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Self-directed Investment Options in 401(k) Plans: Legal and Fiduciary Issues

What is a Self-Directed Option?

As an extension of the continuing trend toward expanded participant investment options in 401(k) and other defined contribution retirement plans, investment providers are marketing an option that provides participants access to brokerage accounts, from which they may elect to invest in a broad array of investment vehicles. These arrangements are generally referred to as brokerage windows or self-directed options ("SDOs").

If an SDO is adopted, a plan participant is allowed to transfer money from the plan's regular menu of investment funds to a brokerage's money market account. From that money market account, the participant then may choose to invest in any of the investment options available under the particular brokerage arrangement agreed upon between the plan's sponsor and the investment company (or companies). As a rule, investment fees in the SDO are the same as those charged for an individual retail investor-in other words, the fees are most often higher than the fees negotiated by the plan sponsor for the regular menu of funds.

What types of investments may be made available through an SDO?

Some of those marketing SDOs and some employees lobbying for them suggest that there should or need not be any particular restrictions on the types of investments that would be available by way of an SDO. This is incorrect as a policy and legal matter.

For the employee who says "this is my money and I should be able to invest it however I want," the response is that there are important distinctions between money in an employer-sponsored retirement plan-including the money contributed by the employee-and personal investments made with take-home pay.

If not for special tax rules enacted by Congress for employer plans, the value of an employee's plan account would be taxable to the employee as soon as it vested. Instead, if an employer plan satisfies the requirements of the Income Tax Code and ERISA, income tax is deferred on the contributions (except for employee after-tax contributions) and earnings until the payout date. These special tax benefits are provided by law to encourage employer-sponsored retirement plans. But in exchange for these tax benefits, plans must be designed to serve the public policies of ERISA. In particular, the primary public policy of ERISA is to ensure that employees have adequate retirement savings. Not surprisingly, then, an ERISA plan must be designed to minimize the risks of large investment losses. The employee has a choice, then: invest within a restricted universe using tax-deferred funds or invest within an unrestricted universe using after-tax dollars and paying tax on earnings currently.

Specific legal prohibitions and fiduciary rules impose a number of restrictions on the types of investments that may be offered through an SDO. These rules are discussed below in detail.

Background on ERISA section 404(c)

Most employer 401(k) plans and other defined contribution individual account plans are intended to be ERISA section 404(c) plans. Under section 404(c) of ERISA, if a plan provides for individual accounts and permits a participant to exercise control of the assets in his or her account, then the plan's fiduciaries may not be not liable "for any loss, or by reason of any breach, which results from such participant's, or beneficiary's exercise of control." To satisfy section 404(c), a plan must comply with detailed regulations about the characteristics of at least three "core" investment alternatives that must be offered and about investment rights and information that must be provided.

Many articles have been written about section 404(c) and I do not propose to go into detail on that subject in this article. Instead, I will assume that the plan for which an SDO is being considered does, in fact, comply with section 404(c). However, it is important to keep in mind that it is the Department of Labor's position that compliance is determined on a case-by-case basis and that any person claiming relief from liability under section 404(c) "will have the burden of proving that the conditions of section 404(c) and any regulation thereunder have been met."1

Potential liabilities associated with an unrestricted SDO

Although ERISA section 404(c) is itself worded broadly, the legislative history and regulations make it clear that the plan fiduciaries of a section 404(c) plan still retain significant fiduciary and other duties and liabilities 2 that restrict the range of investments that should be permitted under an SDO. In addition, certain Internal Revenue Code rules and other legal rules and practical considerations make restrictions advisable. These liabilities, duties and advisable restrictions are generally described in greater detail in this article, but they are first summarized below:

  • To avoid a breach of fiduciary duty by the plan sponsor, no investment should be permitted that would cause the plan to hold assets with "indicia of ownership" outside the jurisdiction of the federal district courts of the United States;
  • To avoid a breach of fiduciary duty by the plan sponsor, no investment should be permitted that is not permitted by the plan document or that would jeopardize the plan's tax qualified status;
  • To avoid a breach of fiduciary duty by the plan sponsor, no investment transaction should be permitted that could result in the loss of an amount greater than a participant's account balance;
  • To avoid breaches of fiduciary duty by the plan sponsor and other persons related to the plan, and the imposition of excise taxes on these persons, no investment should be permitted that would result in a "prohibited transaction" or that would greatly increase the difficulty of compliance with the "prohibited transaction" rules;
  • To avoid potential problems with distributions and IRA rollovers, no investment should be permitted if it is illiquid or not permitted for IRAs; and
  • The plan sponsor may want to prohibit investments that would generate unrelated business taxable income ("UBTI") for the plan.

Prudence in fund selection and retention

Compliance with section 404(c) only shields the plan fiduciaries from any loss or any breach that results from the plan participant's exercise of control over the assets in his or her account. The regulations point out that it is necessary to determine, in any particular case, whether a loss or breach actually resulted from a participant's investment decision, and state that relief for fiduciaries is available only if the loss or breach is the "direct and necessary" result of the participant's exercise of control.

In the Preamble to the section 404(c) regulations, the Department of Labor "points out that the act of limiting or designating investment options which are intended to constitute all or part of the investment universe of an ERISA 404(c) plan is a fiduciary function which, whether achieved through fiduciary designation or express plan language, is not a direct or necessary result of any participant direction of such plan." Therefore, "the plan fiduciary has a fiduciary obligation to prudently select such vehicles, as well as a residual fiduciary obligation to periodically evaluate the performance of such vehicles to determine, based on that evaluation, whether the vehicles should continue to be available as participant investment options."

While the Preamble language makes it clear that any choices the plan sponsor makes in designating investment options must be prudent (and the retention of those choices must also be prudent), it leaves unclear whether the prudent fund selection/retention duties are inapplicable if the plan sponsor places no limits on the investment universe of a section 404(c) plan. To date, no regulations or rulings address this point. It seems highly unlikely, however, that a plan sponsor could duck one of the most fundamental fiduciary duties in ERISA-the duty of prudent investment-by the simple expedient of making the inherently imprudent decision to place no restrictions whatever on the investment vehicles a participant may choose. In any event, as is explained further in this article, there is no doubt that the plan sponsor will want to place some restrictions on investment vehicles offered through an SDO. That being the case, the Preamble compels the conclusion that the fiduciary duties of prudent selection and retention of investment vehicles will apply to the SDO.

This conclusion immediately leads to the question: how is it is possible to fulfill this fiduciary duty if a very large universe of investments is offered through an SDO? This question also has yet to be answered in any regulations or rulings. A good argument can be made that the fiduciary duty applies to the selection of the SDO, not to the individual investments available through the SDO. The argument would be that the same standard should apply as applies under old trust law cases, since the law of trusts is supposed to apply under ERISA. Under old trust law cases, a trustee's prudence is judged on the entire portfolio, not on each individual investment, standing alone. That sort of analysis makes sense for SDOs, because a participant may well choose an investment that is a counterbalance to another investment and only makes good investment sense when viewed in the context of the entire portfolio. If this analysis applies, the sponsor would be required to make a prudent selection of SDO provider, carefully design the SDO with that provider and monitor the operation of the SDO to ensure that it operates as it is designed.

Even if the fiduciary duty of prudent investment selection applies to the individual investments available through the window, it would not be impossible to meet. The prudent-investor duty does not require that the fiduciary select the absolute best investments, but the fiduciary should be sufficiently knowledgeable about investments to make the types of choices that a prudent investment expert would make. As a practical matter, this would mean that the universe of SDO investment vehicles should be defined and limited. That would still mean that hundreds, or even thousands, of vehicles could be available, so long as they all satisfy specified criteria, such as one would normally find in a plan's investment policy. And the fiduciary would have to have a system to permit it to conduct periodic reviews to ensure that it eliminates investment options that do not meet these criteria or that fail to satisfy the investment performance standards of a prudent investment policy.

The following is a detailed discussion of the principal types of investments that should not or must not be offered through an SDO.

Avoid fiduciary liability for maintaining the indicia of ownership of assets outside the United States

ERISA section 404(b) provides that it is a breach of fiduciary duty for a fiduciary to maintain the indicia of ownership of any plan outside the jurisdiction of the district courts of the United States. The regulations under ERISA section 404(c) provide that the requirements of section 404(b) continue to apply to a section 404(c) plan.

Congress enacted ERISA section 404(b) to protect plan participants against "runaway assets." It is fairly easy to imagine how a runaway asset problem could occur in an unrestricted SDO environment. Some business commentators have identified the Russian Republic as a hot business market, but one with risks because of the transition from communism to capitalism and widespread "gangsterism" in Russian society. A participant might invest in Russian business and might lose all or some of the investment because of illegal activity or for some other reason. If the "indicia of ownership" of the investment are not maintained within U.S. jurisdiction, then the participant could claim that it was a breach of fiduciary duty for the plan sponsor to permit the investment. In that case, the sponsor could be required to make up the losses, pay a civil penalty and incur liability for other equitable remedies.

In light of the fact that no ERISA section 404(c) protection is available to the plan sponsor in case of a violation of the "indicia of ownership" rule, the sponsor would want to ensure that no participant could direct his or her account to an investment that does not comply with section 404(b).3

Avoid fiduciary liability for making available investments not permitted by the plan document or that would jeopardize the plan's tax qualified status

ERISA section 404(c) protection is not available with respect to any instruction to invest in a vehicle that is not permitted by the plan document or that would jeopardize the plan's tax qualified status. Appropriate plan drafting could ensure that the plan-document issue does not arise. The sponsor would, however, want to ensure that any SDO does not permit investment in any vehicle that would jeopardize the plan's tax qualified status, such as a vehicle that has a high minimum investment amount requirement (such that it would cause the plan to fail the qualification requirement that rights under a plan be available on a nondiscriminatory basis).

Avoid fiduciary liability for permitting investment in a vehicle that could result in a loss in excess of a participant's account balance

ERISA section 404(c) protection is not available with respect to any investment instruction that could result in a loss in excess of the participant's account balance. 4 If the plan included an SDO, the sponsor would want to ensure that the participant is not able to invest in margin arrangements, commodities contracts, short selling and any other investments with a loss potential in excess of the participant's account value.

Avoid prohibited transactions

ERISA section 404(c) protection is not available for any investment instruction that would result in a direct or indirect:

  • Loan to the plan sponsor or any of its affiliates;
  • Acquisition or sale of real property that is leased to an employer of employees covered by the plan (or to an affiliate of the employer);
  • Acquisition of any employer security that is not a qualifying employer security (such as sponsor common stock); or
  • Sale, exchange or lease of property between the plan and the plan sponsor or any of its affiliates (other than the purchase or sale of a qualifying employer security or the acquisition or disposition of an interest in an investment fund managed by the plan sponsor or any of its affiliates).

To avoid potential fiduciary liability, the sponsor would want to ensure that the SDO would not permit a participant to make an investment that would run afoul of these rules.

In addition, regardless of whether an investment is problematic under the above rules, if it constitutes a prohibited transaction under the Internal Revenue Code rules, then the sponsor could be subject to prohibited transaction excise taxes.5 The Code prohibited transaction rules are similar to those listed above, but they include transactions between the plan and any fiduciary, the plan sponsor, an employee organization whose members participate in the plan and any person providing services to the plan, as well as some related persons (collectively, "disqualified persons"), and also include the following transactions:

  • Furnishing of goods, services or facilities between a plan and a disqualified person;
  • Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
  • An act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account; or
  • Receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

Because of the so-called "plan asset" rules, adding an SDO can greatly increase the possibility that inadvertent prohibited transactions can occur under either ERISA, the Code or both. Under the plan asset regulations, 6 when a plan invests in an entity by purchasing a publicly-offered security registered under specified provisions of the Securities Exchange Act of 1934 or a security issued by an investment company registered under the Investment Company Act of 1940, the plan's assets are considered to consist of an interest in the entity, not in any of the underlying assets of the entity. If, however, the plan invests in other types of investments (which we will refer to as "nonregistered investments"), the general rule is that the plan is considered to invest also in the underlying assets, unless the nonregistered investment qualifies for exemption as an "operating company" or because equity participation in the nonregistered investment by benefit plan investors is "not significant." 7

This plan asset "look through" rule generally causes the managers of the look-through investment entity to become ERISA fiduciaries, and transactions involving the entity's assets to be subject to the prohibited transaction rules. For example, assume that a participant uses the SDO to purchase an interest in a real estate investment partnership that is not a registered investment, does not qualify as an "operating company" and in which investment by benefit plan investors does not satisfy the "not significant" test. The plan would be deemed to hold, not only a partnership interest, but also an interest in all of the underlying assets of the partnership. If it happened that the real estate investment partnership had an interest in real estate leased by the plan sponsor, the plan could have engaged in a prohibited transaction: the acquisition of real property leased by the plan sponsor.

Because of the complexities of the prohibited transaction rules, and the near impossibility of policing compliance if the plan holds nonregistered and nonexempt investments, the plan sponsor would want to ensure that the SDO only permitted participants to invest in registered investments and nonregistered investments that satisfy one of the exemptions that avoid the "look through" rule.

Avoid illiquid investments and investments not permitted by IRAs

Most plan distributions are made in cash or a combination of cash and sponsor stock. Thus, the distributions generally involve converting plan investments other than sponsor stock to cash. Despite this conversion requirement, most plans today can process distributions for payment on the same day that the distribution election is made. If an SDO is added to the plan, investments in the brokerage account would also have to be converted to cash and pushed back through the SDO window to the trustee for distribution. Usually, when a participant has an SDO through which s/he has invested only in mutual funds, it takes one or two extra processing days to convert the investment to cash and process the distribution. But if the SDO permits investment in a broader range of investments than mutual funds, the conversion may take even longer and may be problematic. If the investment is illiquid, how can it be converted to cash for distribution? What if a minimum required distribution must be made by the plan administrator, but assets cannot be converted to cash to make the legally required distribution? What if there is a substantial penalty for withdrawal or conversion? The sponsor may wish to establish investment guidelines that will ensure that any SDO does not permit illiquid investments or investments that impose substantial withdrawal penalties.

The sponsor should also consider the employee relations issues that may arise of the plan requires that all distributions be made in cash and/or company stock. Participants using an SDO may demand the ability to have SDO investments distributed in kind, which may increase the plan's administrative burden.

IRAs are not permitted to invest in life insurance contracts or "collectibles." 8 If these investments were permitted under an SDO, and rolled over in kind to an IRA, the rollover would be ineffective and would be considered a taxable distribution (at least as to the assets that may not be held by an IRA). If the plan permits, or may in the future permit, in-kind distributions of any investments other than company stock, the sponsor may wish to ensure that the SDO does not permit investment in life insurance contracts or collectibles.

Consider avoiding UBTI

Some investments, such as certain partnership investments, generate unrelated business taxable income under the Code, which would require the normally nontaxable trust to pay some income tax. It is legally permitted for a plan to have UBTI, but before investing in an UBTI-generating vehicle, the fiduciary should consider whether the after-tax return compares favorably with the before-tax return on more conventional investment vehicles. Since the nature of the SDO makes it impracticable for the sponsor to engage in this assessment, there is some question whether UBTI-generating investments ought to be permitted at all. If such investments were under consideration, the sponsor would also want to take into account the income-tax return and payment obligations that the plan may incur. These income tax obligations alone make most employee benefit plans reluctant to invest in vehicles that generate UBTI.

Other considerations

  • In order to maintain the plan's section 404(c) status, administrative procedures would have to be put in place to ensure that the information required to be provided to participants automatically and upon demand will be provided with respect to investments accessed through the SDO.
  • If participants are able to purchase sponsor securities through the SDO, SEC section 16 insider trading reporting and short-swing profits rules will come into play.
  • Administrative systems will be necessary to ensure that investments through the SDO are reported accurately and in a timely manner on the plan's recordkeeping system. These systems must also provide enough data for the designated party to ensure that information about the SDO is properly reflected on Form 5500 annual reports.
  • Plan assets are legally required to be valued at least annually. Only investments capable of proper valuation should be permitted and systems for ensuring that valuations are timely made must be put in place.
  • Additional participant disclosure and education may be necessary if the plan includes an SDO. It would be particularly important to convey information about risk factors and fee structures.
  • The sponsor should carefully negotiate an appropriate form of agreement with the SDO provider. In particular, the sponsor should ensure that the provider is liable for all consequences of any failure to satisfy the agreed-upon limitations on permitted investment vehicles and that the sponsor has the right to audit the operation of the SDO.
  • If an SDO is adopted, the sponsor must prepare plan amendments and revised communications concerning the SDO, including the different cost structure, the effect on the timing of plan transactions and any other relevant matters. If the plan is subject to the SEC prospectus requirement, then the plan prospectus must be updated and delivered in advance of implementation.
  • The sponsor should determine whether this arrangement will increase its fees for recordkeeping and other administrative services and or increase the cost of the plan's annual audit or inhibit reporting, recordkeeping and valuation.
  • Determine whether any dollar threshold for establishing a brokerage account would be deemed to discriminate against nonhighly compensated employees.
  • The sponsor would have to make arrangements with the provider to ensure that sufficient information is provided to the sponsor to permit it to fulfill its fiduciary duty of prudence concerning investment selection and retention.

Footnotes

1Section I of the Preamble to Regulation section 2550.404c-1.[^ back to article text]

2Several parts of this article discuss actions that could cause a breach of fiduciary duty. Under ERISA, if a fiduciary breaches his or her duty, a plan participant, beneficiary, other fiduciary or the Secretary of Labor may bring a civil action to enjoin the act or practice that causes the breach or to obtain other appropriate equitable relief. The breaching fiduciary is liable to make good to the plan any losses resulting from the breach and to restore to the plan any profits the fiduciary may have made through use of the plan's assets by the fiduciary. In addition, the fiduciary may be required to pay a civil penalty equal to 20% of any amount recovered from the fiduciary. Excise tax penalties may also be levied in case of a breach that is also a prohibited transaction, as discussed later in this article. (See sections 409 and 502 of ERISA.) [^]

3There is a major regulation expanding on, and providing for exceptions to, ERISA section 404(b). A discussion of that regulation is beyond the scope of this article. [^]

4Regulations section 2550.404c-1(d)(2)(ii)(D). [^]

5For each prohibited transaction, there is an excise tax of 15% of the amount involved. This accelerates to 100% if the prohibited transaction is not corrected within a short period.[^]

6Regulations section 2510.3-101. These regulations apply to the prohibited transaction rules under ERISA and the Code.[^]

7Under the regulations, an "operating company" includes a "venture capital operating company" and a "real estate operating company" that complies with extensive regulatory requirements. The regulations also set forth extensive requirements for determining whether benefit plan investment in an entity is "not significant."[^]

8A "collectible" is defined in Code section 408(m) as any work of art, rug or antique, metal or gem, stamp, most coins and any alcoholic beverage. Other tangible personal property may be designated as collectibles by the Secretary of the Treasury.[^]

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