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Trust Examination Manual
Advisory Opinion 2005-09A
May 11, 2005
ERISA Sec. 408(b)(8)
Donald J. Myers, Esq.
Reed Smith LLP
1301 K Street, NW, Suite 1100 East Tower
Washington, DC 20005-3373
Dear Mr. Myers:
This is in response to your request for an advisory opinion on behalf of Vanguard Fiduciary Trust Company (Vanguard) concerning the application of section 408(b)(8) of the Employee Retirement Income Security Act of 1974, as amended (ERISA), and the parallel provisions under section 4975(d)(8) of the Internal Revenue Code of 1986, as amended (the Code),(1) to an in-kind investment in a bank collective investment fund, as made under the circumstances described herein.
You represent that Vanguard is a trust company, based in Valley Forge, Pennsylvania, that is organized under the laws applicable to such entities under the Pennsylvania Banking Code. Vanguard is supervised by the Pennsylvania Department of Banking. Vanguard is a wholly-owned subsidiary of The Vanguard Group, Inc. (Vanguard Group).
The Vanguard Group manages assets through registered open-end investment companies, pursuant to the Investment Company Act of 1940 (i.e., mutual funds). Vanguard manages assets held in collective trust funds for employee benefit plans covered by ERISA. You state that many Vanguard Group mutual funds and Vanguard trust funds serve as investment options for participant-directed individual account plans, organized to comply with section 401(k) of the Code (“401(k) plans”), and as investments for other qualified retirement plans.
Vanguard structures stable value investment options, designed to allow investors to receive current interest income and preserve principal amounts, for many 401(k) plans either using a commingled trust, or as a separately managed account for a particular plan. You state that over 900 plans use the commingled trust structure, and approximately 40 are using the stable value separate account structure (referred to collectively herein as “stable value portfolios”).
The commingled trust structure uses a collective investment vehicle, the VRST Master Trust. Plans do not hold interests directly in the VRST Master Trust, but instead invest in one of seven “feeder” trusts – the Retirement Savings Trusts – that invest all of their assets in the VRST Master Trust. Investment management fees are imposed at the “feeder” trust level.
The commingled trusts used by Vanguard take the form of collective investment funds intended to qualify as group trusts, pursuant to Revenue Ruling 81-100, 1981-1 C.B. 326, and Revenue Ruling 2004-67, 2004-28 I.R.B., that are tax exempt under section 401 and 501(a) of the Code. Vanguard serves as trustee for such commingled trusts.
Plans pay fees to Vanguard only at the level of the stable value investment portfolio in which the plan directly invests. This is the level of the separately managed account or, with respect to the VRST Master Trust, the “feeder” trust level.
Vanguard’s stable value portfolios (i.e., the commingled trusts or the separately managed accounts) currently invest in, among other things, a series of fixed-income commingled trusts, the Vanguard Targeted Return Trusts (the TRTs). The TRTs were established quarterly on a rolling basis, each with a 5-year term, and managed to a constantly decreasing duration to provide liquidity at the end of the 5-year term. At any one time, there would be 20 TRTs in existence with durations ranging from one quarter of a year to 5 years. Each quarter, one TRT would expire and a new one would be created. The stable value portfolios managed by Vanguard, including the VRST Master Trust, have invested in the various TRTs based on their available cash, other investments and liquidity needs. The VRST Master Trust holds the majority of the assets of each TRT.
You state that Vanguard created the TRTs as stable value portfolios with high-quality fixed income securities with fixed maturity dates. These securities were then backed by “wrap” contracts with insurance companies or banks to provide for certain disbursements to be made at the “book” value of the assets, rather than the market value. This structure is commonly referred to as a “synthetic” guaranteed investment contract arrangement.
You represent that for various reasons related to investment management strategies and cost efficiencies, Vanguard has begun to phase out the TRT program. As the existing TRTs mature, they are being replaced by investments in two commingled trusts of comparable aggregate duration – the Vanguard Intermediate-Term Bond Trust (ITBT), and the Vanguard Short-Term Bond Trust (STBT). These trusts (collectively, the Bond Trusts), like the TRTs, invest principally in high-quality fixed-income securities.
As a means of transitioning to the new investment management structure, and more quickly realizing the efficiencies and other benefits of managing assets through the Bond Trusts rather than the existing TRTs, Vanguard would like to transfer the assets of the TRTs in-kind to the Bond Trusts as soon as possible, and then terminate the TRTs.
Specifically, TRT securities would be allocated to the Bond Trusts based on the TRTs’ average durations. Each TRT would receive in return interests in the applicable Bond Trust – i.e., the STBT or ITBT – that are equal in value to the value of the securities it transferred to the respective Bond Trust. The same business day, the TRT would distribute those Bond Trust interests to each stable value portfolio that holds interests in the TRT, in proportion to the portfolio’s TRT interests, and then terminate. At the end of the business day, each stable value portfolio would hold Bond Trust interests equal in value to its former TRT interests.
The principal advantage of liquidating the TRTs through in-kind exchanges of securities for interests in the Bond Trusts, as opposed to liquidations for cash on the open market, would be to avoid transaction costs. The total transaction cost estimates are in the range of $5.4 million as existing TRTs have securities with an estimated market value of approximately $3.4 billion. In addition, Vanguard seeks to avoid the possibility of the Bond Trusts not acquiring the same securities on the open market that are sold by the TRTs.
You represent that the trust documents for the TRTs and the Bond Trusts provide the necessary authority for Vanguard to cause the TRTs to make an in-kind investment in the Bond Trusts. You state that the TRTs, by their terms, permit investment in a collective investment fund maintained by the trustee of the TRTs (i.e., Vanguard), where the fund invests principally in securities of the type in which the TRT is permitted to invest. Specifically, Article 6.1(a) of each TRT gives the trustee the authority, in its sole discretion, “to invest and reinvest the Trust in such investments and other property, without restrictions to investments authorized for fiduciaries, as the Trustee determines in accordance with the Trust’s investment objective as set forth in Article 1.2 …, including, without limitation, (i) any other collective investment trust maintained by the Trustee…”
Your represent further that the trust documents for the Bond Trusts permit investment by any common, collective or commingled trust fund or group trust that consists solely of the assets of pension, profit-sharing and other qualified plans, and/or other types of retirement plans or vehicles holding retirement plan assets. Under Article 1.02 of the STBT and Article 2.2 of the ITBT, an investment in units of the respective Trust may be made in the form of cash, or in the form of other property acceptable to the trustee.
For purposes of the in-kind investments by the TRTs in the Bond Trusts, you state that the assets being transferred would be valued in a consistent manner by both the investing and receiving trusts, using independent pricing sources.
Specifically, for valuing fixed-income securities, Vanguard uses the same pricing services for both the TRTs and the Bond Trusts. Where none of the pricing services used makes a value available for a particular security, or where there has been a significant change in value of the security from the previous price used (i.e., greater than 1%), Vanguard will obtain quotations from three (3) different independent brokers, and will use the lowest of the three available quotes. You state that pricing services and broker quotations are not used for short-term instruments maturing within 60 days. Thus, pursuant to the trust document’s valuation provisions, these instruments would be valued at cost (plus or minus any amortized discount or premium). All valuations would be made as of 3:00 p.m. Eastern Time on the valuation date.
Vanguard serves as trustee of both the TRTs and the Bond Trusts – all of which, as bank collective investment funds, are deemed to hold “plan assets” subject to ERISA pursuant to the Department’s regulations (see 29 CFR §2510.3-101(h)(1)(ii)). For this reason, you state that Vanguard would find itself acting in a discretionary role on both sides of any transaction between the TRTs and the Bond Trusts. Thus, the in-kind investment by the TRTs in the Bond Trusts could be viewed as a sale by the TRTs of their securities to the Bond Trusts, with Vanguard, in its capacity as trustee, acting in the role of both the buyer and the seller.
Advisory Opinion Requested
You request an opinion as to whether a purchase of interests in a collective investment fund through an in-kind investment of securities would be exempt from the prohibited transaction provisions of section 406 of ERISA by reason of the statutory exemption contained in section 408(b)(8) of ERISA.
Relevant Provisions of ERISA and Analysis
Section 406(a)(1) of ERISA provides, in part, that a fiduciary with respect to a plan shall not cause the plan to engage in certain direct or indirect transactions with a party in interest, including sales or exchanges of property between the plan and a party in interest (section 406(a)(1)(A)), and transfers to or use by or for the benefit of a party in interest of any assets of the plan (section 406(a)(1)(D)).
Section 406(b)(1) of ERISA prohibits a fiduciary with respect to a plan from dealing with the assets of the plan in his or her own interest or for his or her own account. Section 406(b)(2) of ERISA provides that a fiduciary shall not in his or her individual or in any other capacity act in any transaction involving the plan on behalf of a party (or represent a party) whose interests are adverse to the interests of the plan or the interests of its participants or beneficiaries.
Section 3(21) of ERISA defines a “fiduciary” of a plan to include a person who exercises any discretionary authority or control respecting management or disposition of its assets; or who renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of the plan, or has any authority or responsibility to do so.
Section 3(14) of ERISA defines the term “party in interest” to include a fiduciary and a person providing services to a plan.
The Department’s regulation at 29 CFR §2510.3-101 defines what are considered to be “plan assets” when a plan invests in another entity. The regulation provides, at 29 CFR §2510.3-101(h)(1)(ii), that when a plan acquires an interest in a common or collective trust fund of a bank, its assets include its investment as well as an undivided interest in each of the fund’s underlying assets.
As you have acknowledged, Vanguard is a fiduciary under section 3(21) of ERISA with respect to ERISA-covered plans for which it serves as trustee. Pursuant to the Department’s regulations defining “plan assets” (as noted above), Vanguard is also a fiduciary for ERISA-covered plans that invest in the TRTs, either through separately managed accounts or commingled trusts, by reason of its discretionary authority and control over such assets. You indicate that Vanguard receives investment management fees from plans that invest in such accounts or trusts invested in the TRTs, at either the separate account or “feeder” trust level, as applicable.
Therefore, unless an exemption applies, you are concerned that Vanguard would violate sections 406(a)(1)(A), 406(a)(1)(D), 406(b)(1), and 406(b)(2) of ERISA if, as a fiduciary of ERISA-covered plans, it caused “plan assets” invested in the TRTs to be invested in the Bond Trusts.
Section 408(b)(8) of ERISA exempts, in pertinent part, any transaction between a plan and a common or collective trust fund maintained by a party in interest which is a bank or trust company supervised by a state or federal agency, if the following conditions are met:
the transaction is a sale or purchase of an interest in the fund,
the bank or trust company receives not more than reasonable compensation, and