Are You Sure You’re 404(c) Compliant?

Navigate the voluntary safe-harbor provisions that protect 401(k) sponsors from fiduciary liability

By Diane Cadrain Sep 1, 2004
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HR Magazine, September 2004

Someday, warns Matt Hutcheson, an independent Employee Retirement Income Security Act (ERISA) fiduciary who is president of MDH Consulting in Portland, Ore., a long-term 401(k) plan participant will sue the fiduciaries of his plan sponsor because his investments haven’t paid off the way he expected. The fiduciaries may be surprised to learn that what they thought was a foolproof defense—Section 404(c) of ERISA, which protects officials of self-directed 401(k) plans from liability for employees’ poor investment choices—does not save them from an expensive court judgment.

Such a lawsuit could pose a real threat to HR managers and others responsible for designing and running participant-directed defined contribution 401(k) plans. The vast majority of defined contribution plans give participants the responsibility for making their own investments. Plans are shielded from liability for employees’ bad investment decisions only if they correctly follow voluntary requirements of ERISA—a long list of conditions that, according to experts, many plans don’t even come close to meeting.

“The vast majority of plans believe that they are 404(c) [compliant] plans but, in my experience, very few of them satisfy all of the 404(c) requirements,” says Fred Reish, an ERISA specialist who is managing partner of the Los Angeles law firm Reish Luftman McDaniel and Reicher. “As a result, the officers and directors who serve as fiduciaries of those plans continue to be at least partially responsible for the prudence of the participant investment directions.”

“The trick is to drive your boat into the safe harbor of 404(c), but there’s no complete road map, and the harbor is still under construction,” concludes Roger Gray, director of client services for Scudder Investments in Boston.

Risky Business

So what happens if plan sponsors don’t adequately comply with the exacting requirements of 404(c)?

“The risk is that the participants could claim that a plan sponsor didn’t give them access to adequate information to make good decisions,” says Gray. “Then the sponsor is liable for their losses.”

“Incredible as it sounds, if a plan permits participants to direct investments—but does not comply with 404(c)—the fiduciaries remain responsible for the prudence of the participant-directed investments,” adds Reish. “If a plan does not comply with 404(c), then the plan administrator is personally liable for any losses attributable to imprudent participant investments.”

“Anyone in the decision-making stream is potentially liable,” says David Wray, president of the Profit-Sharing/401(k) Council of America in Chicago, who was recently named chair of the U.S. Labor Department’s ERISA Advisory Committee. “And because liability is personal, they can take your house. It hasn’t happened yet—but I think it could well happen with a sponsor that drops the ball.”

Satisfying the Basics

Here’s a look at what it takes to protect yourself, and your plan, from liability for employees’ bad investment choices, according to federal regulations promulgated under ERISA, 29 C.F.R. Sec. 2550.404(c). “Compliance with those regulations requires a lot,” says Gray.

“It’s all or nothing,” adds Teresa Delman, a pension attorney with Connecticut law firm Tyler, Cooper and Alcorn. “If you don’t comply in one tiny way, you lose 404(c) protection.”

To gain that protection, plan sponsors must meet three basic requirements that are fairly well known:

  • Offer a selection of at least three investment choices with materially different risk and return characteristics. “Everybody complies with this,” says Wray. “Nobody has three offerings—everybody has around 15.”
  • Provide the ability to change investment allocations at least quarterly. This requirement, too, is easily exceeded by most plans, with telephone and Internet switching privileges commonly available as often as daily.
  • Provide sufficient education and information about the plan to allow participants to make informed investment decisions. “A lot of the protection comes from information that has to be provided, some of it mandatory, some on request,” says Reish.

    “The plan sponsor or trustee must provide information to participants in such a way that they understand, and with that understanding, can make an educated decision about how to invest their funds,” adds Hutcheson.

Devil’s in the Details

While most plan sponsors surpass the requirements for investment options and switching privileges, many drop the ball on elements of the mandatory information that must be kept current, distributed and redistributed as necessary, including:

  • A declaration that the plan is intended to be 404(c) compliant and that fiduciaries aren’t liable for participants’ investment losses.
  • A description of the investment alternatives available and the risk and return objectives of each alternative.
  • The identity of the designated investment manager.
  • An explanation of how and when participants may give investment instructions.
  • A description of any transaction fees and expenses, such as commissions, that will affect participants’ account balances.
  • The name, address and phone number of the plan fiduciary who is responsible for providing information on request, and what information may be requested.
  • A description of the confidentiality procedures for information relating to investment in employer stock and the identification of the plan fiduciary responsible for monitoring compliance with the confidentiality procedures.
  • The most recent prospectus of any investment option immediately before or after a participant chooses it. Having all the prospectuses for available investment funds in initial sign-up kits does not meet this requirement—individual prospectuses still must be supplied when a fund is selected. Providing a simplified form of a prospectus (sometimes called a profile) won’t meet the requirement unless the document has been filed with and approved by the Securities and Exchange Commission.
  • Any materials describing participants’ voting and ownership rights. Other types of information must be available to plan participants upon request, such as annual operating expenses of investment alternatives and other financial data about investments and participants’ accounts.

Teaching Investment Principles

In addition to providing up-to-date information, the biggest pitfall for plan sponsors is employee education. The federal regulations require that the participant or beneficiary be provided, or have the opportunity to obtain, sufficient information to make informed decisions about the plan’s investment alternatives.

“Providing employees with enough information to make informed decisions is the biggest pitfall under 404(c),” Hutcheson says. “In a company of 3,000 employees of different backgrounds, what is ‘informed’? It means that adequate information is given and understood. That’s a real tough challenge.”

“Many plan participants can’t read or can’t speak English,” adds Wray. “So it’s very difficult to provide information in a usable fashion. How do you explain it? It’s complicated to deliver the information effectively.”

“You have to give employees access to information that is suited to them. For example, for the employee in the mailroom, you give an easy-to-read fact sheet. For the lawyer in the corner office, a prospectus,” adds Gray.

“Allowing participants to wander aimlessly, even if you have had educational meetings, is dangerous,” says Hutcheson. “You may not know who ‘gets it’ and who doesn’t, so you should have a good follow-up system. It’s important to communicate proactively, ask the right questions and keep on it until the participants understand. This ensures that your employees have interpreted and internalized the information into something that is useful and meaningful to them.”

When Education Becomes Advice

But there are significant dangers in giving too much information of a personally targeted nature, says Delman. For example, if the plan sponsor crosses the line into giving advice, that raises potential liability for the quality of the advice. “There’s a fine line between educating plan participants and giving them advice,” says Delman. Plan sponsors may, however, hire qualified third-party investment advisers to counsel participants individually, but should apply a high level of prudence and oversight to selecting and monitoring them in order to retain liability protections.

Delman recommends that plan sponsors look at the Department of Labor’s Interpretive Bulletin 96-1, which defines areas of acceptable education that do not constitute individual advice. “All plan sponsors should review it,” says Delman.

The bulletin itemizes types of materials and information that, if provided to plan participants, don’t result in the rendering of advice. Examples include information about the benefits of plan participation and of increasing contributions; the impact of preretirement withdrawals; general background about financial investments, such as the concepts of risk and return, diversification and estimating retirement needs; asset allocation models for hypothetical individuals with different time horizons and risk profiles; and interactive investment materials such as questionnaires, work sheets, software and similar materials that help calculate future retirement income needs and assess the effect of different asset allocations on retirement income.

It’s important to document information and education efforts. Gray thinks that employers can go a long way toward protecting themselves if they provide participants with access to information (such as prospectuses and easily read literature) and annual educational meetings (if not in person, then via conference calls or online seminars). “The key thing to remember is to document the process you went through. If you document what you did from an educational standpoint, that should protect you. You have to show that employees had the ability to make informed investment decisions.”

Is It Worth It?

So if the safe harbor of 404(c) is so difficult to navigate, what’s its value? The answer depends on who is asked.

“Basically, 404(c) is a relatively inexpensive insurance policy,” says Reish. “Plan sponsors and fiduciaries should make every effort to obtain its protections.”

“There’s really not much value,” counters Hutcheson. “It’s worthy to try to comply if it’s really in the participants’ best interest, but statistics show that participant-directed accounts underperform [the general stock market] by six to 10 percentage points. If you go to an employer-directed approach instead of going under 404(c), it would eliminate a host of problems, save money on employee education, eliminate costly election forms and eliminate worry about employee mistakes.

“Would you let the newest intern at your company, who works for minimum wage, manage your personal 401(k) account? No? Really? Why not? Then why would your company make that person invest their own?” asks Hutcheson.

Management by a prudent investment fiduciary, hired by an employer, would bring professional acumen to the investment process and would avoid poor decisions by employees whose investment expertise is less than professional. In those cases, employers would make investment decisions on behalf of employees. In doing so, as long as employers satisfy various fiduciary duties laid out in another ERISA safe harbor (29 C.F.R. Sec. 2550.404a-1), they’ll enjoy protection from liability. Some plans do retain this level of control, Hutcheson says, but comparatively few: In at least 80 percent of plans, employees direct their own investments.

“There’s a recognition in the last two years that many employees don’t want to make these decisions,” explains Wray. “But they still value empowerment, and they would like the employer to help if their investments aren’t doing well. So employers are adding professional management and advice, and giving employees the choice of telling the employer to invest [for them].” Under plans with optional professional management, Wray explains, employees check a box indicating a preference that the employer manage the plan on their behalf. “Because the employee has made the choice, the plans are still considered employer-directed. But if the employee does make that choice, does the employer lose 404(c) protection? That’s not decided yet.”

Another option: Promote consolidated “lifestyle” funds intended to substitute for a la carte selections of various fund types. Lifestyle funds contain designated mixes of stocks and bonds in various proportions targeted for people of different ages. Delman recommends these funds as a way around the danger of giving investment advice.

“They’re increasing in popularity, but they’re still considered participant-directed,” says Delman. “The only problem is that they’re usually made available as one of 15 or 20 offerings, so participants tend to choose them as a small percentage of their investments, but it’s supposed to be about 80 percent.”

Diane Cadrain, J.D., is a freelance writer based in West Hartford, Conn., and a member of the Human Resource Association of Central Connecticut.​

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