ERISA vs. the Prudent Investor Rule: Key Differences

Overview of ERISA and the Prudent Investor Rule

ERISA and the Prudent Investor Rule are pieces of legislation enacted to further and protect the interests of investors and beneficiaries. ERISA generally focuses on the interests of employees who benefit from pension, medical, and other employer-sponsored plans. The main concern under ERISA is the ultimate outcome of the investment. The Prudent Investor Rule has a more general focus on all investors. The focus of trustees under this rule is the continual management of the portfolio according to the diverse requirements of the investor, considered in terms of the investor's end goals, and aimed at maximizing the ultimate outcome.

Both ERISA and the Prudent Investor Rule are focused on providing investors with the safety and security of knowing that their investments are managed by knowledgeable experts who have their best interests at heart. Indeed, the fundamental requirement of this legislation is that trustees and fiduciaries be sufficiently experienced and educated to manage their clients' portfolios for the ultimate benefit of the client.

According to the United States Department of Labor, the Employee Retirement Income Security Act of 1974 generally applies to private-industry pension and health plans that are established voluntarily. The Act sets minimum standards to protect individuals who participate in such plans. There are several requirements for administrators, managers, and controllers of these plans in order to fulfill the Act's intention.

Some of these requirements include: plan information to be provided to participants; fiduciary responsibilities for managers and controllers of the plans; a grievance and appeals process to facilitate the obtaining of benefits; and participants' right to sue for benefits or in cases of fiduciary duty breaches.

The U.S. Department of Labor also notes that there have been some amendments to the legislation to expand the benefits that participants might expect from their plans. These include the Consolidated Omnibus Budget Reconciliation Act (COBRA), providing some participants and their families with continued health coverage after events such as job loss; the Health Insurance Portability and Accountability Act (HIPAA), providing protection for participants with pre-existing medical conditions; the Newborns' and Mothers' Health Protection Act; the Mental Health Parity Act; and the Women's Health and Cancer Rights Act. Because the Act applies to private entities, it does not cover health plans operated by groups affiliated with the government or churches, or plans that concern only workers' compensation, unemployment, or disability.

Key Differences in Scope and Standards of Conduct

Whereas ERISA generally concerns only health and pension plans, the New York Prudent Investor Rule appears to apply to a more general investor field. It functions under the Prudent Investor Act and provides rules and regulations governing a trustee who invests and manages property. It also appears to concern the more active investor, generally providing protection against misconduct by trustees. The Prudent Investor Rule was implemented much later than ERISA, being enacted in 1995.

Another significant difference is the basis on which each law operates. Much of ERISA's requirements are focused on outcomes for plan participants. Participants may, for example, expect a certain result when certain events occur. When a participant falls ill or has a certain condition, the plan is adjusted to benefit the participant. Those who participate tend to be passive, while administrators are required to make decisions according to the conditions governing the plans.

The Prudent Investor Rule, on the other hand, is not focused as much on outcomes as it is on the standard of conduct for trustees. While ERISA administrators are indeed required to adhere to a certain standard of conduct, trustees under the Prudent Investor Rule are required to help investors make sound decisions according to the data available at the time of such decisions — hence the word "prudent." Furthermore, the trustee is to engage in this sound decision-making process throughout the duration of the portfolio. This portfolio in turn is governed by a determined set of purposes, terms, and provisions. The rule is therefore governed by the changing circumstances of the market while being unrelated to any change in the conditions of the beneficiary. In other words, one of the main differences between the Prudent Investor Rule and ERISA is that the former concerns the conditions of the changing financial market, while the latter concerns the individual who benefits and his or her particular circumstances.

The trustee under the Prudent Investor Rule takes a much more active and continuing role than one under ERISA. A further element of the Rule is the consideration of risk and return objectives as determined by the investor's portfolio. Elements that should be considered in this regard include: the size of the portfolio; the fiduciary relationship; the requirements of the governing instrument; economic conditions such as inflation or deflation; tax trends; the role and outcome of each decision within the purpose of the overall portfolio; the expected return of the portfolio; and the needs of the beneficiaries.

Whereas changes within ERISA are related only to changing personal circumstances, changes under the Prudent Investor Rule can be permitted according to predetermined criteria such as financial conditions or market values. Hence a greater degree of freedom is allowed to trustees under the Rule than to those under ERISA. The Prudent Investor Rule also recognizes that there is no determined set of conditions considered to be inherently prudent; the determination of prudence is dependent upon the good judgment of the trustee. The Rule requires the trustee to be able to identify the best conditions for investment, diversification, and disposal of assets. As such, the trustee is required to have specific investment skills and to apply them for the optimal benefit of the beneficiary. These skills are also to be applied to the adjustment of the investment in order to provide optimal benefits.

In addition to positive requirements for trustees under the Prudent Investor Rule, there are also some prohibitions. An adjustment cannot be made, for example, when it diminishes income interest, changes the payable amount in a fixed annuity, or alters an amount payable to a charity.

Trustee Responsibilities and Investment Management

Special investment skills under the Prudent Investor Rule also receive considerably more attention than those under ERISA. The Rule requires trustees to have special investment skills that will serve the beneficiary best. In other words, the trustee is trusted by the beneficiary to obtain the best possible return on investment. Such skills are not specifically required under ERISA. Under ERISA, protection of the end result is the most important factor for beneficiaries, while the Prudent Investor Rule implies a considerable amount of risk during the investment term itself.

The Prudent Investor Rule includes the possibility of delegation. An investment manager can delegate management functions to others, subject to certain precautionary measures. These include: ensuring the suitability of the person to the functions being delegated; defining the scope and terms of the delegation; reviewing compliance during the period of delegation; and considering the role of the delegation in controlling overall costs. The person to whom the functions are delegated accepts responsibility for managing such functions to the best of his or her ability.

Although delegation does not appear to be explicitly addressed in ERISA, its standards of care can be compared in this regard. The Exclusive Purpose Rule requires fiduciaries to act in the interest of participants and beneficiaries while defraying administrative costs. The Prudent Man Rule compares with the Prudent Investor Rule by requiring that fiduciaries exercise care, skill, prudence, and diligence in investing funds according to the financial conditions of the time as well as the end goal of the investment. The Diversification Rule requires that risk be minimized wherever possible by means of diversifying the investment. Finally, the Acting in Accordance with Plan Documents Rule subjects fiduciaries to the documents and instruments that govern the plan according to the provisions of ERISA.

Diversification of investments is also required by the Prudent Investor Rule. Unless the investment is better served by not diversifying, diversification should form part of the investment process. The loyalty requirement under the Rule also compares to the obligation of serving the interests of beneficiaries under ERISA; loyalty entails that trustees should remain loyal to the requirements of the investors they serve.

Investments governed by the Prudent Investor Rule are somewhat more complicated and volatile than those governed by ERISA, precisely because they are subject to circumstances at any given time. A trustee should therefore pay considerable attention to a variety of factors in order to ensure that the investment remains sound. Indeed, the role here is to ensure that not only the long-term goals but also the short-term goals are met.

Under the Prudent Investor Rule, two additional requirements are the Initial Asset Review and Impartiality. The former entails that trust assets should be reviewed within a certain time after being accepted for investment. The latter means that a trustee should remain impartial when investing funds, taking as sole guidance the interests of beneficiaries.

Under the Prudent Investor Rule, investors are also protected by the Fiduciary Oversight requirement. An Investment Advisory Council is to review all investments a fiduciary makes and to recommend suitable policies and changes to existing investments. This protects both the investor and the state. There is no similar provision under ERISA, although participants and beneficiaries are allowed to sue a fiduciary if wrongdoing is suspected. Participants are also protected by provisions prohibiting employers from deducting costs from their tax liability for non-compliance with ERISA.

Conclusion

Both ERISA and the Prudent Investor Rule appear to be focused on benefiting investors and participants. Fiduciaries and trustees are required to implement measures that favor the best possible options at any given time, while also taking into account the ultimate benefit of the investor. While ERISA generally applies to employees and their benefits, the Prudent Investor Rule is more broadly focused on all investors. Furthermore, ERISA tends to focus on the final outcome of the plans in question, while the Prudent Investor Rule focuses more heavily on the investment term itself. Both bodies of law include rules and requirements that specifically serve their respective purposes for the beneficiaries involved.