INTERNAL 401K – 404c
404(c) Final Regulations
On October 13, 1992, the Department of Labor (DOL) released its final regulation under ERISA Section 404(c). The Regulation relieves plan fiduciaries of liability for investment choices made by participants of self-directed defined contribution plans that meet the Regulation’s requirements. It was the Department of Labor’s third attempt in five years to issue standards for self-directed savings and profit sharing plans. The final Regulation attempts to quiet the controversy surrounding earlier drafts of these regulations by giving a little something to everyone.
HISTORY OF THE REGULATION
ERISA Section 404(c) provides that plan fiduciaries are not responsible for participant losses that result from their own investment decisions. The final regulation that implements this section is the product of a lengthy review process by the DOL lasting over five years. The 1987 Proposal: The DOL originally proposed a Section 404(c) Regulation in September 1987. The Regulation set forth the requirements a plan must meet in order for its fiduciaries to claim the protection of Section 404(c). First, the plan was required to offer a variety of investment funds meeting the following investment objectives: . a “safe” (federally insured) fund; . capital appreciation; . a balance of the previous two objectives; and . the highest level of current income consistent with the preservation of capital and a high degree of liquidity. Second, the plan was required to offer participants the right to change their investment allocations with “reasonable” frequency, considering the volatility of the investment. Third, the plan was required to give participants “sufficient information as [to plan investments] to permit informed investment decisions” by the participants.
The proposal raised a storm of protest. It was viewed by some as favoring mutual fund providers, at the expense of insurance companies and banks. Plan sponsors complained that GICs, the single most popular investment among plan participants, were excluded. Others complained that the prescribed investment categories were too narrow and inflexible. The DOL held hearings on the proposal but did not move forward. The 1991 Proposal: The DOL took its second stab at a 404(c) Regulation in March 1991. The re-proposed 404(c) Regulation kept the broad framework of the 1987 proposal, but the details changed significantly. First, the revised Regulation did not specify the investment objectives to be met by the required funds. It simply required that a 404(c) plan offer at least three funds that would enable the participant to “achieve a portfolio with aggregate risk and return characteristics at any point within the range normally appropriate for the participant.” In other words, each of the three options must have different risk and return characteristics. Second, the re-proposed Regulation required that transfers be allowed no less than once every three months, and more often for volatile investments. Third, the re-proposed Regulation removed a provision that would have allowed plan sponsors to avoid fiduciary liability by directing contributions to a default fund if participants failed to give investment directions. The 1991 Proposal was met with misgivings from the pension community. Where the 1987 Proposal had been criticized for being too specific, the 1991 Proposal was said to be too vague. Some commentators had expected the Regulation to be a “safe harbor, allowing a plan sponsor that failed to meet its requirements to show compliance with the statutory language in other ways. The Regulation stated that it was not a safe harbor, but rather the sole and exclusive means of compliance with Section 404(c). The final Regulation was announced in October 1992. It addresses most of the concerns raised in response to the 1991 Proposal. The DOL gave ground on some points, but held firm on others. The end product looks very much like the 1991 Proposal; however, it included major changes relating to areas such as employer stock and required disclosures to participants.
The Regulation remains the exclusive means of complying with Section 404(c). If a plan fails to meet the requirements of the ReguIation, it is not considered to be a “Section 404(c) plan” and the plan fiduciaries retain their responsibilities with respect to participant-directed investment transfers. However, the Regulation’s discussion section also states quite plainly that it is intended only to set forth the requirements to qualify as a Section 404(c) plan. It does not set forth a standard for determining whether a plan fiduciary has prudently discharged its responsibilities. After release of the earlier proposals, some commentators suggested that the Regulation set forth a de facto standard for fiduciary prudence. This view held that a plan sponsor who failed to offer its participants a broad range of investment alternatives, reasonable opportunity to change investments, and sufficient information to make informed investment decisions would have failed to act in a prudent manner. So, although the 404(c) Regulation was by its terms voluntary, its effect was to mandate an industry-wide standard. The final Regulation makes clear that this is not the case. The Regulation may be the sole means of qualifying as a Section 404(c) plan but it does not set a standard for meeting fiduciary responsibilities. If a plan does not meet its requirements, then a plan fiduciary may show prudent discharge of fiduciary responsibilities by reference to the fiduciary provisions of ERISA, not the provisions of the Regulation.
EFFECTS OF COMPLIANCE WITH 404(c)
If a plan qualifies as a Section 404(c) plan then plan fiduciaries are relieved from liability for any loss that is the direct and necessary result of the participant’s exercise of control. If the participant selects an investment manager, the plan fiduciaries are protected from liability in connection with the selection of that manager. However, if the plan, like most plans, offers a series of investment alternatives to participants and selects the managers of those alternatives, then plan fiduciaries retain responsibility for the prudent selection of those managers on an ongoing basis. This includes the selection of a GIC/BIC or synthetic issuer.
The Regulation is transaction-oriented. If a transaction meets the Regulation’s requirements, the plan fiduciaries are exempt from fiduciary liability for that transaction. As a result, a plan could decide to qualify only some of its investments or some of its participants under Section 404(c). Hybrid plans can qualify for 404(c) protection, but only to the extent that they provide an individual investment account for each participant. To the extent that a hybrid plan pools participants’ investment interest, relief is not available. The Regulation lists several types of transactions that are not protected. These include any transactions that violate the terms of the plan or would jeopardize plan qualification, sales or exchanges with, or loans to the plan sponsor and the like.
OPPORTUNITY TO EXERCISE CONTROL
The first major requirement of the Regulation is that a participant be given “reasonable opportunity to give written investment instructions, or oral instructions followed by a written confirmation, to an identified plan fiduciary who is obligated to comply with such instructions.” Several items are included within this requirement. Participants must be given “sufficient information.. . to permit informed investment decisions.” Earlier proposals were vague on what level of disclosure must be provided, and opinions ranged from prospectus disclosures to complete investment education programs. The final Regulation clarifies the types of disclosures that must be made:
If the plan opts to be a 404(c) plan participants must be told that fiduciaries may not be responsible for losses resulting from participant investment decisions;
A description of all investment alternatives available under the plan
A description of the investment objectives and the risk and return of each investment under the plan;
l The investment managers of each investment;
An explanation of investment transfer procedures and restrictions;
An explanation of any restrictions on voting, tender, or other ownership rights;
Description of any participant-based transaction fees and expenses for each investment; l Identification of the plan fiduciary responsible for providing a description of investments;
For a plan with employer stock, all voting information and the procedures for ensuring the confidentiality of participant investment transactions;
l For investments subject to the Securities Act of 1933 (primarily, individual stock issues rather than mutual funds), a prospectus immediately before or after the initial investment;
and, l If voting or tender rights are passed through to participants, any information provided to the plan by investment managers or issuers regarding those rights. Participants must be given the following information on request:
Annual management and operating expenses charged against participant returns, expressed as a percentage of mean assets;
Copies of any prospectus or similar materials that have been provided to the plan;
A list of investments and their values for each investment alternative; unit or share values for investment funds; and, past and current performance of investment funds in the participant’s account. For fixed rate GICs: the issuer, maturity
and guaranteed rate must be shown within any three month period.
FREQUENCY OF TRANSFERS
The final Regulation retains the requirement that transfers be allowed “at least once every three months.” The Regulation provides no guidance on the frequency required for any given level of volatility. The discussion only says that participants “must have the ability to transfer the account assets from investment alternatives at intervals reasonably commensurate with the anticipated volatility of the investments in order to minimize the risk of loss.” The three-month minimum applies only to “core” investment alternatives under a plan. These are the three funds that a plan must provide in order to qualify as a Section 404(c) plan. A plan can provide additional, non-core options that do not provide threemonth transfers, as long as any restriction is appropriate for the risk of the underlying investment. If a plan allows transfers out of its various investment options at different frequencies, then at least one of the core investment options must accept all such incoming transfers. For example, if a non-core alternative allows transfers out on a daily basis, then one of the core options must accept transfers in on a daily basis as well. As an alternative, the plan may provide transfers into a low-risk fund (such as a money market fund) into which participants may transfer until their next opportunity to transfer to a core fund. If a plan offers an employer stock fund, then a similar arrangement must be used. Either a core alternative must accept transfers in as frequently as the employer stock fund allows transfers out, or the plan must provide a low-risk, income-producing subaccount or holding fund. In both cases, the principal is the same; frequently available transfers out of a fund are without meaning unless a participant has somewhere to transfer the money.
BROAD RANGE OF INVESTMENT OPTIONS
The core investment options offered to participants must be sufficient to provide them with a reasonable opportunity to: . Materially affect his or her account’s risk and return; . Choose from at least three investment alternatives, each of which is diversified, has different risk and return characteristics, enables a participant to build a portfolio with risk and return within the range normally appropriate for the participant, and enables a participant to minimize risk by diversification among the available alternatives; and, . Diversify his or her investment to minimize the risk of large losses. The Regulation specifies that “look-through investment vehicles” (diversified mutual funds, GICs and similar collective investments) must be used for small accounts. The definition of a look-through investment vehicle includes a “fixed rate investment contract of an insurance company qualified to do business in a State.” In other words, a plan sponsor is not required to use a GIC pool for small accounts; an individual GIC contract will meet 404(c)‘s requirements.
EXERCISE OF CONTROL BY THE PLAN PARTICIPANT
Section 404(c) is built on the idea that participants should be solely responsible for losses resulting from their exercise of control over the investments in their account. Accordingly, the Regulation discusses situations that may compromise that exercise of control. For example, if voting or tender rights are passed through to participants, they need be given only a reasonable opportunity to exercise those rights. On the other hand, a finding of undue influence by a plan fiduciary will negate the protection of 404(c), as would concealment of material non-public facts. “Inside information,” which may not be disclosed under Federal securities laws, is exempted.
The Regulation provides that employer stock funds are entitled to 404(c) protection if certain conditions are met. The 1991 Proposal had required that the plan sponsor appoint an independent, third party fiduciary who would carry out all activities related to the purchase or sale of employer securities or the exercise of voting or other rights on a confidential basis. This requirement was eliminated from the final Regulation, except in cases “which involve a potential for undue employer influence.” Instead, the plan sponsor must have procedures designed to safeguard the confidentiality of participant transactions, and must designate
a plan fiduciary to monitor plan compliance with those procedures. The
Regulation also requires that an independent fiduciary be appointed if the designated plan fiduciary determines that a potential for undue
influence exists. In addition, 404(c), protection is limited to “qualifying employer securities;” those that are publicly traded on a national exchange with enough frequency to ensure prompt and efficient execution of trades. Participants holding employer stock must be provided shareholder information. Even though employer stock funds meeting these requirements are entitled to 404(c) protection, such a fund may not act as one of the three core options required by the Regulation. The reason is that the fund is not diversified in a manner similar to other core options.
STABLE VALUE INVESTMENTS
The most popular investment alternative for 401(k) plans is the stable value fund, which is typically invested in fixed-rate investment contracts, such as GICs issued by insurance companies and other financial institutions. The Regulation provides that such investments might be used as one of the core investments required under the Regulation, even if the GIC fund is invested with a single issuer. Some GICs restrict transfers to a competing fixed income fund, such as a bond fund or a money market fund. Typically, the restrictions involve an “equity wash,” which requires that transfers between the GIC and the competing fund pass through an equity fund where they are left for three to six months. An equity wash provision might violate 404(c)‘s transfer frequency rules if it would prevent transfers between the two competing funds at least once every three months. However, the plan sponsor may be able to avoid the problem by offering GIC as an additional option outside the three core options. The Regulation provides that a stable asset fund may impose reasonable penalties for early termination. This type of provision is found most often in CDs, which impose a penalty for premature withdrawal. GICs often provide for a market value adjustment on contract withdrawals related to certain “employer-initiated” events, such as large layoffs or plant shutdowns. The Regulation would not appear to prohibit these provisions. However, it may place an additional burden on the plan sponsor to fully disclose those provisions or other penalties to plan participants. The Regulation requires the use of “look-through investment vehicles” to provide diversification in smaller participant accounts. A “look-through investment vehicle” is a pooled or common fimd of securities or stable assets, such as GICs. Some readers of the 1991 Proposal concluded that in-house management of look-through vehicles was prohibited. The DOL had never intended this interpretation and explicitly states in the commentary to the final Regulation that in-house management of GICs is not an issue. The requirement that an independent fiduciary choose all investment managers has, likewise, been dropped from the final Regulation.
RETAINED FIDUCIARY RESPONSIBILITIES
The plan sponsor and other plan fiduciaries do not escape all fiduciary responsibilities under a 404(c) plan. In fact, the only responsibilities that are eliminated are those directly related to investment elections made by participants. Plan fiduciaries remain responsible for the prudent selection of investment managers, unless participants are given the right to designate their own managers, and plan fiduciaries remain responsible for monitoring plan investments on an ongoing basis. The Regulation offers little guidance on the extent or frequency of monitoring required, except to say that it “will depend on the facts and circumstances of each case and vary from investment to investment . .”
IMPLICATIONS OF THE REGULATION
To comply, the trend in the industry appears to be toward more frequent transfers and a wider variety of investment options. The “sufficient information” requirements initially appear to be rather detailed, but they are certainly no more burdensome than the list of items that must be provided in other regulated cornrnunications. In many respects, the final Regulation is less burdensome than either of the previous proposals. The plan sponsor has more flexibility in its choice of investments than under the initial proposal. And, the “independent fiduciary” requirements of the 1991 Proposal have been relaxed, making compliance for employer stock funds easier. GICs and other stable asset funds fared very well under the Regulation. Restrictions on direct transfers between investment options do not necessarily preclude compliance with the Regulation. A plan sponsor who wants to offer competing fixed income options can still obtain 404(c) protection by structuring the plan to offer the competing fund “outside” of the three core funds. Plan sponsors should notify GIC/BIC issuers early in the process if they are considering plan changes to comply with Section 404(c). However, many alternatives are available to sponsors, and the status of GICs as either a core option or a “fourth” option gives these investments added importance in the investment planning process. In summary, GICs and similar products will continue to serve as a viable option under Section 404(c) and will give plan sponsors more flexibility in meeting the Regulation’s objective of educating employees.