Participant-Directed Account Liability


  • Introduction
  • Fiduciary Responsibility
  • ERISA Section 404(c)
  • Types of Investment Alternatives
  • Participant Control Over Accounts
  • Disclosure Requirements
  • Special Employer Security Rules
  • Common Failures
  • Conclusion

  • 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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