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
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.
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:
Investment managers, and
Most recent prospectus;
Information on how participants give instructions to invest
their accounts, including making transfers and exercising voting and
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
Investment management fees,
Prospectuses, financial statements and other reports for each of
the plan's investment options;
List of the underlying assets comprising each portfolio or
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
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.
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
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.
The information contained in this newsletter is
intended to provide general information on matters of interest in the
area of qualified retirement plans and is distributed with the
understanding that the publisher and distributor are not rendering
legal, tax or other professional advice. You should not act or rely on
any information in this newsletter without first seeking the advice of
a qualified tax advisor such as an attorney or CPA.