Market Insight: Guest Articles Walking the Edge of Fiduciary Liability: A Primer On 401(k) Retirement Plans by Michael Koehne
March 2005

Business owners and managers, acting either as trustees or representing the interests of the 401(k) plan trustees, should be especially aware of fiduciary liability in managing their firm’s retirement plan. Being on the front line gives each business owner or manager a unique perspective on the firm’s responsibilities for protecting the most significant benefit program that firms can offer to both their owners and employees.

ERISA: Fiduciary Responsibility and Liability

ERISA, the Employee Retirement Income Security Act, is a federal law established to protect the rights of employees and the security of their retirement funds. ERISA defines “fiduciary” not in terms of a formal title but rather in functional terms of control and authority over the plan. It should be noted here that the partners or shareholders of any business firm can be considered fiduciaries even if they are not named as trustees of the retirement plan. This is because they often make discretionary decisions as a group, which are fiduciary in nature.

The current Enron trial in Houston once again raises the profile of fiduciary responsibilities attendant to qualified plans. A class-action suit by 401(k) participants is only one of many civil actions that former Enron leadership faces. That particular lawsuit focuses on an issue that many trustees of qualified plans give scant attention to-namely, that 401(k) plan fiduciaries can be held personally responsible for participants’ investment decisions, even if the plans are participant-directed. Here, ’responsible’ means that plan fiduciaries can be held liable for participant losses in the plan, to the extent of their own personal wealth.

However, ERISA also provides the ability to elect some protection for plan fiduciaries if certain requirements are met via 404(c) regulations. If met, the liability for investment decisions is with the participants. It is usually worth the effort to take the 404(c) election.

Basic responsibilities of conduct for a fiduciary include: loyalty, prudence, disclosure, and monitoring. Let’s look at each of these responsibilities in some detail and then consider the protections that are available under 404(c):

  1. Loyalty must be to the participants.
    There can be no self-dealing-acts which serve personal interest at the expense of plan participants. Because the purpose of the plan is to provide retirement benefits to participants and beneficiaries, all oversight must serve this overarching goal. For example, all participant deferrals must be deposited into the plan in a timely manner-operational concerns of the firm, such as cash flow needs, cannot be considered.
  2. The “prudent person” rule applies
    When selecting plan investments, weight must be given to: diversification, risk and reward issues, matching the appropriate investment to the appropriate investor, and monitoring the performance of the assets.

    An Investment Policy Statement (IPS) should be established. This is the formal statement of the criteria used for selecting investment options for the plan. Even though an IPS is not required by ERISA rules, most plans benefit from the use of this investment “filter”. Plan trustees then use this document to evaluate investments that will be provided in the plan. The existence of an IPS in any plan will help establish a due diligence intent by plan trustees to comply with ERISA regulations.

    The fiduciary must act with the prudence and skill of a well-informed, long- term investor-investment selection must be based on a reasonable search for investment alternatives, not simply based on the word of an “expert.” Fiduciaries must enable diversification of the plan assets to minimize risk or large losses. This would include the use of “pooled investments” such as mutual funds to attain this goal. Participants must be able to assemble a portfolio that will meet their individual risk-rewardneeds.

    If your plan is “participant-directed,” as most 401k plans are, diversification must not only include basic core investments, such as large-cap or small cap stock mutual funds, but must also include so-called alternative investments such as real estate or natural resource sector funds. Bond and money market funds, for both the conservative investor and for the average or even aggressive investor during market downturns, should be provided to round out diversification for plan participants.

    The fiduciary can choose to hire an advisor to work with the participants. If so, due diligence must be applied to ensure that appropriate qualifications and experience are present in the advisor, and ongoing review of the advisor is needed. It has been shown that appropriate advice can significantly improve both investment performance and the participant’s satisfaction with the plan.
  3. Fiduciaries must disclose.
    Participants have a right to receive correct and complete information that is material to the plan. This includes any knowledge that the fiduciary has about the plan including costs.
  4. Fiduciaries must monitor the plan’s costs and performance.
    All fees and expenses of the plan must be identified and monitored. Expenses can come from the investment platform and from the administration of the plan. Excessive administrative or investment costs erode the returns to the participants and should be avoided.

    The investment platform will have expenses at several levels: mutual fund fees for managing the funds, asset charges for the investment company, and perhaps insurance charges if the platform is an annuity contract. These fees must be reasonable based on the amount of assets in the plan and the number of participants.

    Administration can be provided by a separate Third Party Administrator (TPA) or might be combined in larger plans (at a lower cost) with the investment platform and done by them.

    Reviewing the current investments used by the participants and examining the returns that they are receiving and the amount of risk that they are assuming can assess plan performance. This review can be done by a Financial Planner and includes an assessment of costs and performance.

    Both the costs and performance should be reviewed annually. If it is determined that they are appropriate, and the existing investment platform and administrator are to be retained, this decision should be documented. If not appropriate, then changes should be made and the reasons documented.

Section 404(c) Election Provides Relief

Faced with the threat of lawsuits from current or former plan participants, or from their beneficiaries, or from the retiree who has run short of money-where’s the relief for plan trustees?

Section 404(c) of ERISA allows plan fiduciaries to transfer responsibility-and liability-for losses in their accounts to the participants. By electing 404(c), the fiduciary agrees to (1) allow participants to direct the investments of their own accounts, and, (2) provide investment education according to the requirements of the 404(c) regulations.

The requirements, in essence, require that participants: be offered diversified investment choices, be given the ability to make changes among them, and, be given sufficient information to make informed investment choices.

A 404(c) Checklist

So, how can you, as the business owner or manager, wade through the treacherous shoals of fiduciary responsibilities to get to 404(c)? Here’s a checklist to go over with your plan trustees and other firm fiduciaries to assure that the plan is meeting 404(c) requirements:

  • Conduct an annual plan review, identifying the plan’s total performance and cost, for both Administration and investments.
  • Compare the cost and performance of your plan to other investment platforms and administrators.
  • Determine if you will elect 404(c) and understand your responsibilities.
  • Write and use an Investment Policy Statement that states that the plan intends to comply with 404(c) regulations.
  • Assure that diversification is provided by the investment choices, including alternative investments.
  • Review the plan’s Summary Plan Description to determine if it is congruent with 404(c) regulations.
  • Provide required education to plan participants.
  • Document the participant education in the compliance file, with lists of attendees.
  • Consider Fiduciary Liability Insurance.

In summary, 404(c) can relieve fiduciaries of personal liability for participant losses. A thorough review of the existing situation can provide a plan for action.

About the Author

Michael Koehne is the founding principal of his own management consulting firm, Law Firm Management Services.

Michael Koehne
Law Firm Management Services
P: 415-453-6558
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