Annuities, SECURE 2.0, and Fiduciary Law

While there has been much speculation and anticipation about the possible passage of SECURE 2.0, the recent events involving cryptocurrency, reportedly a major component of SECURE 2.0, appears to make its passage before the end of the year doubtful. The extra time may actually benefit plan participants by allow for a more meaningful review of some of the Act’s more controversial provisions, including the expanded annuity provisions.

SECURE 2.0 will reportedly allow for an even more expanded offering of annuities within 401(k) plans. I have written several posts suggesting that plan sponsors proceed with caution in offering annuities within 401(k) and other pension plans.

My caution is based on ERISA’s provisions regarding a plan sponson’s fiduciary duties of prudence and loyalty. Annuities are often marketed with the promise of “guaranteed income for life.” However, the conditions required to obtain such income are usually not explained and/or understood.

As a former securities compliance director, I am familiar with the common marketing mantra in both the securities and insurance industries is to “sell the sizzle, not the steak.” In other words, push the supposed benefits, avoid discussing the actual product and any negatives.

In the cases of annuities, my experience has been that annuity salesmen stress the “guaranteed income” benefit, while avoiding any discussion of the costs an annuity owner must incur in order to receive such income.

The Fiduciary Duty of Loyalty
Such costs often include the generally high costs of annuities and the requirement that the annuity owner must give up ownership of the annuity and control of the balance in the annuity, with no guarantee of recovering either the principal or any other kind of commensurate return.

The implications of these conditions are significant for plan sponsors and other investment fiduciaries. Both ERISA and the Restatement of Trusts cite a fiduciary’s fiduciary duties of loyalty and prudence.

[T]he duty of loyalty requires a plan fiduciary to “discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries,” with “the exclusive purpose” of “providing benefits to participants and their beneficiaries….1 (both external and internal quotation marks omitted) (emphasis provided)

I would be interested in hearing how a plan sponsor or any other investment fiduciary would attempt to justify offering any investment option that requires the owner to forfeit ownership of the investment, without any assurance of a commensurate return, qualifies as acting “solely in the interest of participants and beneficiaries.” That is even more true given the fact that in most cases annuities are structured so that (1) the likelihood that the annuity owner will ever breakeven on their investment, and (2) the annuity issuer stands to recover a windfall at some point once the annuity owner gives up ownership of the annuity, the windfall being the balance, if any, remaining in the annuity at some point in time, often upon the death of both the annuity owner and their spouse.

Annuity advocates often counter that there are options by which an annuity owner can guarantee a commensurate return, a recovery of the balance forfeited by the owner. That is generally true…but only if the owner pays an additional fee.

Annuity advocates often point out that there are benefits to annuities, such as annual withdrawals and deferred taxation. However, withdrawals are usually subject to restrictions and taxed when made. As for tax-deferral, there are plenty of other investment options that offer that same benefit without requiring the annuity owner to give up the value built up in the annuity without assurance of a commensurate return, thereby hurting the owner’s heirs.

Since a plan sponsor has a responsibility to conduct an independent, objective and thorough investigation and analysis of each investment option offered within their plan, they definitely should be aware of these disadvantages when considering annuities. If they are not, the courts will definitely point them out in any subsequent litigation.

Fiduciary Duty of Prudence

The duty of prudence requires a plan fiduciary to discharge its duties “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use….”2

In addition to the potential fiduciary prudence issues with annuities mentioned above, plan sponsors and other investment fiduciaries should be aware that fiduciary law is basically a combination of thrust, equity, and agency law. A basic tenet of equity law is that “equity abhors a windfall.” To the extent that any portion of an annuity, other than reasonable costs and fees, could potentially/foreseeably inure to the benefit of the annuity issuer at the cost of the original annuity owner and their beneficiaries, an argument could be made the inclusion of such annuity within a 401(k) constitutes a breach of the plan sponsor’s fiduciary duties of loyalty and prudence. 

Prohibited Transactions and Fiduciary Liability
Whenever I discuss these fiduciary liability issues with other attorneys, the question of potential fiduciary breaches based upon prohibited transactions comes up. I believe that the decision to offer annuities in 401(k) could raise a number of potentially interesting issues vis-a-vis the question of fiduciary liability.

ERISA expressly prohibits certain kinds of transactions between a plan and a “party in interest.”3 This provision “supplements the fiduciary’s general duty of loyalty … by categorically barring certain transactions deemed likely to injure the pension plan.”  

ERISA states that

A fiduciary with respect to a plan shall not cause the plan to engage in a transaction, if he knows or should know that such transaction constitutes a direct or indirect—(A) sale or exchange, or leasing, of any property between the plan and a party in interest;(B) lending of money or other extension of credit between the plan and a party in interest;(C) furnishing of goods, services, or facilities between the plan and a party in interest;(D) transfer to, or use by or for the benefit of a party in interest, of any assets of the plan; or(E) acquisition, on behalf of the plan, of any employer security or employer real property in violation of section 1107(a) of this title.4 (emphasis added) (emphasis added)

In turn, ERISA defines a “party in interest” of an employee benefit plan as:

(A) any fiduciary (including, but not limited to, any administrator, officer, trustee, or custodian), counsel, or employee of such employee benefit plan;(B) a person providing services to such plan; [or](C) an employer any of whose employees are covered by such plan;…5 (emphasis added)

The two fiduciary liability issues that come to mind in connection with the prohibited transaction rules are (1) the practice of some plan sponsors to agree to plan advisory contracts that contain fiduciary disclaimer clauses, and (2) the question of whether plan sponsors who include annuities in their plans are can possibly be deemed to be enablers to annuity issuers/plan advisors who recommend annuities that require annuitization and forfeiture of the annuity in order to receive the guaranteed income benefits, with no guarantee of even breaking even or any other form of commensurate returns.

The annuity issuer, whether personally or through authorized agents, would presumably be a co-fiduciary in recommending annuities to a plan sponsor. Therefore, a plan partiThe cipant victimized by such an annuity would presumably have recourse against both the plan sponsor and the annuity issuer and/or its agent.

However, if a plan sponsor agrees to the inclusion of a fiduciary disclaimer clause in their advisory contract, the plan sponsor has effectively denied a plan participant that right of recourse against the annuity issuer and/or agent, without any commensurate benefit to the plan participant. Many plan sponsors try to justify agreeing to such provisions by claiming the plan received other benefits, such as revenue sharing.

In my opinion, such arguments have no merit. First, revenue sharing usually only goes to administrative costs, and in no way makes up for the long-term impact of an otherwise unsuitable investment. Second, the idea that any amount of revenue sharing would adequately compensate a plan participant and their heirs for the impact of the losses discussed herein is absurd.

Going Forward
I fully expect the usual response from the annuity advocates: “You are unfair and biased” and “you did not even mention the other benefits annuities offer.” I just mass delete them, as my loyalties are to my clients and true investment fiduciaries.

What annuity advocates do not understand, or want to understand, is that fiduciary law is not a matter of balancing alleged advantages against proven disadvantages. In fiduciary law, you get one chance to get it right. There are mulligans or “do-overs” in fiduciary law. One mistake is all it takes.

I discussed the potential fiduciary risks associated with several types of annuities in an earlier post. Anticipating a negative response, I relied heavily on and cited noted industry experts throughout the post. In my opinion, the failure of the annuity industry to recognize and address the legitimate fiduciary issues that plan sponsors and other investment fiduciaries face is the primary reason why the annuity industry has never marketed successfully to fiduciaries.

I am a fiduciary risk management counsel to plan sponsors, trustees, and other investment fiduciaries. My sole concern is in identifying potential fiduciary risk “traps” and helping my clients ignore them.

I am not interested in the various bells and whistles that annuities may offer because they will not matter if an annuity is not otherwise prudent, for even one reason, under fiduciary law. Again, fiduciaries get one chance to get it right.

I tell my fiduciary risk management clients to always ask three questions as part of their required fiduciary investigation and evaluation process:

1. It the investment expressly required by ERISA?
2. Is the investment consistent with the fiduciary standards set out in the Restatement (Third) of Trusts?
3. Could/would the investment potentially expose the plan and plan sponsor to unnecessary fiduciary liability?

If the answer to the first two questions is “no,” or the answer is “yes” to the third question, then clients know my manta – “why go there?” As that great philosopher Forrest Gump once said, “stupid is as stupid does.” My experience has been that the majority of risk management/fiduciary liability mistakes made by plan sponsors and other investment fiduciaries is due to the fact that they do not truly understand their fiduciary responsibilities and they listen to advice from conflicted “advisers.”

1. 29 U.S.C. § 1104(a)(1)(A)
2. 29 U.S.C. § 1104(a)(1)(B)
3. 29 U.S.C. § 1106(a)(1)
4. 29 U.S.C. § 1106(a)(1)
5. 29 U.S.C. § 1002(14)

Copyright InvestSense, LLC 2022. All rights reserved.

This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ member and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors on sound, proven investment strategies that will help them protect their financial security.
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