There’s been a strong push in the past 20 years for 401k plan sponsors to offer participant-directed plans, meaning employees direct their own investments instead of the trustees directing plan investments.
The thinking was that technological breakthroughs involving the Internet allowed workers to direct their investments easily, but more importantly, ERISA §404(c) participant-directed plans can help a plan sponsor limit their liability for sustained losses.
On paper, it’s too good to be true and there are shocking truths of which a plan sponsor may be unaware.
What is ERISA §404(c)?
As a general rule, retirement plans fiduciaries will be liable for all aspects of selection and monitoring of plan investments. It means they’re on the hook for any participant claims for any losses incurred in the plan.
Section 404(c) is an exception to that rule, but it’s a limited exception.
ERISA §404(c) applies to individual account plans such as 401k and 403b plans.
Under ERISA §404(c), fiduciaries would not be liable for any claim of a breach related to a participant’s selection of investments.
But it’s only part of the story. ERISA §404(c) isn’t all or nothing, it’s a process, and a plan sponsor that fails to diligently follow the process may not get the full blanket of protection it offers. It’s a sliding scale, and the more a plan sponsor follows a prudent fiduciary process, the more liability protection that they can get.
The ERISA §404(c) Mutual Fund Magic
Until the 1990s, most retirement plans that could offer ERISA §404(c) participant direction did not. The technology that allowed easier participant direction just wasn’t available.
But with the wide adoption of the Internet, selling of ERISA §404(c) daily-valued 401k plans were backed by mutual fund companies seeking more distribution of their products, which would raise their revenue through management fees.
It’s hardly a coincidence that mutual funds became the most popular investment of 401k investment when ERISA §404(c) participant-directed plans followed suit.
The Basic Requirements of ERISA §404(c)
Employers that fully comply with 404(c) can shift responsibility for investment losses to plan participants.
ERISA §404(c) essentially offers a “safe harbor” for plan fiduciaries involving investment losses suffered by plan participants who self-direct their investments.
To qualify for the safe harbor, plan sponsors must comply with the requirements for investment selection, plan administration, and plan/investment disclosures. One major requirement under the safe harbor is that the plan must offer a “broad range” of investment options.
This is a fairly easy requirement to meet. A broad range is defined as at least three investment alternatives. Each option must be diversified, offer risk/return characteristics different from the others, and offer diversification for a participant’s overall portfolio when combined.
Most defined contribution plans today meet this requirement. The plan must also allow participants to become informed about, and to direct. their investments. This opportunity to exercise control must allow plan participants to give reasonable investment instructions to make their elections, have an opportunity to obtain written confirmation of such instructions, and receive sufficient information to make informed investment decisions.
Participants must also be able to make changes to their investments at least quarterly.
The Problem of Investment Selection
One of the biggest problems with ERISA §404(c) is that plan sponsors neglect to deal with investment selection. They only think they need to offer a certain number of investment options for participants to choose—and that’s it.
The idea that a plan sponsor can “set it and forget it” is an absolute mistake, one that could cause major liability headaches. As a plan sponsor, investment selection is about a process. First, the sponsor needs a financial advisor to help guide them through the intricacies of dealing with investments and plan participants.
The process needs a blueprint for investment selection and that blueprint is an investment policy statement (IPS). While it’s not legally required, an IPS is a perfect tool to show why investments were selected and by what criteria they’re either retained or replaced.
An IPS is a living document and must be followed. Having an IPS and not following it is more detrimental from a liability standpoint that not having one at all.
Fees and Expenses
One of the biggest problems in dealing with investment selection is investment expenses.
Investments with high fees certainly reduce the amount a participant can save for retirement. It’s the reason for the swell of litigation against plan sponsors. Luckily fee disclosure regulations make the fees associated with investments more transparent, so it means no excuses not to be diligent.
The biggest concerns over investment expenses are:
1) high fees,
2) whether revenue sharing payments paid by the mutual fund to the third-party administrator (TPA) was a major reason for investment selection,
3) using mostly proprietary funds of one of the plan providers, and
4) using improper share classes when less expensive share classes were available.
In a nutshell, concern about investment expenses is all about making prudent decisions in selecting investment options that are reasonable in cost.
Selecting mutual funds simply because the plan provider offers them, or because the mutual fund company may help defray plan administrative costs, isn’t reasonable.
Offering Participants an Educational Hand
The last prong of ERISA §404(c) deals with a requirement that most plan sponsors also neglect.
In order to get liability protection, plan sponsors need to make sure their plan participants have access to sufficient information about each investment option so that they can make informed investment decisions.
What is “sufficient” information? The human resources director at my old law firm simply distributed Morningstar mutual fund profiles offered in the plan before I begged her to hire a financial advisor.
Most plan participants can’t make heads or tails of those reports.
The Department of Labor (DOL) clearly states in the regulations that it does not require the plan sponsor to provide investment advice to plan participants to be a §404(c) plan. However, they did go out of their way to issue an Interpretative Bulletin in 1996 that encouraged plan sponsors to offer investment education by delineating which activities fell under investment education.
A plan sponsor providing plan information, general financial and investment information, asset allocation information, and interactive investment materials would be allowed. If the DOL gives a blueprint on what investment education is, and encourages plan sponsors to offer it, plan sponsors need to provide it to plan participants in order to receive §404(c) liability protection.
Document Everything
If sponsors want the full faith and credit of ERISA §404(c) protection, they need to make sure to document everything. Not only does it mean maintaining an IPS, but it also means taking minutes for all investment decisions made for the plan.
It also means keeping records of all investment education materials given to plan participants.
I would also recommend keeping records of all participant enrollment and education meetings, including keeping an attendance sheet.
ERISA §404(c) is all about following a process, not guaranteeing a certain investment result. The way to demonstrate a process was followed is in documenting how it was done. I call it “papering the process,” and it’s incredibly important.
Ary Rosenbaum is an author and ERISA/retirement plan attorney for his firm, The Rosenbaum Law Firm P.C.
He is also the host of That 401(k) Conference, a fun and informative retirement plan conference taking place at Dodger Stadium in Los Angeles on Friday, February 22, 2019, from 9:00 am to 2:00 pm. Special guest: Steve Garvey.
Rosenbaum’s latest book, humbly titled “The Greatest 401(k) Book Sequel Ever,” is available in Kindle and paperback at Amazon.com.