdom.” In a retirement plan, if the money touches it, the discretionary trustee is responsible for it. That is their “kingdom.”

Discretionary trustees oversee custodians, trades, mutual fund companies and myriad other plan aspects. This comprehensive array of services could be appealing to many business owners who don’t have the in-house resources required to properly coordinate a 401(k) plan, monitor investments and select appropriate funds and share classes.

In short, they lack the expertise to “manage and control the assets” of the plan, which is required of plan trustees by ERISA. Outsourcing those responsibilities to an expert discretionary trustee can enable plan sponsors to focus on what really matters to them — running their respective businesses.

2. Directed and discretionary provide differing levels of fiduciary protection. A directed trustee can help keep a business owner out of trouble by disclosing whether a given course of action would be a breach of fiduciary duty or otherwise a violation of ERISA. In other words, these trustees have a duty to follow instructions, unless those instructions break the rules.

But if the action is legal and in accordance with the Plan Document, a directed trustee must follow the instruction. Thus, they aren’t responsible for the consequences of executing it and won’t advise whether other, better options might make more sense.

As the name implies, a directed trustee does as directed as long as it isn’t in direct violation of the Plan Document, ERISA or the Internal Revenue Code. So a directed trustee provides some protection in terms of fiduciary outsourcing, but it is highly limited.

On the other hand, discretionary trustees provide the most extensive coverage available, taking full responsibility to manage and control the assets of the plan and thus shouldering the potential liability associated with their own decision-making. 

3. The purview of a discretionary trustee extends to the participant level. As a “Named Plan Fiduciary,” the plan sponsor is ultimately responsible for the plan. However, other Named Plan Fiduciaries are allowed as well, so the plan sponsor can allocate (outsource) certain roles and responsibilities to others.

As we’ve discussed, they can appoint a discretionary trustee in the Plan Document to help limit their overall risk. The purview of the discretionary trustee extends to all assets of the plan, not just some of the assets or only the assets of the owners or other key players.

In most 401(k) plans today, the participants direct the funds. However, participant direction is not a right under ERISA but rather a feature. The decision to allow participant direction is made by the plan trustee, and the trustee is responsible for those participant decisions.

Thus, it is in the trustee’s best interest to ensure that the plan follows 404(c), a series of rules designed to be best practices. If followed, these can be cited as protection for the plan fiduciaries in the event that a participant does sue them in court. Accordingly, a good discretionary trustee would ensure that they (and the other fiduciaries) are protected by 404(c) compliance.

4. The DOL holds discretionary trustees to a higher legal standard. Unlike directed trustees, discretionary trustees can’t participate in any kind of revenue sharing or otherwise engage in any prohibited transaction such as self-dealing or controlling their own compensation.

For instance, if revenue sharing is built into mutual fund expense ratios, the fund company would “kick back” this revenue to service providers such as recordkeepers, third-party administrators or even corporate trustees. In this circumstance, discretionary trustees are legally required to return that money to the plan (DOL AO 97-15A).

Additionally, discretionary trustees must manage investments under the exclusive benefit rule, which states that a decision and its rationale must solely (meaning only) be in the best interest of participants and their beneficiaries or that course of action can’t be taken.

5. Discretionary trustees can provide better participant outcomes. Over the past 30-plus years, some amazing tools have emerged in the retirement industry, including planning calculators, online comparisons, integrations between payroll vendors and 401(k) service providers and the introduction of HSAs. Yet readiness for retirement hasn’t changed significantly despite all these advances.

Depending on which study you consult, only 15-40% of plan participants are on pace to retire when they want to and adequately and sustainably replace their paychecks for the rest of their lives. So more than half the American working population isn’t on track, and they’re relying on plans that predominantly feature self-trusteed or directed trustee models.

A discretionary trustee that has full authority over asset allocation, participant investments and risk over time, as well as the ability to conduct actuarial analysis to match assets and liabilities, can change this trajectory for the better. In some cases, retirement success rates could even improve to north of 75% of plan participants.  

A discretionary trustee offers the highest level of protection

The bottom line is that having a discretionary trustee provides the highest level of fiduciary protection to plan sponsors. Costs may be greater, but so are the benefits, protections and potentially the results. Often in life, you get what you pay for, and I believe many business owners would find the benefits of a discretionary trustee to be well worth the money.

Philip Gould, MBA, AIF, is an institutional retirement consultant with Unified Trust Company, headquartered in Lexington, Kentucky.