It seems that
every month there are new stories in the financial press
about participants suing their employers for mismanagement
of the company 401(k) plan. While most of these suits have
been directed at larger companies, the increasing frequency
has employers of all sizes looking for ways to minimize
their liability. One way to do that is to comply with a set
of "safe-harbor" rules found in section 404(c) of ERISA.
ERISA (the Employee Retirement Income Security Act) was
passed in 1974, more than a decade before 401(k) plans came
along. Since participant-directed plans were not the norm
that they are now, many of ERISA's fiduciary rules focus on
plans in which the trustees and their advisors are
responsible for making the investment decisions and don't
necessarily translate well into the era of the modern
401(k).
One of the core principles of ERISA is that plan
fiduciaries are required to follow a prudent process in the
selection and monitoring of plan investments. They must
carry out that duty just as an expert would. If plan
sponsors and/or trustees do not have that expertise, they
must hire someone who does. But how does that change when
investment decisions are turned over to plan participants?
The short answer is "not much." Fiduciaries generally retain
the same level of responsibility for the investment
decisions made by the participants.
However, section 404(c) of ERISA creates a framework that
provides an alternative method of managing that
responsibility. In short, plan fiduciaries that follow the
checklist of requirements can achieve a measure of
protection from liability arising from participants'
imprudent investment decisions.
First, we will take a look at the basic requirements of
404(c) and then consider some of the factors to be weighed
in choosing to pursue this safe harbor.
404(c) Basic Requirements
The regulations are extremely detailed, and a quick
Google search on "ERISA 404(c)" yields more than 400,000
hits. With that said, the requirements can be distilled to
around 20 items, most of which involve providing a laundry
list of disclosures to participants. Prior to that, there
are a couple of threshold requirements that must be
satisfied.
First, participants must be given the opportunity to
direct the investment of their accounts at least quarterly
and must be able to choose from at least three options that
span a broad range of risk and return. If market volatility
dictates, it may be necessary to allow participant direction
more frequently than quarterly. Since it is commonplace for
plans to allow daily access to 20+ options from the very
conservative to the very aggressive, few plans will have
trouble meeting this requirement.
Second, plan fiduciaries must follow a prudent process to
select and monitor the investment menu that will be offered
to plan participants. This one is not quite as
straightforward and requires plan fiduciaries to remain
involved in the investment process by carefully considering
plan investment options on an ongoing basis to ensure they
remain appropriate for participants.
The participant disclosures that are required can be
broken down into two broad categories: those that must be
provided automatically and those that must be provided only
when requested.
Automatic Disclosure
- Explanation of plan's intention to comply with 404(c)
and that plan fiduciaries may be relieved of liability for
losses that directly result from participant investment
decisions;
- Description of each investment option available in the
plan:
- Objective,
- Risk/return characteristics,
- Investment managers, and
- Most recent prospectus;
- Information on how participants give instructions to
invest their accounts, including making transfers and
exercising voting and tender rights;
- Transaction fees and expenses;
- Identification of and contact information for plan
fiduciaries responsible for providing these disclosures.
Disclosure on Request
- Description of annual operating expenses for each
investment option:
- Investment management fees,
- Administrative fees,
- Transaction costs;
- Prospectuses, financial statements and other reports
for each of the plan's investment options;
- List of the underlying assets comprising each
portfolio or mutual fund;
- Performance information (past and current);
- Current share values.
I complied with 404(c), and all I
got was this lousy T-shirt
There are many opinions and a great deal of
misinformation circulating about what, exactly, plan
fiduciaries get for their efforts. These range from little
more than that lousy t-shirt all the way to a "get out of
jail free card" that provides complete immunity. The truth
lies somewhere in the middle.
Compliance with 404(c) provides fiduciaries with relief
from liability for investment losses that are the direct
result of participant investment decisions. Sounds good,
right? Well, the "catch" is in how that relief is provided.
It is not a simple matter of just claiming 404(c)
compliance; rather, it is what is referred to in legal terms
as an affirmative defense.
ERISA litigation is very complex, but generally speaking,
the party bringing the lawsuit (the plaintiff) must prove
that the plan fiduciaries breached their responsibility and
that the breach resulted in losses. The fiduciaries, on the
other hand, seek to rebut the assertions made by the
plaintiff. The plaintiffs prove; the fiduciaries rebut.
When plan fiduciaries claim a 404(c) defense, the roles
reverse. The fiduciaries must prove that they complied with
all aspects of 404(c), and the plaintiff tries to rebut that
assertion. In short, 404(c) compliance does not guarantee a
fiduciary can't or won't get sued. It just changes the
manner in which that fiduciary demonstrates he or she is not
responsible for the losses in question.
Compliance Challenges
Complying with 404(c) is not as easy as it might seem.
For starters, it is all predicated on the plan's investment
menu being prudently selected and monitored. If, for
example, a plan fiduciary followed a prudent process to
select the menu a couple of years ago but cannot show that
he has monitored the options on an ongoing basis, he is
probably on shaky ground regardless of how faithfully he has
provided all the required disclosures.
To further complicate matters, 404(c) is, in many ways,
an "all or nothing" proposition. It is possible for plan
fiduciaries to satisfy 404(c) for some participants but not
others or for only certain investment options; however, if
any single requirement is missed with regard to a
participant or account, protection is completely lost.
Consider the most recent prospectus in the Automatic
Disclosure list above. If a plan sponsor provides all other
disclosures but neglects to provide the most recent
prospectus for any of the investment options, 404(c)
protection is lost.
While the solution may seem simple—just make sure none of
the disclosures are missed—the devil is in the details. Many
employers and participants alike are accustomed to receiving
information electronically. However, the Department of Labor
(DOL) has very specific rules governing when and how
electronic disclosure is permitted in the context of
employee benefit plans. A sponsor that provides 404(c)
disclosures electronically but does not follow the DOL's
rules for doing so is deemed to have not provided the
disclosures at all.
Something as simple as using a personal e-mail account
instead of an employment-related account without proper
consent could be treated as a missed disclosure resulting in
loss of 404(c) protection.
Many recordkeepers have built systems to help plan
sponsors comply with most of ERISA 404(c)'s requirements;
however, given the potentially tenuous nature of the
protection, it is worthwhile for employers to read the fine
print in service-provider contracts to make sure they
understand which parties have responsibility for the various
aspects of compliance.
Working with a third party administrator, consultant or
investment professional who has expertise in working with
404(c) can also be a great way to identify any potential
gaps.
An Optional Safe Harbor
In some circles, there is a misperception that ERISA
mandates compliance with 404(c). The reality, however, is
that it is completely optional. Throughout the various rules
governing qualified retirement plans, there are "safe
harbor" provisions. Such provisions are generally offered as
one option to comply with a more general rule. Since safe
harbors provide some form of compliance assurance, they tend
to offer less flexibility than their non-safe-harbor
counterparts.
Take the safe harbor 401(k) plan as an example. It is
possible to maintain a 401(k) plan with no company
contributions and up to a six-year graded vesting schedule.
However, if an employer is willing to commit to make a
contribution and provide full vesting, they can get a free
pass on the ADP and ACP nondiscrimination tests.
Like the safe harbor 401(k) plan, 404(c) is also a
safe-harbor. It is a method to demonstrate compliance with
one aspect of ERISA's fiduciary rules. To the extent a plan
fiduciary prefers not to pursue this safe harbor, there is
nothing inherently illegal, unethical or otherwise imprudent
about choosing another means of demonstrating he or she has
followed a prudent process in managing plan assets.
Worth the Effort?
There are differences of opinion as to whether 404(c) is
worth the effort, and it is really a decision that each plan
fiduciary must make given their specific facts and
circumstances. Some believe allowing participants to
transfer among investments with regular frequency tends to
yield less favorable investment results; therefore, they
restrict transfers to the beginning of each year. That may
be a prudent design given the circumstances, yet it does not
satisfy 404(c)'s requirement to allow investment direction
at least quarterly.
Others take a broader perspective. Since the general rule
is that fiduciaries need to follow prudent processes when
managing plan assets, they will use 404(c) as a part of
their process rather than as the process in and of itself.
This approach has an added benefit. If a plaintiff is able
to rebut the 404(c) defense by demonstrating that the
fiduciary missed one of the checklist items, the fiduciary
can still fall back on the non-safe-harbor rule by showing
that it had documentation of having followed a prudent
process.
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