Monday, May 22, 2006

404(c) Myth or Magic

Fred Reish nails down common misperceptions about 404(c),

404(c): Myth or Magic by Fred Reish
What you think you see may not be what you get

Next to the prudent man rule, 404(c) is perhaps the most discussed—and perhaps least understood—provision in ERISA. Does 404(c) offer mythical hope or magical protection for fiduciaries? As you might suspect, it is some of both: Read on. First, if the conditions for 404(c) protection are satisfied, it is a defense to some, but only some, claims of fiduciary breach in participant-directed plans, like 401(k)s and 403(b)s.

However, it doesn't protect against many fiduciary breach claims, most significantly a claim for losses due to a failure to select investments prudently and to monitor and remove inferior investments. As the DoL stated in
Advisory Opinion 98-04A:

"In connection with the publication of the final rule regarding participant-directed individual account plans, the Department emphasized that the act of designating investment alternatives in an ERISA section 404(c) plan is a fiduciary function to which the limitation on liability provided by section 404(c) is not applicable."

So, even if a participant directs his investments, if the loss is due to the poor performance of an option that should have been removed, the fault (and liability) lies with the fiduciaries and not with the participant.

What does 404(c) protect against? In a nutshell, it offers a shield against imprudent participant investment decisions. As an example, consider a 25-year-old who decides to put his account in the money market fund—and keeps it there for 40 years. Or a 65-year-old who invests his entire account in an aggressive growth fund and loses significant amounts in a bear market. In a 404(c) plan, the fiduciaries will not be legally responsible for the imprudence of those decisions. However, if part of the underperformance was attributable to the imprudent selection or retention of the particular investment option, the fiduciaries would be responsible for that part, even in a 404(c) plan.

So, as you can see, 404(c) is a myth in the sense that many people believe that it protects fiduciaries from all investment claims by participants. However, it offers some magic because it can transfer legal responsibility for investment decisions to the participants.

Let’s consider the flip side of that statement. If a plan doesn’t comply with 404(c), then the plan has transferred the power to direct investments to the participants, but the legal responsibility for the prudence of the investments stays with the plan fiduciaries. Is that possible? In the Enron case, US District Judge Harmon concluded, in language that was brief and to the point:

“If a plan does not qualify as a 404(c) [plan], the fiduciaries retain liability for all investment decisions made, including decisions by the Plan participants.”

In its “friend of the court” filing in that case, the Department of Labor formally stated its long-standing position:

“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 investment in his own account, provided that the participant exercised control over the investment and the plan met the detailed requirements of a Department of Labor regulation [that is, the 404(c) regulation].”
(PM Note – this is important in the context of auto-enrollment where default investment options are selected by the plan sponsor – under the current rules, the plan sponsor is the fiduciary for the default funds since the participant would not likely have been deemed to have exercised control)

So, yes, it is possible; in fact, it is the law. To make matters worse, in my experience, most plans do not satisfy the
20 to 25 conditions for 404(c) compliance, although surveys show that the vast majority of plan sponsors think they are complying with the 404(c) conditions. That suggests that committee members and other fiduciaries may be in for a rude awakening if they are faced with claims of investment losses because of imprudent participant decisions.

Having said that, the first and best course of action is for fiduciaries to work to make sure that participants are well-invested. Using a sports analogy, these efforts would be a good “offense.” My observation is that the easiest way to accomplish that goal is with professional assistance: age-based lifecycle funds, risk-based lifestyle funds, or managed accounts. Fiduciaries should work with their providers to make sure that the participants understand those options and are using them.

However, from a risk management perspective, your plan also should have a good defense—and 404(c) provides just that.

Fred Reish is managing director and partner of the Los Angeles-based law firm of Reish Luftman Reicher & Cohen.


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