Forty years ago, very few U.S. employees were personally affected by what happened on Wall Street. Six in 10 Americans were covered by a pension that they could count on regardless of the stock market. Today less than 2 in 10 workers in the private sector have a pension and most workers only option is to invest in retirement accounts such as 401(k)s, IRAs, and 403(b)s in which they have to chose where to put their money and the consequences of bad advice or a bad decision can be devastating and irreversible.
Recently, the U.S. Department of Labor (DOL) has proposed regulations requiring additional disclosures of investment-related information to participants in plans with self-directed investments.
Most 401(k) plans permit participants to direct the investment of their accounts. Under Section 404(c) of the Employee Retirement Income Security Act (ERISA), employers and other plan fiduciaries may avoid liability for poor investment performance so long as employee-participants have a meaningful opportunity to direct the investments. Among other things, employees must have access to sufficient information about their investment options.
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Defined-benefit and defined-contribution plans
Retirement plans, including those subject to ERISA’s fiduciary requirements, fall into two basic types: defined-benefit and defined-contribution plans. A defined- benefit plan, often refered to as a pension, provides employees with a stated benefit at retirement, generally determined by reference to their compensation during a specified portion of their career and the duration of their service with the employer. Defined-benefit plans have historically been the province of large, often unionized, public and private employers. The social security system represents another type of defined-benefit program.
While defined-benefit plans still occupy an important niche in the American retirement system, they increasingly have been supplemented or replaced by defined-contribution plans, such as 401(k)s and 403(b)s. Under those plans, employees aren’t promised a fixed benefit at retirement. Rather, during an employee’s career, contributions are made by the employer and/or the employee to his plan account and invested for his benefit.
The 401(k) plan is the preeminent example of today’s defined-contribution plans. Employees make contributions to the plan on a pretax basis through elective deferrals deducted from their compensation. Employers will typically match those contributions within stated limits. In some cases, employers may also make discretionary profit-sharing contributions to employees’ accounts.
During an employee’s career, her account normally generates investment gains. Historically, the investments were directed by the plan trustee or investment manager, but employers increasingly have opted to permit (or indeed require) participants to control the investment of their accounts. In either case, the employee’s benefit consists of the account balance accumulated at the time of retirement or other termination of employment.
Because 401(k) plans involve the element of employee choice in terms of elective deferral contributions, they were among the first to permit participants to direct the investment of their plan accounts. An employee with a 401(k) therefore controls both of the key aspects of the plan: the amount to be contributed (by her and by the employer if it makes matching contributions) and the investment of those contributions.
Section 404 of ERISA
Under Section 404 of ERISA, plan fiduciaries must ensure that plan assets are invested prudently, in accordance with the plan documents and in a diversified manner unless it would be imprudent to do so. However, Section 404(c) provides that if a plan gives employees a meaningful opportunity to direct the investment of their accounts, the fiduciaries will not be held liable for the performance of the investments so long as they otherwise operate the plan in a prudent manner.
For example, if (as is usually the case) employees’ investment choices are limited to something less than the entire universe of potential investments — such as funds offered by a single mutual fund company — the fiduciaries must act prudently to ensure that the investment provider is reputable and a sufficiently diverse range of investment options is available to plan participants. Employees must also be permitted to exercise reasonable control over their investments by being allowed to change the investment mix of their accounts with reasonable frequency.
Some years ago, the DOL issued regulations governing the Section 404(c) exemption. Those regulations explain when a plan permitting participant-directed investments will be deemed to satisfy the Section 404(c) requirements outlined above. Note that not all plans providing for participant-directed accounts satisfy the requirements. While such plans aren’t illegal, their fiduciaries won’t be fully insulated from potential liability under Section 404(c).
That can be a problem for the fiduciary because participants in such plans still have significant control over their accounts, but the fiduciary can still be liable for the poor outcome of their choices. Most sponsors of plans with self-directed investments therefore make every effort to satisfy the Section 404(c) requirements.
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DOL seeks informed choices
While the basic Section 404(c) regulations have been in place for some time, in the wake of the collapse of Enron and its 401(k) plan as well as other well-publicized problems involving plans with participant-directed accounts, the DOL recently mounted an initiative addressing disclosures to plan sponsors and participants. The agency’s initiative has three parts. The first involves changes to the information plan administrators are required to file annually with the government on Form 5500. The second requires plan service providers (like mutual funds) to provide information to plan sponsors about their services and fees.
The final proposal in the DOL’s initiative deals with the information plan fiduciaries must provide participants. The proposal attempts to enforce some consistency in disclosure practices required by the Section 404(c) regulations, which currently vary widely among plans and their service providers. The proposed regulations would require plan sponsors to provide participants with a summary of the plan’s investment options and the fees and expenses related to each option.
It’s important to note that most of that information is already furnished (or at least available) to participants in a variety of ways, including through mutual fund prospectuses, websites, and plan enrollment and investment election forms. The DOL proposal focuses on the key pieces of information that the government feels fiduciaries must provide to participants to help them make informed decisions about their retirement investments, including:
- basic information about investment options available under the plan, including the name of the investment (such as a mutual fund or guaranteed investment contract), the investment category (such as a growth or money market fund), annual fees and expenses for each investment option, and past performance of the investment relative to an appropriate “benchmark” investment;
- additional information, made available on a website, relating to each investment option, including the investment strategy and the risk attendant to that investment, portfolio turnover, and performance-related fees;
- information about the way the plan handles investments, such as the details of how and when participants can direct their investments, including any voting rights relating to the investments that are passed through to participants; and
- information concerning fees and expenses that may be charged, including investment-related expenses, administrative fees, and transaction-based charges, such as sales charges or “loads” and fees for loans or withdrawals.
The proposed regulations include detailed guidelines on proposed disclosure methods and timing requirements for providing information to participants.
While an in-depth discussion of the requirements is beyond the scope of this article, plan sponsors will need to work closely with their service and investment providers to assemble the required information and see that it’s presented in the appropriate format and disseminated to participants in a timely manner using the methods prescribed in the regulations. Since the DOL proposes to make the regulations effective for plan years beginning on or after January 1, 2009, prompt action will be required to ensure compliance.
Bottom line
Even though most of the information that must be disclosed under the new DOL regulations is already available to participants in one form or another, complying with the proposed rules will place a significant burden on plans that allow self-directed investments. Although the compliance obligation ultimately rests with the plan sponsor and other fiduciaries, most of you (or at least those of you with small and midsize plans) will need to rely heavily on your mutual fund company or other plan investment provider for assistance in assembling, organizing, and presenting the required information.
Many investment providers are proactively reaching out to their retirement plan clients in an effort to ensure compliance. If you have plans that will be subject to the new rules and you haven’t been in touch with your providers, contact them as soon as possible. Your plan fiduciaries and investment providers can develop strategies to help you comply with the new regulations.