The Department of Labor issued final regulations under section 404(c) of ERISA at the end of 1992, effective for 1994 plan years. As we discussed in detail in our December, 1992 Bulletin, ERISA section 404(c) provides that if a participant or beneficiary of a plan is permitted to exercise control over the investment of assets of his or her individual plan account, and does exercise control, then any plan fiduciary who carries out the investment directions is not liable as a fiduciary or cofiduciary for any loss that may result. Now that the section 404(c) regulations are effective for calendar-year plans and soon to be effective for other plans, sponsors have questions about how and whether to comply with the detailed rules in the regulations. In this article, we address three questions we've been asked recently.
Question: My company's plan offers more than three investment funds and lets participants and beneficiaries make investment transfers quarterly (or monthly or daily). Is that enough to satisfy the 404(c) regulations?
Answer: No, but you should be about two-thirds of the way there. When the DOL issued proposed 404(c) regulations in 1991, they focused on the number of funds offered and the frequency with which participants and beneficiaries could make investment transfers. The plan had to offer participants and beneficiaries the opportunity to diversify investments across a broad range of investment alternatives, which meant a choice among at least three "core" investment alternatives, each of which was diversified, and that together offered a range of risk/return choices. The plan also had to give participants and beneficiaries the opportunity to give investment instructions with a frequency appropriate to the volatility of the investment, but at least once every three months.
After the 1991 proposed regulations were issued, most plan sponsors made sure they offered at least three diversified funds of different risk/return types and at least quarterly investment transfers. The three types of funds would generally be an equity index fund or other broad-based equity fund, a money market fund and a long-term fund of debt instruments. Often, even more funds would be offered.
When the final regulations came out, they included new and significant information requirements. The regulations list certain items of information that must be provided to participants and beneficiaries and other items of information that must be available to them. Here are checklists of each:
Mandatory Disclosure. The following items of information must actually be provided to participants and beneficiaries:
- An explanation (in an SPD or other communication) that the plan is a 404(c) plan and that plan fiduciaries thus may be relieved of liability for any investment loss that the participant or beneficiary may incur.
- A description of the investment alternatives and a description of the investment objectives and risk and return characteristics of each alternative.
- The identity of the investment manager, if relevant.
- An explanation of how investment instructions can be given and any related restrictions.
- An explanation of any restrictions on any voting or similar rights under the investment instruments.
- A description of the transaction costs affecting the participant's account in connection with the purchase or sale of interests in the investment alternatives (e.g., commissions, sales loads, deferred sales charges, and redemption or exchange fees).
- The identification of the plan fiduciary responsible for providing information on request and a description of the information that participants and beneficiaries may request.
- A description of the procedures established to provide for the confidentiality of information relating to investment in employer stock and the identification of the plan fiduciary responsible for monitoring compliance with those procedures.
- After the individual selects an investment option, the most recent prospectus. (This requirement is also satisfied if participants receive a prospectus for each investment alternative before they make an investment selection.)
- After the individual selects an investment option, material describing the ownership and voting or similar rights that the individual might have (to the extent these rights are passed through).
Disclosure Made Upon Request. In addition, the identified fiduciary must provide the following information at the request of a participant:
- A description of the annual operating expenses of each investment alternative that reduce the rate of return under the investment option and the aggregate amount of the expenses, expressed as a percent of the net asset value of the option.
- Copies of the prospectuses, financial statements and reports and other materials relating to investment alternatives, to the extent this information is provided to the plan.
- A list of the assets in each portfolio that constitute "plan assets" under ERISA and the value of the assets, and in the case of any such asset that is a fixed-rate investment contract issued by a bank, savings and loan or an insurance company (a GIC or a BIC), the name of the provider, the term of the contract and the rate or return.
- Information conveying the value of the shares/units of the investment alternative and past and current investment performance determined net of expenses.
- Information concerning the value of the investments in a participant's account.
If you've decided you want to comply with the 404(c) regulations, you may want to use these checklists to be sure you meet the information requirements in the regulations. Attorneys in our group are also available to perform 404(c) audits for clients.
Question: I think I've got a good grip on the 404(c) requirements, but I'm having a hard time deciding whether it's worth the expense and effort to make sure my company's plan is in compliance with every single 404(c) rule at all times. What benefit do I really get from having a 404(c) plan---or what's going to happen if I don't have a 404(c) plan?
Answer: That really is the ultimate question, isn't it? To answer it, first you have to step back and look at the fiduciary issues. ERISA generally requires a plan fiduciary to manage a plan with the care, skill and prudence of a prudent expert and to diversify investments so as to "minimize the risk of large losses." If a plan is a 404(c) plan, the person who is ordinarily the plan fiduciary will not be liable for losses resulting from the participant's or beneficiary's exercise of investment control.
There are significant limitations on the benefits of having a 404(c) plan. Having a 404(c) plan does not relieve the plan fiduciary of liability for the choice of investment funds offered under the plan. If the fiduciary offers funds or retains funds that a prudent expert would not offer or would discontinue, the fiduciary will be liable for resulting losses, regardless of whether the plan is a 404(c) plan. The plan fiduciaries also retain responsibility for any investments made because of a default investment that the plan provides for when the participant or beneficiary does not make an election.
Also, in order to claim section 404(c) protection, the fiduciary must prove compliance with all of the requirements of the regulations. Moreover, compliance with the 404(c) requirements is not a "safe harbor." In other words, a participant or beneficiary who brings suit will not be tossed out of court as soon as the 404(c) flag is waved.
On the other hand, even if a plan is not a 404(c) plan, the plan fiduciaries are not automatically liable for any loss incurred by a participant or beneficiary. To expose the fiduciary to risk, the loss must be caused by a fiduciary breach. Again, that means a failure to act prudently or a failure to diversify so as to minimize the risk of large losses. If the plan offers a good selection of funds across the risk/return spectrum, if each fund is internally diversified and if participants and beneficiaries are given frequent investment elections, then the plan is positioned to minimize the risk of large losses and the fiduciary's exposure is not great even if 404(c) is not satisfied in every detail.
But what if each fund is not internally diversified? That will be the case for all plans that offer company stock funds and other plans that offer niche funds with a narrow focus and high volatility. In that case, the plan fiduciary of a non-404(c) plan could be held liable if the participant chooses to invest all of his or her account in the niche fund and the fund nosedives. However, a 404(c) plan fiduciary should not be liable in these circumstances unless, of course, it was imprudent to select or retain the niche fund. The fiduciary of a plan with a niche fund should either comply with 404(c) or take other actions to reduce exposure to the diversification risk, such as designing the plan so that the participant cannot concentrate his or her investment in the niche fund.
Other plans can evaluate the costs and benefits of complying with the detailed requirements of the 404(c) regulations from a more neutral position, taking into account just how close they already are to full compliance.
Question: A lot of my company's employees just leave all of their money in the conservative, low-earning funds, which avoids short-term volatility risk, but exposes them to long-term inflation risk. Our plan offers a broad range of investment alternatives, frequent investment opportunities and information about each of the funds, but we're not sure if we've complied with all of the elements of the 404(c) regulations. Would 404(c) plan status protect the company if these employees wake up at retirement time and claim that it's the company's fault that their plan portfolio lost ground against inflation?
Answer: It's unlikely that 404(c) status will matter one way or another in this case. The section 404(c) regulations do not require a fiduciary to give participants and beneficiaries investment advice or general information about investment strategies. In litigation, the participant's effort to shift the blame for his or her plight to the company could be successful only if it could somehow be shown that it was caused by the company's breach of fiduciary duty.
Just because the company is not likely to be exposed to significant fiduciary risk does not mean that this is not a matter for legitimate concern. For a high proportion of employees in this country, a company-sponsored individual account plan is the primary source of retirement funds. For the good of employee and retiree relations purposes alone, then, the company should consider providing basic investment information to its employees. This can be done through communications in writing and other media provided by the company and third parties. For example, some companies sponsor investment seminars and we often now include information about investing for retirement in SPDs that we draft for our clients.