A major trend in qualified
plans, particularly 401(k) plans, is participant-directed accounts, which
enable a retirement plan to give participants control over investment of
their own plan accounts. Often times, plans are structured as
participant-directed accounts to reduce company fiduciary investment
responsibility under ERISA section 404(c) provisions.
Many employers are under the misconception that if their plans permit
participants to direct the investment of their own accounts and are
designed to comply with the 404(c) safe harbor requirements, they have no
fiduciary liability. However, this is not the case, since the plan
fiduciaries are still liable for selecting and monitoring the investment
alternatives offered to the participants as well as numerous disclosure
requirements.
This misconception cost First Union $26 million when suits were filed
against it, not only because First Union limited investments to its own
proprietary funds, but also because the available funds charged higher
fees and had lower returns than comparable investments.
Fiduciary Responsibility
The Employee Retirement Income Security Act of 1974 (ERISA) imposed the
requirement that plan fiduciaries invest the assets of a qualified
retirement plan in a prudent manner with proper diversification. A plan
fiduciary is, for example, the employer sponsoring the plan, the plan
committee responsible for administering the plan or the plan’s trustee
responsible for investing and managing plan assets.
For qualified defined contribution plans, ERISA section 404(c) allows
fiduciaries to transfer investment responsibility to participants who
direct the investment of their accounts. Generally, fiduciaries are not
liable for losses resulting from the participant’s exercise of investment
control if all of the ERISA 404(c) rules are satisfied.
ERISA Section 404(c)
Under ERISA section 404(c), plan fiduciaries may be relieved of
fiduciary liability for investment choices made by the participants if the
plan satisfies certain requirements. Choosing to have a plan comply with
section 404(c) regulations is voluntary. In order to be afforded 404(c)
protection, over 20 requirements must be satisfied that fall into the
following three categories:
- Offering a broad range of investment alternatives;
- Permitting participants the ability to exercise control of their
investments; and
- Providing participants with specific information disclosures to help
them make informed investment decisions.
The limited liability protection provided by 404(c) only applies to
that portion of a participant’s account on which he exercises control. If,
for example, a 401(k) plan permits the participant to invest only that
portion of his account attributable to his own deferrals, the plan’s
fiduciaries are only granted protection for the deferrals portion of the
participant’s account. They are still liable for that portion of the
participant’s account which is attributable to employer-contributed funds,
if any, i.e., matching contributions.
Types of Investment Alternatives
Regulations require the plan to offer a broad range of investments,
consisting of at least three diversified investment alternatives ("core
investment alternatives"), each of which has materially different risk and
return characteristics. The core investment alternatives must allow a
participant, by choosing among them, to achieve a portfolio with
appropriate risk and return characteristics and diversification.
The regulations do not specify what the core investment alternatives
should be. However, the regulations make it clear that the selection and
monitoring of the core investment alternatives which are offered to
participants and beneficiaries is a fiduciary responsibility.
Not only must there be diversification within investment categories,
there must also exist diversification in the fund itself. In general, in
order to achieve the required diversification, each core investment
alternative will have to be a pooled investment fund such as mutual funds;
common or collective trust funds and deposits in fixed rate investment
contracts of banks or similar institutions; and pooled separate accounts
or fixed rate investment contracts of insurance companies.
Participant Control Over Accounts
The 404(c) regulations require that participants have the right to
direct investment changes at least once in any three-month period. For
more volatile funds, the regulations require that transfers be permitted
more frequently than once every three months.
The participant’s direction of investments must be independent, not
influenced by the plan sponsor. The plan may impose charges on the
participant’s account for reasonable expenses if the participant is
informed of the expenses.
ERISA Blackout Periods
An ERISA blackout period is a period of time that exceeds three
consecutive business days during which the participants or beneficiaries
in a qualified plan are limited or restricted from their normal right to
direct or diversify assets in their accounts or obtain plan loans or
distributions. This situation usually occurs when a plan is changing
recordkeepers or investment options.
An ERISA blackout period is required to be preceded by an advance
notice to participants. If a restriction or limitation is regularly
scheduled and was previously disclosed in writing, then it does not meet
the definition of an ERISA blackout period. In general, the plan
administrator must provide a notice to affected participants and
beneficiaries at least 30 days before the last day on which participants
may exercise their rights to process a transaction.
It is unclear whether fiduciaries have 404(c) protection during the
blackout period since the participants technically are no longer
exercising control over their accounts. Therefore, the length of a
blackout period should be as short as possible to reduce exposure to
fiduciary liability.
Disclosure Requirements
Many of the disclosure requirements imposed by the regulations are
detailed and burdensome. The summary plan description delivered to the
participant must explain that the plan is intended to constitute a plan
described in section 404(c) of ERISA, and that the fiduciaries of the plan
may be relieved of liability for any losses resulting from participant or
beneficiary investment decisions.
In addition, the participant or beneficiary must be provided with, or
have the opportunity to obtain, sufficient information to make informed
decisions with regard to investment alternatives available under the plan
as described below.
Required Disclosures
Participants are required to receive the following disclosures:
- A description of investment alternatives available under the plan, a
general description of the investment objectives and risk and return
characteristics of each of these alternatives as well as the identity of
any investment managers;
- An explanation of the rules governing investment instructions,
transaction fees and expenses affecting the participant’s account
balance;
- Immediately following an initial investment in a registered
security, a copy of the most recent prospectus provided to the plan,
unless the participant has already been provided with a copy of the most
recent prospectus immediately prior to his investment (DOL Advisory
Opinion 2003-11A permits a mutual fund summary prospectus, referred to
as a "Profile," to be provided if it is the most recent prospectus in
the plan’s possession);
- To the extent that voting rights of an investment are passed through
to participants, an explanation of the plan provisions relating to those
rights and the materials provided to the plan to exercise those rights;
and
- A description of information which may be obtained by participants
upon request (see below) and the name of the plan fiduciary responsible
for providing the information.
Disclosures Upon Request
The following information must be provided to participants either
directly or upon request:
- A description of the annual operating expenses of each core
investment alternative and the total amount of these expenses;
- Copies of prospectuses (or "Profiles" as described above) and any
other materials relating to the plan’s core investment alternatives;
- A list of the assets making up the portfolio of each core investment
alternative (for example, the assets of a fund managed for the plan);
and
- Information concerning the value of a share or unit and of the
participant’s interest in each core investment alternative as well as
the past and current investment performance of each alternative.
Special Employer Security Rules
If plans permit participants to direct investments in employer
securities, that investment alternative must be a separate fund, not one
of the three core investment alternatives. A number of restrictions and
special requirements apply, and the 404(c) protection of the regulations
only applies if the securities are publicly traded.
Common Failures
Fiduciaries are not liable for losses resulting from the participant’s
exercise of investment control unless all of the ERISA 404(c) rules are
satisfied. Some of the most common failures include:
- Failure to notify the participants that the plan is intended to
constitute an ERISA section 404(c) plan and that fiduciaries may not be
responsible for investment losses;
- Failure to identify the plan fiduciary responsible for providing
disclosure information;
- Failure to act prudently in selecting the investment alternatives
offered under the plan and/or not monitoring the performance and costs
of the investment alternatives to ensure they remain prudent;
- Failure to provide a prospectus (or Profile) immediately preceding
or following an initial investment; and
- Failure to identify the plan as intending to meet 404(c)
requirements on Form 5500.
Conclusion
In today’s litigious society, it’s not only giants like Enron and First
Union that have the potential for litigation for failure to meet fiduciary
responsibilities. Small companies can be affected as well if fiduciaries
seeking ERISA section 404(c) protection do not monitor their plans for
compliance with the long list of requirements. Fiduciaries can even be
held personally liable for investment losses.
Many plan sponsors do not fully understand the ways to comply with
section 404(c). Qualified professionals have the knowledge to assist plan
fiduciaries in complying with these many rules. To ensure that your plan
fiduciaries are protected, perhaps it’s time for your plan to have an
in-depth ERISA section 404(c) compliance audit.
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