Dick and Jane started work together 28 years ago. She was an administrative assistant, he a warehouse helper. They´d known each other since childhood, and their families were neighbors. She´d married young, and he had done a stint in the Army before settling down. Each raised 3 children with their spouses, and now they had a couple of grandchildren as well. They both worked their way up the ranks of the company doing different jobs and taking on more responsibilities. And, both retired about the same time.

They both started saving in the company´s 401(k) plan about 20 years before retirement with each putting in 3% of their wages. Each increased their savings rate in the plan over the years to the same level. And, every pay raise, they´d put a little bit more towards saving for retirement in their 401(k).

Dick was pretty happy with his nest egg, having made out better than putting his money in the bank. And, of course, the company had put in money, too. The 401(k) account statement said he´d averaged a return of 6.1% every year, and that was more than double the rate he´d got from his passbook savings at the bank. After retiring, he was going to work part-time for his son who owned a small business, so he wouldn´t need to touch the $175,000 he´d saved in his 401(k). With the house paid for and social security, he reckoned he´d have no problem with a comfortable retirement.

Jane was happy with her nest egg, too. Her account statement said she´d averaged a pretty decent annual return of 10.4%. Even with that "Internet Bubble" that had worried her so much, she´d done alright, and besides, her son had helped her pick the best mutual funds available in the company´s 401(k) plan. And, thank goodness, too, since she really didn´t understand much about how to invest or finances in general. There were growth funds, index funds, money market funds, balanced funds - too many choices with words that were like a foreign language to her! In retirement, she thought she´d do some volunteer work and pick up some extra money doing sewing alterations, but she wasn´t going to touch the $270,000 she´d saved for retirement in her 401(k). With the house paid for and social security, she didn´t figure she´d have any problem with a comfortable retirement.

As fate would have it, one of her kids fell in love with one of his, married, and Dick and Jane weren´t just neighbors anymore. They were family. And, it was at one of the family shindigs over at Jane´s place that she mentioned her 401(k) savings was doing pretty good, having gone up about $8,000 over the past three months. She said she hoped it´d keep going that way, since the sewing might not bring in enough to live on before she was able to start collecting Social Security.

Dick thought that was a lot to make in 3 months, as he´d only made about $2,500 in his account which worked out to be about $10,000 a year. He asked Jane if she didn´t mean that $8,000 was from the past year, otherwise she´d be talking $32,000 a year and that was just too good to expect. Nope, no mistake, she replied. Jane told Dick that, according to her account statement, she´d made about a 12% return, if it was calculated for the year. Taken back, he blurted out, "How much did you have in your 401(k) from work to start with?"

"$270,000," she replied before thinking he was being a little too nosey about all this.

Dick was flabbergasted. In fact, he was pretty upset about it. When he got home, he called some of his retired work buddies to tell them about Jane´s 401(k) hoard. They couldn´t believe it either, since they´d all gotten together a long time ago and picked about the same investment choices as Dick in each of their 401(k) accounts. They agreed that they´d made the best investment choices under the circumstances, and thought they´d done pretty well, considering what the bank paid! Boy, were they wrong! The only reason Jane made out so well must have been the investment advice her son had given her, not that she was any smarter than they were! Heck, why hadn´t the company at least given them a chance to get some good financial advice, too?

Dick called an attorney he knew. The attorney listened and told him to gather up all his paperwork for him to look over, along with his buddies´ stuff too. After they´d scheduled an appointment and said their good-byes, the attorney smiled to himself and wondered if Dick´s company had ever heard of ERISA Section 404(c). Either way, he smelled the makings of a case.

ERISA Section 404(c) Saves You

As an employer and fiduciary of your company's 401(k) plan, you must take care that you are in compliance with ERISA Section 404(c) or run the risk of losing the protection it provides to defend fiduciary breach claims involving participant-directed plans such as a 401(k). Said another way, it gives you a way to put a stop to lawsuits by your employees that could come from their having made poor investment choices.

The Employee Retirement Income Security Act of 1974 (ERISA) set a legal structure for all tax-deferred defined contribution plans (such as 401(k)s). In addition to preventing the mishandling of investments by administrators, trustees, and others, all plans must meet the rules set forth in ERISA Section 404(c) regarding the education of employees about their plan and disclosure of the plan and other investment-related information.

Your ability to use Section 404(c) as protection against frivolous lawsuits rests on whether you satisfy all the requirements in it, not just the most commonly cited three or four. This protection stems from complying with nearly 30 requirements covering the plan as a whole, the employees or participants that the plan benefits, and the transactions that are carried out within the plan. The full text of ERISA Section 404(c) is available at www.dol.gov/dol/allcfr/Title_29/Part_2550/29CFR2550.404c-1.htm.

Trouble with Dick and Jane

As our story of Dick and Jane illustrates, legal action against employers over retirement benefits may not be that immediate. But as more U.S. businesses switch from defined benefit plans to defined contribution plans, they are exposing themselves to a formidable liability down the road. Present dramatic inconsistencies in retirement savings outcomes before a jury, such as we saw between Dick and Jane, and substantial monetary penalties may result. Imagine the closing remark that Dick´s attorney might give at the conclusion of the trial:

Ladies and gentlemen, this heartless corporation, motivated only by greed and profit, traded in its once dependable and predictable pension plan for what could be best described as one of instant gratification for its stockholders. A plan where future pensioners must roll the dice to see if they can retire comfortably or be left in a state of poverty - all because the company left investment decisions to those least prepared to make the appropriate and well-educated financial choices, their employees. Ladies and gentlemen of the jury, we ask that you rule in favor of our clients and the future of all the hard working citizens of these United States.

Don´t Forget ERISA Section 404(a)

A sister regulation, ERISA Section 404(a), further increases potential exposure to class-action law suits. Although not the main thrust of this article, it is worth noting that this regulation creates what´s known as the "Prudent Man Rule" standard: every individual or entity engaged in investment or administrative decisions that impact other people's money will be held to standards found in Common Law. Section 404(a) also touches on subjects like the important "Exclusive Benefit Rule," general investment diversification requirements, and on holding of qualified employer securities within a plan. In the defense of any litigation that may be anticipated, you must be aware of the big picture encompassing other ERISA regulations, too. Right, now back to Section 404(c). 

Enron

The Enron scandal put compliance with Section 404(c) in the spot light for everyone to see. The trial judge and the Department of Labor said Enron´s plan fiduciaries - administrators and its plan´s trustees - were responsible for all investment decisions in the plan, including those made by the employees, unless it complied with ERISA Section 404(c). The judge said:

If a plan does not qualify [under Section] 404(c), the fiduciaries retain liability for all investment decisions made, including decisions by the plan participants. (Tittle v. Enron Corp., 284 F.Supp.2d 511, 578; S.D. Texas 2003)

The Department of Labor pitched in with their nickel´s worth:

The only circumstances in which ERISA relieves the fiduciary of responsibility for a participant-directed investment is when the plan qualifies as a 404(c) plan[...] Under ERISA 404(c)[...], a fiduciary is not liable for losses to the plan resulting from the participant´s selection of investments in his own account, provided that the participant exercised control over the investments and the plan met the detailed requirements of the Department of Labor regulations [for ERISA Section 404(c)]. (Amended Brief of the Secretary of Labor)

Although Enron is explicit, the Seventh Circuit Court of Appeals just handed down a ruling [Jenkins v. Mid America Motorworks, Inc., April 2006] stating that ERISA Section 404(c) cannot be used exclusively to prove breach of a 401(k) plan´s fiduciaries´ responsibility for investment decisions. It also said that when a plan´s assets suffer a loss, that alone is not sufficient to hold the plan´s trustees responsible for those losses.

Even with this apparent contradiction, the requirements set forth in ERISA Section 404(c) must still be satisfied to prevent the shifting of liability over investment decisions from the employees back to their employers. Most plan providers do an excellent job satisfying a dozen or so of the nearly 30 requirements contained in ERISA Section 404(c), but all must be examined, complied with, and regularly audited. Below, we have compiled a list of all the most notable requirements in ERISA Section 404(c) for current and later reference. 

Requirements About Information That Must Be Provided to Employees

It may not come as a surprise to anyone that one of the most significant requirements under ERISA Section 404(c) is that certain information must be provided to employees, so they can make informed investment decisions. This includes explaining the following:

• Their plan is intended to be a 404(c) plan;
• The plan fiduciaries may not be liable for investment decisions;
• Each investment alternative available under the plan should be described in general as well as advising them to review the information on each investment before they invest;
• The investment objectives and risk and return factors for each alternative should be described as well as information regarding the type and diversification of assets within the portfolio;
• Identify the designated investment manager(s);
• Explain the circumstances under which employees will be given investment instructions including any limitations with those instructions, restrictions on transfer, limitations on voting rights, and information on penalties or adjustments related to fund transfers;
• Describe transaction fees and expenses chargeable against the employee´s account;
• Provide "hold-harmless" information on the plan fiduciary´s responsibility for giving requested information;
• Detailed information about investing in the employer´s securities including a description of the process to provide confidentiality and to identity the fiduciary charged with monitoring compliance with this confidentiality requirement;
• Immediately before or after investing in one of the plan alternatives, a copy of the most recent prospectus should be provided, if the investment is subject to the Securities Act of 1933; and,
• After an investment is made, employees must be provided with plan materials related to the exercise of voting, trading investments, or similar rights. If there are plan provisions regarding the exercise of such rights, employees must receive a description of or reference to such provisions. While the plan is not required to pass through these rights, relief of liability under Section 404(c) isn´t available to the extent that plan fiduciaries exercise those rights.

With this first set of requirements, it shouldn´t be a surprise when we advise that education is the key to ERISA Section 404(c). Educating employees about their 401(k) plans creates additional benefits, too, including increased employee participation and higher savings rates for those participating. An interpretive bulletin that really delves into the heart of employee investment education related to ERISA 404(c) is at http://www.dol.gov/ebsa/regs/fedreg/final/96_14093.pdf. 

Requirements about the Range of Investment Alternatives

ERISA Section 404(c) also requires that employee investment selections must permit them a reasonable opportunity to achieve different potential returns and degrees of risk with their investments. They should be able to choose from at least three investments that are:

• Diversified;
• Materially different with respect to risk and return factors;
• Able to achieve aggregate risk and return characteristics within a range that is "normally appropriate for the employee;" and,
• When combined with the other alternatives, able to minimize the overall risk of the portfolio through diversification.

The employees must be allowed the choice to diversify their investments and minimize the risk of loss while accounting for the nature of the plan and the size of the employee accounts. The investment options should be reviewed annually by the plan committee or a designated investment advisor.

Requirements about Employee Requests for Information

Employees must be provided certain information when they ask for it. This material has to be based on the latest information available to the plan and include the following:

      Details about annual operating expenses of each designated investment alternative, including investment manager fees, administrative fees, and transaction costs that may reduce the rate of return to the employee. The combined amount of such expenses must be expressed as a percentage of average net assets of the particular investment alternative. If the information can be found in the prospectus, providing the prospectus is all that´s necessary;

• Copies of prospectuses, financial statements and reports, and other materials about the investment alternatives;
• For each of the designated investment alternatives:
  1. List the assets in the portfolio of the investment alternative including the value of the assets; and,
  2. Should the asset be a bond or some other kind of fixed rate investment, then the name of the issuer, its term, and the rate of return should be disclosed;
• The value of shares or units and the past and current return performance of each available investment alternative, net expenses; and,
• The value of the investments in that particular employee's account. 

Requirements for Carrying Out Investment Instructions

The opportunity for employees in a plan to exercise control or self-direct the course of their investments requires that they can give investment instructions by whatever means provided but must have the opportunity to receive confirmation in writing of those instructions. The instructions must be given to the plan fiduciary who is required to comply. The plan may charge a reasonable fee for carrying out those investment instructions so long as it has a procedure to inform employees periodically of the expenses incurred against their accounts. 

Requirements on Frequency of Giving Instructions

Employees have to be given the opportunity to switch their investments as often as the volatility of the investment might require it. They must be able transfer out of core investment alternatives at least every three months.

If any of the plan´s investment alternatives allows changes more frequently than once every three months, another core investment must allow the same frequency of change. The investment that employees can transfer into must be low risk, liquid, and producing income. Non-core investments are not required to follow the three month requirement but must abide by the general volatility rule. 

Prohibited Investments

Investment transactions cannot be made if they:

-         Are not permitted by or contradicts the plan´s directives;

-         Would put the tax status of the plan at risk;

-         Would result in a loss that exceeded the balance in an employee´s plan account;

-         Would result in income that is taxable to the plan;

-         Require ownership of assets in the plan outside the United States;  and,

-         Are prohibited by federal ERISA or IRS rules.

Also, the following transactions between a plan and the employer or fiduciary of the plan aren´t permitted if they benefit "parties in interest," as defined in ERISA Section 3(14). Said another way, the following transactions aren´t allowed, if the transaction financially benefits a plan´s fiduciary and/or any closely related person or entity to that fiduciary. Here´s the no-no list:

-         Sale, exchange, or leasing of any property between the plan and "parties in interest;" 

-         Lending money or any other extension of credit between the plan and "parties in interest;"

-         Furnishing goods, services, or facilities between the plan and "parties in interest;"

-         Transferring to and any use of assets of the plan by or for the benefit of "parties in interest;" and,

-         Acquisition of any employer security or employer real property on behalf of the plan.                    

See Dick Run

ERISA Section 404(c) is meant to protect employers or plan fiduciaries against liability related to their employees´ investment decisions in a participant-directed retirement plan. However, it doesn´t provide absolute protection. For this reason, employers should make sure that the employees receive regular investment education and advice, ample investment alternatives to choose from, and the opportunity for managed accounts by qualified investment advisors. If the employees´ account investments are managed properly, the "Prudent Man Rule" of ERISA Section 404(a) is satisfied, and the protection from liability that ERISA Section 404(c) affords is maximized.

All the same, it is wise to be proactive in avoiding the need to rely on ERISA Section 404(c) as a defense in the first place. As one could assume, most plans will adhere to the requirements in ERISA Section 404(c), if an employer or plan fiduciary pays heed to all that´s involved. One way to make sure of this is to have one person take charge of and be accountable for maintaining compliance and conducting regular internal reviews of the plan, including supervision of compliance audits. In most cases, prominent plan service providers will have the resources to keep you in compliance with ERISA Section 404(c), but the responsibility stil remains with you. When everything´s said and done, the best approach is to make sure you´re always doing something positive for the employees who participate in the plan in order for them to end up with a respectable retirement nest egg.

Should you have questions regarding any of the material presented, we´d recommend speaking to your designated professional to look at your company´s particular circumstances. If you still keep getting heartburn over this, we´d be happy to help you by answering any of your questions at www.KitchenTableAdvice.com. Just click on the "Reach Us" tab and type away!  Ray Andrée, President and Chief Advice-Giver, Kitchen Table Advice, LLC.