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404(c)

Relief from liability associated with participant investment decisions

Congress recognized that retirement plans might wish to extend to participants the ability to control or manage their individual accounts within the retirement plan. Accordingly, ERISA Section 404(c) addresses the liability issue as follows:

In the case of a pension plan which provides for individual accounts and permits a participant or beneficiary to exercise control over assets in his account, if a participant or beneficiary exercises control over the assets in his account (as determined under regulations of the Secretary):

  1. Such participant shall not be deemed to be a fiduciary by reasons of such exercise, and
  2. No person who is otherwise a fiduciary shall be liable under this part for any loss, or by reason of any breach, which results from such participant's, or beneficiary's exercise of control.

How necessary is 404(c)?

Should you offer participant direction without complying with 404(c)?

A Plan Fiduciary who permits a participant or beneficiary to direct the investments within their account without the statutory protection of 404(c) has the burden of proving that each and every transaction affected by participant or beneficiary was in fact prudent and reflects an expert understanding of the capital markets.

Without the protection of 404(c), investment decisions of participants and beneficiaries become the investment decisions of the Plan fiduciary. Under ERISA Section 404(a)(1) fiduciaries are bound to discharge their duties "solely in the interest of the participants" and "with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity" would use and "by diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so".

Against this standard and in hindsight, was each and every decision of the participant and beneficiary prudent? If not, the Plan fiduciary is personally liable for the losses of the participant and beneficiary. Losses will be calculated as the difference in the actual account and what the participant or beneficiary should have earned.

Safe Harbor Status?

Are there other ways to get relief and not follow the DOL's guidelines?

In its Preamble to the Final Regulations for ERISA Section 404(c) Plans, the Department of Labor stated it deliberately decided against extending Safe Harbor status to the Final Regs.

The DOL specifically stated that their decision would NOT allow "a fiduciary of a plan which fails to comport with the requirements the opportunity to argue that the particular plan and any participant directed transaction pursuant to such plan falls within the statutory definition, and, as such, should be afforded the exception to fiduciary liability described in ERISA section 404(c)."

The ONLY way to secure relief from the fiduciary liability associated with a participant's direction of their investments is to comply with ALL of the regulations issued by the DOL.

The DOL also states that "the person asserting applicability of the exception will have the burden of proving that the conditions of 404(c) and any regulations thereunder have been met."

The DOL emphasizes that statutory relief is based on a transaction by transaction basis only.

Conditions To Be Met

Complying with ERISA Section 404(c) is not impossible, but it requires diligence and significant support from your investment manager and your plan administration service company. The continuing obligation to assurance compliance with each and every transaction makes it impossible for a Human Resource Department alone to affect compliance.

–Notice

  You must tell Participants you are seeking 404(c) protection

You must notify plan participants in writing that the plan is seeking 404(c) protection and this is generally done in brief form in the Summary Plan Description (SPD) by including language similar to the following.

"This plan is intended to constitute a plan described in section 404(c) of the Employee Retirement Income Security Act, and title 29 of the Code of Federal Regulations Section 2550.404c-1, and that the fiduciaries of the plan may be relieved of liability for any losses which are the direct and necessary result of investment instructions given by such participant or beneficiary"

There are several mandatory disclosures under section 404(c) and most plan fiduciaries chose to include all of them in a single written 404(c) Notice.

Click here to access a sample 404(c) Notice covering all of the mandatory disclosures.

–Investment Options

  You need only make three options available

Generally speaking paragraph 2550.404c-1 requires that the plan "provides a participant or beneficiary an opportunity to choose, from a broad range of investment alternatives" ((b)(1)(ii)) and goes on to indicate ((b)(3)(i)(C)-1) that this can be accomplished with "at least three of the investment alternatives made available pursuant to the requirements of paragraph (b)(3)(i)(B) of this section, which constitute a broad range of investment alternatives."

The requirements of (b)(3)(i)(B) are very specific and fairly lengthy. In attempt to be brief, three options will only suffice if they have materially different risk and return characteristics, are each alone diversified, and together allow the participant to "achieve a portfolio with aggregate risk and return characteristics at any point within the range normally appropriate for the participant or beneficiary."

You can accomplish the requirements of 404(c) with just three options if you satisfy the specific portfolio construction characteristics enumerated by the DOL. This is not a simple task and requires portfolio science and investment management expertise. It should also be noted that the regulations indicate that an "option" might consist of a category of investments (like Domestic Large Cap Equity) with several investment alternatives available within that category and that more than three categories can be used to achieve the requirements for a properly constructed set of investment options.

–Frequency of trading

  How often must participants be able to make investment switches?

A plan may impose reasonable restrictions on the frequency of investment switches, but in no event less than quarterly or more frequently if the market volatility of the investment would make more frequent switching appropriate.

Additionally, if some investments on the menu allow more frequent switching then the investments included to satisfy the requirements of (b)(3)(i)(B) must allow the same frequency. In short, if some of the options allow daily switching, then all options must allow daily switching.

–Access to Information

The mandatory information disclosures in addition to the notification that the plan intends to seek relief under 404(c) are:

  • Description of the available investment alternatives including a general description of their investment objectives and their risk/return characteristics
  • Identification of any designated investment manager
  • Explanation of the various methods for giving investment instructions along with an explanation of any transfer or rights restrictions associated with any investment alternatives
  • Disclosure of fees and expenses the plan may charge for any investment transactions including commissions, redemption fees, etc.
  • Upon initial investment, a copy of the most recent prospectus for any investment alternative subject to the Securities Act of 1933
  • Description of the plan provisions for exercising voting or other rights related to the investment alternatives where the plan passes through the rights to the participant
  • Information specific to an investment alternative that consists of employer securities
  • Description of all other information available on participant request.

Click here for a sample 404(c) notice.

One of the key attributes of a 404(c) plan is that the participant has the ability to exercise "independent control" over his/her assets, which by definition necessitates the participant having access to the information appropriate to properly exercise independent control. Paragraph 2550.404c prescribes a set of mandatory information disclosures and enumerates other information that must be made available on request.

–Upon Request

  Some information you only need provide if it is requested.

Additional information that must be available on request is as follows:

  1. Information about the value of a participant's interest in the various investment options
  2. Information about the value and investment performance of the investment options offered
  3. Annual operating expenses for each investment option (e.g., expense ratio of mutual funds or investment management fees of other options) as to type and percent amount
  4. Copies of prospectuses, financial statements or other materials the plan has about the investment options
  5. If the holdings of an investment option (such as a collective trust) are considered assets of a plan, then a list of these assets along with relevant information about their nature

The Plan Administrator can limit to once a calendar quarter the requests from participants for information listed in the column to the left from. Click here to see a sample 404(c) notice.

All information whose distribution is mandatory or only if requested can be delivered electronically per Safe Harbor guidelines issued by the Department of Labor. Click here for more information

405(d)(1) relevance—

Can you achieve 404(c) compliance without the help of an Investment Manager?

Offering a 404(c) compliant set of investment options for participant direction is substantially similar to establishing the investment strategy and asset allocation for a pooled portfolio--with one additional significant complicating factor. A 404(c) compliant set of investment options is not one portfolio, but rather an "interactive" set of investment options that will be used by many participants to create many different investment strategies covering the risk/return spectrum.

2550.404c requires the offering of a broad range of investment options that gives the participant the opportunity to "achieve a portfolio with aggregate risk and return characteristics at any point within the range normally appropriate for the participant". A plan fiduciary would certainly be wise to seek further statutory relief under 405(d)-1 for the investment decisions involved in the construction of the 404(c) compliant investment menu by appointing a qualified investment manager or advisor to undertake this task.

The Plan Fiduciary decides if the Plan will offer the opportunity for a Participant or Beneficiary to direct the investments within their account. The Participant must decide whether to exercise that privilege. He cannot be forced to direct the assets within his account.
Thus, the Plan Fiduciary must stand ready to manage those plan assets of participants and beneficiaries who decline to direct their own investments. The Plan Fiduciary must manage these assets in the same manner in which he would manage all of the Plan assets if participant-direction were not permitted.
A Plan Fiduciary is encouraged to retain the services of an investment manager for management of Plan assets. Click here for more information.

Required Oversight—

Delegation to an Investment Manager requires regular oversight

The Department of Labor regulation paragraph 2509.75-8, FR-17 recites the extent of the guidance provided for the monitoring of an Investment Manager

At reasonable intervals the performance of trustees and other fiduciaries should be reviewed by the appointing fiduciary in such manner as may be reasonably expected to ensure that their performance has been in compliance with the terms of the plan and statutory standards, and satisfies the needs of the plan. No single procedure will be appropriate in all cases; the procedure adopted may vary in accordance with the nature of the plan and other facts and circumstances relevant to the choice of the procedure.

Plan fiduciaries have the responsibility under ERISA Section 405(d)(2) for both the decision to appoint an investment manager and obligation to periodically monitor the performance of such investment manager with reasonable diligence.

 

 

Self-Directed Accounts—

What's the difference between Participant-Direction and Self-Direction?

For purposes of discussion in this website, NWCM makes the distinction between a participant-directed and self-directed account.

A participant-directed account is one in which a participant's investment alternatives are limited to only those options identified by the Plan Fiduciaries.

A self-directed account allows a participant to invest in "any asset administratively feasible for the plan to hold." The self-directed account is a brokerage account registered in the name of the Plan "for the benefit of" a specific participant or beneficiary. Such an account is commonly called an IDA, or Individually Directed Account.

The paperwork to establish the IDA is signed by the Plan's Trustee. However, the participant directs the investments within the account. Typically, all transaction expenses associated with an IDA account is charged directly to the brokerage account.

ERISA 404(c) does not require the Plan to limit the investment alternatives available to Plan Participants and Beneficiaries to only those that meet the "broad range" requirement. Statutory relief is available for Plans that permit investment in any "asset administratively feasible for the plan to hold."

The Plan Fiduciary can, and in some instances must, limit the assets participants and beneficiaries cannot purchase within their accounts, such as investments:

  • Which would result in a prohibited transaction;
  • Which would generate income that would be taxable to the Plan;
  • Which would jeopardize the plan's tax qualified status
  • which could result in a loss in excess of the participant's or beneficiary's account balance

(The above list is not exhaustive.)

Self-Directed Account Pros—

Why would A Plan Fiduciary want to offer Self-Directed accounts?

The Plan Fiduciary seemingly has no obligation to identify three investment alternatives that satisfy the "broad range" requirement of the Regulation. In the Final Regulation, the DOL gives an example of a complying 404(c) plan in which only one broadly diversified equity fund has been identified as an investment alternative in which participants can invest along with "any other asset administratively feasible for the plan to hold."

By offering only self-directed accounts, the Plan Fiduciary does not have the liability to identify three designated investment alternatives nor to monitor their ongoing performance.

Participant-directed investment programs necessarily must limit the available investment alternatives to a restricted list, precluding the opportunity for more sophisticated investment strategies that would focus in on individual securities. Many participants view the ability to self-direct their accounts as a real opportunity to maximize their investment returns in an effort to save for their retirement.

Self-Directed Account Cons—

Why would A Plan Fiduciary not permit Self-Directed accounts?

Self-directed account balances may not be deemed 404(c) compliant for all participants of the Plan if the "investment alternatives offered by the plan would not permit those participants with small account balances to diversify their investments"

If a participant wanted to diversify their account by investing solely in individual securities, the DOL recognizes that a "substantial amount of investment capital to achieve such diversification" would be needed, precluding 404(c) relief.

A self-directed account almost always affords the opportunity to invest within mutual funds. As a "look-through investment," mutual funds would meet the Regulations need for the opportunity for the participant to diversify the account

The Plan Fiduciary must make certain that every participant has a sufficient account balance to invest in at least three broadly diversified mutual funds. Since most mutual funds would require a minimum investment of $1,000, participants with less than $3,000 should normally not have available a self-directed account as an investment option.
Due to account sizes, the Plan Fiduciary may have to provide for a participant-directed account platform in which all assets are pooled, thus allowing choice among three designated investment alternatives.

–Limited access to Self-Directed accounts could be discriminatory & expensive

The Plan Fiduciary may be forced to limit access to a self-directed account option because of the dollar value of the participant's account balance. As sometimes happens, the availability of the self-directed account option may be restricted—for very real practical reasons—to the Highly Compensated participants. This could be deemed discriminatory.

The Plan may need to demonstrate the "current availability" of the right to a self-directed account by passing the Ratio Percentage Test, or alternatively, the Average Benefits Test.

Aside from the additional testing requirements, there is sometimes a greater administrative burden in reconciling numerous individual brokerage account statements. Specialized software is available to facilitate the administration of participant-directed accounts, but this same software does not necessarily facilitate easily self-directed accounts. Some trust companies can interface with participant-directed accounting software to allow processing of the self-directed accounts, but there is a custodial expense for this. And the trust company will usually restrict the choice of the brokerage firm to a specific company.

Restriction of the choice for a brokerage account when setting up the self-directed account is not necessarily a bad thing from an administrative viewpoint. If participants can set up their accounts at any firm, the Plan Fiduciary can have a difficult time chasing down statements to prepare annual administration reports.

A qualified retirement plan may not discriminate in favor of the Highly Compensated Employees (HCEs) and must make available on a non-discriminatory basis any right and feature under the plan-including access to a self-directed account.

–Is a self-directed account really "independent control"?

A Plan Fiduciary allows for self-directed accounts. In many respects, the participant or beneficiary is "on their own." However, the Plan Fiduciary has an initial and continuing obligation to make certain that disclosure exists.

In the preamble to the Regulations, the Department writes:

First, the Department has concluded that the obligation of an ERISA section 404(c) plan fiduciary to disclose information should not be limited to information concerning those investment alternatives intended to satisfy the "broad range" requirement of the regulation, but rather should extend to information concerning the plan itself and each investment alternative made available under the plan. The Department can find no reasonable basis for distinguishing between information concerning investment alternatives which are intended to satisfy the "broad range" requirement and information concerning any other investment alternative made available under a plan in terms of value to participants and beneficiaries in evaluating their investment options and making informed investment decisions. Second, the Department has concluded that fiduciaries of an ERISA section 404(c) plan should have an affirmative obligation to ensure that participants and beneficiaries are provided or can obtain basic information concerning the investment alternatives made available under the plan. The Department is persuaded that merely referring participants and beneficiaries to a source for investment information and requiring them to obtain the information is insufficient to ensure that participants and beneficiaries are in a position to make informed investment decisions. While, as discussed below, there is nothing in the regulation which precludes a plan fiduciary from designating another person or persons to actually furnish the required information, the regulation contemplates that the identified plan fiduciary will remain responsible for ensuring disclosure.

A plan will be deemed in compliance with 404(c) if it provides the participant or beneficiary the "opportunity to exercise independent control." One of the litmus tests for that opportunity is the ability "to obtain sufficient information to make informed decisions with regard to investment alternatives."

 

As the statute expressly states, relief under 404(c) exists if the associated regulations from the Department of Labor are fully complied with. The regulations, published in October, 1992 as the Final Regulation Regarding Participant Directed Individual Account Plans, comprised 6 pages of the Federal Register. Its preamble was 26 pages in length!

Anecdotal evidence suggests that few fiduciaries and their consultants have read not the Final Regs in their issued format but only commentaries on them. Many such commentaries contain errors or lack sufficient detail.