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Complying With ERISA:
A Primer for Pension Plan Trustees

By Stanley L. Iezman

Following a few simple rules will enable trustees to sleep easy.

Many pension plan trustees have read with some trepidation that the US Department of Labor (DOL) has started to evaluate pension plan investments in real estate more vigorously in order to monitor the compliance of plans with the Employee Retirement Income Security Act of 1974, as amended (ERISA). The DOL's increasing interest arises because of the growth in total assets of pension funds (now close to $5 trillion) and, in particular, the growth of their real estate assets, which now exceed $200 billion. Given the size of these pools of assets and the political, social, and financial fallout that would result from problems with their soundness, the DOL wants to be certain that all pension plans are complying in all respects with the procedural requirements of ERISA. The DOL does not attempt to determine whether a pension plan has made a sound investment (which it expects that the plan will in fact do); rather, it tries to determine whether the plan's trustees have exercised their responsibilities in a prudent manner and have complied with the law's procedural requirements.

Real estate investment managers and pension plan trustees, subject to ERISA, who have made real estate investments are delighted that the DOL has waited until now to begin its evaluation of real estate portfolios. Three or four years ago, most real estate portfolios were underperforming, but today the market has recovered, and many portfolios are performing as well as or better than was anticipated when they were originally underwritten. Many "bad" investments of yesterday look much better today.

In any case, the standards and guidelines that ERISA has established are designed to focus on process and procedure, rather than simply on the return on the investment. This requires trustees to exercise procedural prudence in making investment decisions and to evaluate investment decisions with substantive prudence. In essence, the law imposes coordinates on the manner in which investments are made, rather than on the result of those investments. If the process was, in fact, appropriate, and complies with the overall ERISA guidelines and subsequent interpretations, the plan trustees have performed their fiduciary responsibilities.

The DOL has identified the following five areas of concern:


The standards by which investments are made.
The manner in which investment advisers are hired and selected.
The way the pl n an periodically values these investments.
The ongoing monitoring of the performance of the investment portfolio and the investment manager.
The level of fiduciary responsibility exercised by the trustees.

These issues will become increasingly important during the next 10 years.

PENSION PLAN INVESTMENT POLICY

Before they can invest plan assets, the trustees of each pension plan should develop an investment policy or investment guidelines. If they do not want co-fiduciary responsibility for the investments t hat they make and they intend to hire outside independent investment managers, they must establish a plan and investment policy that provide for the delegation of investment responsibility. The plan documents must expressly establish procedures that make it possible for plan trustees to allocate or delegate responsibilities to an investment manager. Otherwise, the trustees of the plan may not divest themselves of investment responsibility and have breached their fiduciary duty should they have delegated that authority. Parenthetically, if the trustees have delegated that authority and they maintain control over the investment process and decision rather than simply monitoring the investments, they will de facto have retained legal and ERISA responsibilities for the investments.

Establishing investment guidelines may be the trustees' most difficult task. The investment mix will govern the returns to the pension trust and the risks to which it is exposed. The guidelines should consider diversification, manager selection, asset allocation, controls over the process, and other similar issues. They should be tailored to the trustees' risk expectations and financial goals. The investment guidelines must articulate clearly the investment strategy for each asset class and the return expectations for that asset class. They must carefully specify the types of real estate investment that the trust will consider, and indicate the degree of liquidity that the trust desires, as well as all other aspects of the type, form, and substance of the real estate investment.

All pension plan trustees know how carefully they must use an asset allocation model to establish the various asset classes they will hold in the portfolio and to create the allocation that best meets the trust's short-, medium-, and long-term needs. It is generally accepted that a well-thought-through allocation model that diversifies assets among many classes (stocks, bonds, cash, real estate, and others), best serves the financial needs of most trusts. The appropriate allocation should take into account the trust's need for funds (actuarially computed cash requirements), while carefully considering the amount of risk that the trustees wish to accept. As an obvious example, a fully mature fund that anticipates heavy, short-term cash requirements would not want to invest in illiquid real estate. Alternatively, a small fund may wish to avoid the risks of development-oriented investments because it does not have sufficient assets to cover both its future funding requirements and the risk of a limited return from such development-oriented investments. While real estate provides excellent cash returns, long-term appreciation benefits, and an excellent inflation hedge, it is not a suitable investment for every pension plan. Care must be taken in determining whether real estate, like all other asset classes, fits the long-term goals of the plan.

The parameters of the real estate investment guidelines should, at a minimum, evaluate the 12 variables listed in Exhibit 1. In addition, the trustees should also give a great deal of thought to the ownership vehicles they will employ in making the various real estate investments. The choice of vehicle affects control, liquidation, liability, decision making and the like. Investors may choose to use one or more of the following investment vehicles: separate account or commingled fund; public and/or private investment; title holding corporation; group trust; limited liability company; limited or general partnership; or joint venture. They must carefully evaluate the benefits and drawbacks of each.

For each particular investment, the trustees should ensure that the investment manager examines the following substantive issues:

Does the investment consider the overall diversification of the portfolio?
Does the investment fit into the pension plan's overall investment portfolio? (This is an issue of quality, not diversification.)
Does the investment meet the needs of the plan?
Are the risks of loss and the opportunity for gain favorable, relative to those of other investments?
Is the investment justified considering the needs for liquidity and overall return to the plan? and
Does the investment take into account the funding objectives of the plan?

INVESTMENT MANAGER SELECTION

Once the pension plan has established appropriate investment guidelines, it must develop a procedure for selecting the investment manager. The following elements must be documented and set forth in the records of the pension plan:
The trustees should carefully document procedures by which competent investment managers will be identified.
The trustees should obtain sufficient information from each identified candidate to enable them to prudently choose the investment manager. That information, with appropriate supporting documentation, should include, but not necessarily be limited to, the types of information listed in Exhibit 2. The information provided should be verified with reliable independent sources.
Inquiries should be made of the DOL and the Securities and Exchange Commission as to whether any enforcement actions have been initiated within a relevant period with respect to the proposed investment manager, its officers or directors, or its investment professionals who will have responsibility for the plan's account.
The trustees should review the information provided by the candidates and the information obtained in the verification process and then select an investment manager(s) based on this information and any other information they deem to be relevant.
After selecting the investment manager and consulting with legal counsel, the trustees should enter into an appropriate investment management program. This agreement should carefully document the relationship between the parties. It must set forth the terms and conditions of the investment manager's engagement and the right of the pension plan to terminate that manager should it wish to do so. The investment guidelines are an important part of this agreement and should be attached to it.

MONITORING THE INVESTMENT MANAGER

Once the plan has selected the investment manager, it has a continuing obligation to monitor both the investment manager and the investments. It should undertake all the actions listed in Exhibit 3 on a regular basis to ensure that the investment manager is performing its duties in accordance with ERISA and the investment guidelines established by the plan. In addition, because real estate is an illiquid investment, the trustees should review the investment manager is doing its job effectively.

APPRAISALS AND VALUATIONS OF REAL ESTATE ASSETS

All pension plans are required to "mark to market" their investment assets on a regular basis. Marking the asset to market means adjusting the books of the pension plan to reflect the current market value of all real estate assets, including both real estate loans and real estate equity investments. Determining the current market value of assets that are by nature illiquid is difficult and it is made more difficult by the fact that most pension plans invest in the nonpublic real estate market. There are many reasons for marking assets to market, of which the following are the most important:
To determine whether the plan is properly funded.
To ascertain whether there are sufficient assets to meet current liabilities.
To calculate the internal growth rate of plan assets so that the trustees can judge whether they can meet future benefit requirements.
To help establish the level of contributions required to meet the current and future plan needs.
To complete the filing of Form 5500 with the Internal Revenue Service.
Many pension plans that have real estate in their portfolios have not properly valued these assets or marked them to market appropriately. In those cases, it is only when an asset is ultimately sold and/or disposed of that the trustees became aware of its "true value." If the liquidation price turns out to be less than the amount at which the investment was carried on the books, the trustees become acutely aware of the exposure resulting from their failure to appraise assets annually.

The DOL is concerned that pension plans are not properly valuing their assets because plan managers do not wish to reveal the impact on portfolio values of the depressed real estate market that emerged in 1991 - 1992. Marking down the value of the asset may have significant personal costs for pension fund executives. Those who were involved in the original investment decision (trustees, administrators, chief investment officers, and others) may be in jeopardy. More important, because these markdowns may cause a plan to be underfunded, an immediate financial problem arises that must be rectified by additional contributions. Usually, the contributions must come out of someone's pocket: in public pension plans, from taxpayers of participants; in corporate pension plans, from dividends and profits; and in Taft-Hartley pension plans, from wage increases or employer contributions.

Unlike stocks or bonds, which are traded in active markets, and which, therefore, can be valued on a daily basis, real estate must be valued on the basis of the opinions of appraisers whose analyses are based on one of a combination of the approaches required to be considered by the Appraisal Institute: the Income Approach; the Sales Comparison Approach; and/or the Cost Approach.

Readers who are not professional appraisers can find numerous articles that have appeared in this journal that discuss which valuation approach is valid under various circumstances. In the current real estate environment, many investments were purchased at material discounts to replacement cost. Consequently, the Replacement Cost Approach has little bearing on the appraisal of much of today's real estate.

ERISA permits funds to undertake external appraisals performed by independent appraisers hired either by the pension plan or by the investment manager, or internal valuations that normally are performed by the investment manager.

VALUATION POLICIES

To comply with ERISA guidelines and to protect the fund against a DOL review, the investment manager and the trust funds should do the following:

Establish written policies concerning valuations.
Establish procedures for external appraisals that specify the interaction between the manager and the independent appraiser.
Establish procedures that govern internal valuations.
Indicate the timing and management of required appraisals
External Appraisals Different pension plans engage in different external appraisal processes. These processes differ primarily in the degree of participation in the valuation process by the trustees of the plan. Exhibit 4 describes a typical external appraisal procedure.

The outside appraiser selected by the plan should have appropriate certification and credentials. The most widely accepted credential for appraisers of commercial properties is the MAI designation awarded by the Appraisal Institute. Although possession of the MAI designation ensures that the appraiser has completed certain educational prerequisites and possesses a certain amount of appraisal experience, the trustees must nevertheless evaluate the particular experience level of each candidate to determine whether the appraisal is likely to be reliable.

Some appraisers may submit drafts of their appraisal to the plan manager and request comments before they make final valuation estimates. Those who approve of this procedure indicate that it is beneficial because the manager is likely to have reliable knowledge regarding the property, and he/she is in a position to recommend useful modifications, additions, or deletions to the assumptions and provide supporting data for those recommendations. However, critics point out that an external appraiser should be an independent professional, and a review of the appraiser's report by an interested party leads to the possibility of valuation manipulation. Therefore, an appraisal review should conform to the requirements of a written appraisal review procedure and be documented in writing. The DOL is less likely than in the past to assume automatically that the code of professional ethics to which the appraiser is required to adhere is certain to eliminate the possibility of valuation manipulation between the manager and appraiser.

If the appraiser and manager disagree on appropriate value estimates and the appraiser rejects the manager's "recommendations," the manager is certain to appeal to the trustees of the plan. Trustees are then unlikely to mediate between these positions without obtaining additional professional advice.

To assist trustees to determine whether the external appraiser has submitted a competent estimate, Exhibit 5 lists six basic questions to which the trustees must obtain satisfactory answers.

Internal Valuations In most plans, investment managers are responsible for preparing the internal valuations. Typically, they use the Income Approach and make value estimates based on both discounted cash flow analysis and direct capitalization analysis.

They support these valuation estimates with analysis based on the sales comparison method. (Occasionally, the sales comparison method may be the primary indicator of value, and the income method used as support.)

When they undertake income analysis, most investment managers rely on the discounted cash flow analysis because of its flexibility and because it is commonly used by buyers of institutional-quality real estate. The direct capitalization method is acceptable in certain circumstances (such as when the property being valued has a stabilized occupancy, a bond-like income stream, and minimal competition).

The written policy for the preparation and updating of internal valuations should focus on critical market observations and assumptions as they affect the market value of the real estate. It should include a process to review the previous valuation and/or appraisal market observations and assumptions. If any changes have occurred in the observations or assumptions, the investment manager should explain, in writing, what caused the changes.

The investment committee or some other senior peer review board should sign off on all valuations. Their review should be documented in writing and signed by the responsible reviewing parties. Exhibit 6 is a sample checklist for an internal valuation model.

Timing Of Appraisals/Valuations


It is recommended that a pension plan carefully consider how often it wants its real estate assets to be valued. Internal valuations should certainly be done annually, possibly quarterly. An external appraisal should be done every one or two years and certainly after the lapse of three years.

TRUSTEES' FIDUCIARY RESPONSIBILITIES

Past performance does not predict future results. However, if either the trustees or the investment manager have breached their fiduciary responsibilities, a comparison of current and past performances may enable observers to determine the extent of consequential damages. For this reason, the DOL has been examining the performance of trusts' real estate portfolios to determine whether the performance of investments that did not meet expectations was the result of market conditions or of the trustees' failure to comply with ERISA's Section 404. This section, sometimes called ERISA's Golden Rule, identifies the following fiduciary obligations:

Loyalty. Acting solely for the exclusive benefit of the plan.
Prudence. Acting with the skill, care, and diligence of persons in like circumstances.
Diversification. Diversifying the plan assets.
Effectuation. Acting in accordance with plan documents.
The DOL emphasizes that prudence and diversification are the most powerful of the four obligations for mitigating risk and liability. The rule concerning prudence states:


The Manager must act with the care, skill, prudence, and diligence under the circumstance then prevailing that the prudent man, acting in a like capacity and familiar with such matters, should use in the conduct of an enterprise of a like character and with like aims.

Required diversification varies with varying portfolio conditions. Diversification varies with the purpose of the plan, the amount of plan assets, and financial and economic conditions. Plans diversify by type of investment, geographical regions, industry (or property type), and holding period (term to investment maturity).

Real estate holdings diversify a stock and bond portfolio. Additionally, if the real estate itself is properly diversified by property type, geographical region, and opportunity class, the portfolio can provide excellent diversification within its own class.

The fact that the trustees and manager follow the four fiduciary duties to the letter cannot always safeguard against poor performance. However, the investment manager should usually be able to achieve at least average performance through the proper use of diversification within the asset class.

INVESTMENT ACCOUNT OPERATIONS

The other current review targets of the DOL are the operations of the real estate investment accounts and compliance with the governing agreements and guidelines. To guard against possible technical violations, the trustees should periodically assess their compliance with the investment management agreement and with the investment guidelines between the investment manager and pension plan (the Agreements), particularly provisions relating to adviser fees, distributions, and withdrawals. In addition to examining compliance with the Agreements, the DOL is also examining issues in the areas of:

Property management
The manager's use of affiliates
Property Management

The DOL is concerned about the quality of the manager of the assets on a day-to-day basis and regarding what guidelines are in place to govern those management activities. The investment management agreement and investment guidelines obviously provide the basic rules of governance, but the DOL is interested in day-to-day rules and relationships. It asks, for example, the following:

Who approves a lease and under what conditions?
How is a prospective tenant's credit rating evaluated and deemed acceptable?
How is a service provider selected?
What are the annual budgeting criteria?
How are capital dollars expended?
Who approves the use of outside vendors?
What method is in place to control cash disbursements?
What is the timing of the property management reports?
The best way to answer these questions is with written policies and procedural statements concerning the management of the real estate assets by the investment manager. These rules should have been reviewed and approved by the trustees.

Use Of Affiliates

The DOL prefers that investment managers avoid using affiliates to provide services for the plan assets. If a manager must employ an affiliate, the transaction should be extensively documented to demonstrate that the transaction was undertaken at "arms length" and at market prices. Trustees must be aware when an investment manager plans to use affiliates, under what circumstances and to the extent affiliates will be used, what controls the manager will impose on the fees, how it will monitor the affiliate's work efforts, and how it will evaluate the progress of the work.

Prohibited Transactions

ERISA Section 406 (29 USC § 1106) and Code Section 4975(c) list a number of "prohibited transactions." These are either transactions between a plan and a party-in-interest or specific conflict-of-interest transactions involving the fiduciary of the plan. The broad categories of prohibited party-in-interest transactions include the following:

Sales, exchanges, or leases of property between a plan and a party-in-interest.
Loans and other extensions of credit between a plan and a party-in-interest.
Provision of goods, services, or facilities between a plan and a party-in-interest.
A transfer of plan assets to a party-in-interest or a use of plan assets by or for the benefit of a party-in-interest.
Dealing with a party-in-interest to the plan is a gross breach of fiduciary duty and is to be avoided at all costs. The pension plan's investment guidelines must articulate clearly that prohibited transactions must and will be avoided and must describe how they will be identified and avoided.

The trustees of the plan are personally liable for party-in-interest violations unless the transaction falls within a class exemption. One of the most useful exemptions is PTCE 84-14, the qualified professional asset manager (QPAM) exemption. This exemption states that an investment manager that is a bank, insurance company, or registered investment adviser may negotiate the terms of an investment and determine whether a plan may enter into a transaction that is otherwise prohibited.

The rule specifies several conditions designed to ensure that the QPAM is independent of the plan and its party-in-interest. The exemption is not available if the plan represents more than 20% of the assets that the QPAM manages. There is no exemption if the party-in-interest has the ability to hire or fire the QPAM, to negotiate the QPAM's fees, or if it has done so within the past 12 months.

CONCLUSION

The trustees of a pension plan can operate relatively free of fear of a DOL audit if they follow the easy rules outlined in this article. They must create documents that govern the investment management relationship with the plan and make sure that the investment manager complies with those documents and with the various laws and regulations of ERISA. Beyond this compliance, it is critical that the plan maintain records to support the prudence and reasonableness of all investment actions and recommendations. All of the touchstones discussed in this article provide a further benefit - an economic one - because it is likely to result in fewer underperforming or nonperforming real estate investments and higher overall investment returns to fund future benefits of the plan.


NOTES 1.
ERISA is primarily codified at 29 USC § 1001 et seq. And, in the Internal Revenue Code of 1986, as amended. While governmental pension plans are not covered by ERISA, the trustee of governmental pension plans should follow the procedural and substantive touch-stones outlined in this article.
Stanley L. Iezman, Esq. is the President and Chief Executive Officer and Scott W. Darling, Esq., is the Director of Portfolio Management of American Realty Advisors, an investment manager and QPAM under ERISA and a registered investment advisor with the Securities and Exchange Commission, that currently manages almost $1 billion in real estate investments for domestic pension plans. Mr. Iezman is also an adjunct professor of real estate asset management at the University of Southern California’s School of Policy, Planning, and Development Lusk Center for Real Estate Development. American Realty Advisors is located in Glendale, California (818/545-1152).

 

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