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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