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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