KEYWORD:

EMPLOYEE BENEFITS MEMORANDUM

Date:	February 22, 1996
Re:	ERISA Section 404(c)

Summary of Regulatory Requirements

Overview
Scope of the Protection Provided
Participant Control of Assets
Breadth of Investment Alternatives
Information About Investment Alternatives
Information to be provided automatically
Information to be provided on request
General information about disclosure
Giving Investment Instructions
In general
Frequency of opportunity to give instructions
Floors, caps, and expenses charged by plan to participant accounts
Limitations on requirement that fiduciary follow investment instructions.
Special Rules Relating to Employer Securities

Overview

Section 404(c) of ERISA provides,

In the case of a pension plan which provides for individual accounts and permits a participant or beneficiary to exercise control over assets in his account, if a participant or beneficiary exercises control over the assets in his account (as determined under regulations of the Secretary)--

such participant or beneficiary shall not be deemed to be a fiduciary by reason of such exercise, and
no person who is otherwise a fiduciary shall be liable under this part for any loss, or by reason of any breach, which results from such participant's or beneficiary's exercise of control.

Labor regulation 29 CFR  2550.404c-1 sets the standard for determining whether a plan permits a participant to "exercise control over assets in his account" and whether a participant in fact exercises such control within the meaning of the statute. If the plan provides such opportunity and the participant in fact has exercised such control, then no fiduciary will be liable under the fiduciary responsibility rules of ERISA for loss to a participant that is, in the words of the regulation, the "direct and necessary result" of that participant's exercise of control.

A plan does not permit a participant to exercise control unless it allows the participant to

choose from a broad range of investment alternatives consisting of at least three diversified investment alternatives, each of which has materially different risk and return characteristics;

obtain enough information to make informed decisions about investment alternatives available under the plan; and
give investment instruction with a frequency which is appropriate in light of the market volatility of the investment alternatives, but not less often than once within every three month period.

If a lawsuit is filed, the focus will be on the specific facts of the transaction at issue as well as on general plan policies and procedures. If an individual participant, for example, fails to give investment instructions, the general fiduciary rules of ERISA require the trustee to prudently invest the account for him, and section 404(c) protection would not apply to any loss to the participant's account. Note that the regulation does not allow section 404(c) protection if a participant's choice is not affirmative, even if participants are notified that their money will be invested in a designated default option unless they elect otherwise. Moreover, the regulation's preamble states that, even if a plan does not attempt to comply with section 404(c), general fiduciary duty principles prevent plan fiduciaries from blindly following a default option--the fiduciary must determine whether it is prudent to do so.

Nothing in the statute requires a plan with participant-directed investments to comply with section 404(c), and the regulation states that its standards are not intended to be applied in determining whether a fiduciary has fulfilled its general fiduciary duties under ERISA. Consequently, if a participant sued a fiduciary of a plan not in compliance with 404(c), the court is supposed to apply general principles of fiduciary duty rather than the requirements of the 404(c) regulations. The DOL representative to whom I posed questions regarding section 404(c) confirmed that a great number of participant directed plans still do not comply with section 404(c).

Scope of the Protection Provided

The protection provided by section 404(c) is narrow. If a participant sues plan fiduciaries because of a transaction that resulted in poor investment results, then plan fiduciaries are protected from liability for loss to that participant's account if they can prove that (1) the requirements of section 404(c) were met in connection with the transaction at issue and (2) the loss is "the direct and necessary result" of the participant's exercise of control.

The regulation gives the following example:

Participant P directs a plan fiduciary F, a bank, to invest all of the assets in his individual account in a collective trust fund managed by F that is designed to be invested solely in a diversified portfolio of common stocks. Due to economic conditions, the value of the common stocks in the bank collective trust fund declines while the value of the publicly offered fixed income obligations remains relatively stable. F is not liable for any losses incurred by P solely because his individual account was not diversified to include fixed income obligations. Such losses are the direct result of P's exercise of control; moreover, under the regulation F has no obligation to advise P regarding his investment decisions.

However, if an investment loss under a section 404(c) plan is not a direct and necessary result of a participant's exercise of control, then section 404(c) provides no protection. The regulation provides the following example:

Assume the same facts as above, except that F, in managing the collective trust fund, invests the assets of the fund solely in a few highly speculative stocks. F is liable for losses resulting from its imprudent investment in the speculative stocks and for its failure to diversify the assets of the account. This conduct involves a separate breach of fiduciary duty that is not a direct or necessary result of P's exercise of control.

In addition to prudent management of investment alternatives, choosing an investment manager or investment alternative (such as a mutual fund) is a fiduciary act for which section 404(c) provides no protection. A fiduciary also has an obligation to periodically evaluate the performance of investment managers and investment vehicles to determine whether they should continue to be available as participant investment options. Section 404(c) provides no shield in this connection.

The individual investment decisions of an ERISA-qualified investment manager who manages a mutual fund or similar vehicle are not considered to be the direct and necessary result of the participant's choice of such vehicle. Thus, an imprudent investment decision subjects such a fiduciary to liability, even if the plan complies with section 404(c). Any fiduciary who engaged the investment manager would not be liable unless the decision to hire or keep the investment manager was imprudent.

Note that section 404(c) relief is not available with respect to plan loans to participants--plan fiduciaries remain responsible for determining the prudence of making plan loans.

The regulation also provides that section 404(c) relief is not available in connection with a transaction if (1) the plan sponsor or a plan fiduciary has improperly influenced the transaction; (2) a plan fiduciary possessed and failed to reveal non-public information material to the transaction unless such disclosure to participants would violate any provision of federal law or controlling provision of state law; or (3) the participant is legally incompetent when he gives the instruction and the plan fiduciary knows this. Transactions between a plan and a fiduciary or affiliate are not protected by section 404(c) unless they are fair and reasonable to the participant--that is, unless they comply with ERISA's adequate consideration rules.

Finally, if a prohibited transaction is committed, section 404(c) does not relieve any liability for payment of excise taxes.

Participant Control of Assets

A participant is deemed to have exercised control over the assets in his account if he in fact directs the investment of his account and if the plan meets requirements concerning breadth of investment alternatives, information about investment alternatives, and frequency of opportunity to give investment instructions.

Breadth of Investment Alternatives

The plan must offer at least three investment alternatives that meet certain requirements. The regulation calls these three (or more) alternatives "core investment alternatives." The plan can also have other investment alternatives that do not meet the requirements. The core investment alternatives must materially differ with respect to risk and return. In the aggregate, the core alternatives must enable the participant, by choosing among them, to achieve a portfolio with risk and return characteristics at any point within the range normally appropriate for his circumstances. In addition, the regulation states that each of the investment alternatives, "when combined with investments in the other alternatives, [must tend] to minimize through diversification the overall risk of a participant's . . . portfolio." Each core alternative must itself be diversified--for example, employer securities would not be a permissible core investment alternative but they could be offered as a supplemental alternative.

Unless all participants have large balances, the core investment alternatives must be "look-through" investment vehicles such as mutual funds, bank investment vehicles (including common or collective trust funds, pooled investment funds, and guaranteed investment contracts), insurance company contracts, or in-house funds. Otherwise, the small investor would have no meaningful opportunity to diversify his holdings.

Information About Investment Alternatives

A plan fiduciary who is responsible for providing information to participants must be designated. The fiduciary may be designated by function rather than name, and the designated fiduciary can delegate such responsibility to another person. Information required to be disclosed falls into two categories--information to be provided automatically, and information to be provided on request.

Information to be provided automatically

The following information must be provided to participants automatically:

Notice of Limited Liability. An explanation that the plan is intended to constitute an ERISA section 404(c) plan as described in the regulation, and that plan fiduciaries may be relieved of liability for any losses that are the direct and necessary result of investment instructions given by the participant. (This requirement is intended to emphasize to the participant that he must take responsibility for investment decisions).

Description of all investment alternatives. A description of all investment alternatives available under the plan, along with a general description of the investment objectives and risk and return characteristics of each alternative, including information relating to the type and diversification of assets comprising the portfolio.

Identification of any designated investment managers.

Investment instructions and restrictions. An explanation of the circumstances under which participants may give investment instructions (to whom, how, and when instructions are given) and an explanation of any specified limitations on such instructions under the terms of the plan, including any restrictions on transfers (such as penalties that result from transfers out of a vehicle before maturity) or restrictions on exercise of incidental rights such as voting or tender (such as notifying participants that voting rights are not passed through).

Transaction fees. A description of any transaction fees or expenses that will be assessed directly against the participant's account balance (such as commissions, sales loads, deferred sales charges, redemption or exchange fees).

Provider of information. The name, address, and phone number of the plan fiduciary (or any person designated by the fiduciary) responsible for providing on-request information, and a description of the types of information available on request.

Confidentiality in connection with employer stock. In the case of plans offering as an investment alternative the ability to directly or indirectly acquire or sell any employer security, a description of the procedures established to ensure confidentiality for participant decisions concerning such stock, and the name, address, and phone number of the plan fiduciary responsible for monitoring compliance with the procedures.

Prospectuses. For initial investment in an investment alternative that is required by the Securities Act of 1933 to provide a prospectus, a copy of the most recent prospectus provided to the plan. This can be provided immediately before or immediately after the participant's initial investment. It is not necessary to pass through to such participants every subsequent updated prospectus provided to the plan. However, these materials should be provided on request.

Pass-through proxy materials. After a participant's investment in an investment alternative, if the plan passes through voting, tender rights, or similar rights, relevant materials provided to the plan and references to plan provisions regarding pass-through must be provided to participants if the plan wants participants to be considered to have exercised control with respect to such rights. The regulation does not require pass-through of such rights except with respect to employer securities but, naturally there is no 404(c) protection for exercise of such incidental rights unless pass through is provided.

Information to be provided on request

The plan must provide the following information on request (and may also do so automatically if it wishes to):

Operating expenses. For any investment alternative, a narrative description of annual expenses that reduce the rate of return to participants, such as investment management fees, administrative fees, and transaction costs, and the "aggregate amount of such expenses expressed as a percentage of average net assets" of the investment alternative.

Financial reports. Copies of any prospectuses, financial statements and reports, and any other materials relating to investment alternatives available under the plan, to the extent such information is provided to the plan. If operating expenses are provided in these materials, there is no need to provide them separately pursuant to the above item. The plan need not create such materials unless the plan sponsor is the fund manager.

List of assets. For assets within a portfolio that constitute plan assets within 29 CFR  2510.3-101 (which includes group trusts, bank common or collective trust funds, and certain separate accounts of insurance companies, but does not include mutual funds), a list of these assets and the value of each asset or the proportion of the fund devoted to it. The preamble to the regulation states, "It is anticipated that the disclosure of plan asset information based on the plan's latest form 5500 will satisfy this requirement so long as such information is accurate enough to enable the participant to make an informed investment decision." With respect to each investment in this category that is a fixed rate investment contract issued by a bank, savings and loan association, or insurance company, the name of the issuer of the contract, its term, and the rate of return must be provided on request.

Overall investment performance. Information about the value of shares or units in available investment alternatives, as well as past and current investment performance of such alternatives determined, net of expenses, on a reasonable and consistent basis. This can be based on the most recent materials available to the plan.

Individualized investment performance. The value of shares or units held by an individual participant, based on the most recent information available to the plan. The plan can limit the frequency or times of such requests "as long as such limitations do not result in participants . . . being prevented from obtaining sufficient investment information to make informed investment decisions."

General information about disclosure.

The following general observations apply to disclosure of relevant information:

Fiduciaries do not have to revise any materials to make them more understandable to participants.
Complying with the disclosure requirements of the regulation does not, in and of itself, constitute giving investment advice within the meaning of ERISA.
It is anticipated that, in most cases, fiduciaries do not have to create any documents to comply with these requirements unless information is specific to a participant or the plan.
Information must be given in time to give the participant a reasonable opportunity to make an informed decision. The preamble to the regulation states that all but the last two items in the "automatic disclosure" category above should be given to participants before they are permitted to give investment instructions. Any material changes in the information must be furnished in enough time to allow participants to take such changes into account before making an investment decision.
Information provided on request must be the most recent information available to the plan.

Fiduciaries have no obligation to provide investment advice to participants.

Giving Investment Instructions

In general. The plan document must identify a fiduciary who is obligated to follow participant instructions (with some exceptions described below). Although a participant may communicate his instructions by any means, he must be given the option of obtaining written confirmation of his investment instructions.

Frequency of opportunity to give instructions. Section 404(c) relief is available for an investment in a particular investment alternative only if participants can give investment instructions with a "frequency commensurate with the reasonably expected volatility of the investment alternative." In connection with the three or more core investment alternatives that are designed to provide the broad range of investment alternatives required for compliance with the regulation, the same rule applies, with the additional requirement that participants must be given an opportunity to give investment instructions at least once in any three month period.

When giving instructions with respect to existing account balances, it is meaningless to have frequent opportunities to move money out of a highly volatile fund if movement into all the other alternatives is allowed less frequently. The regulation offers two ways to solve this problem: (1) Transfers into at least one of the core investment alternatives must be allowed as often as investment instructions are permitted for any alternative that permits instructions more frequently than once within every three month period; or (2) With respect to each investment alternative that permits participants and beneficiaries to give investment instructions more frequently than once within any three month period, participants must be allowed to direct their investments from such alternative into an income producing, low risk, liquid fund. In addition, participants must be allowed to direct investments from such low risk fund into one of the core investment alternatives as often as they are allowed to give instructions with respect to such alternative. Similar (but slightly more stringent) rules apply for transfers out of employer security funds.

Floors, caps, and expenses charged by plan to participant accounts

It is permissible to require investment decisions to relate to a minimum dollar amount or percentage of account as long as the amount bears a reasonable relationship to related administrative costs. The regulation uses 5% as an example of a percentage-related minimum, but 10% should be permissible as long as it can be justified. (The DOL representative told me that the DOL has issued no additional guidance that would help us determine whether a 10% increment is permissible.) No maximum investment amount or percentage is permitted in connection with any core investment alternative. A plan may charge participant accounts for the reasonable expenses of carrying out investment instructions, provided that the plan has procedures for periodically informing participants of the actual expenses incurred in connection with their individual accounts.

Limitations on requirement that fiduciary follow investment instructions.

Section 404(c) relief is not available in connection with instructions that would be contrary to plan documents, jeopardize the plan's qualified status, cause a fiduciary to maintain the indicia of ownership of any assets of the plan outside the US except as permitted by law, cause a participant's account to have a negative balance, or result in certain transactions between a plan and a party in interest (this list is more stringent than the prohibited transaction rules--for example, it disallows 404(c) protection for any plan loan to a participant). In addition, a fiduciary is not obligated to follow instructions that would result in a prohibited transaction or that would generate income taxable to the plan. The plan is allowed to impose other reasonable restrictions on participant instructions, such as restrictions on transfers out of a particular investment option. The regulation requires that any limitation on a participant's ability to exercise control (such as restrictions on transfers) be set out in the plan. However, the DOL apparently is willing to take a flexible view of what documents are considered part of the plan.

Special Rules Relating to Employer Securities

A section 404(c) plan must have in place procedures designed to safeguard the confidentiality of information relating to the purchase, sale, holding and exercise of voting and similar rights with respect to employer securities, and the plan must designate a plan fiduciary to monitor plan compliance with these procedures. Employer securities must be publicly traded and able to be turned around quickly in a market not influenced by the plan sponsor. Participants must also receive any information provided to shareholders. Voting, tender, and similar rights on employer securities must be passed through in order to get 404(c) relief for any aspect of investment in employer securities. If a plan fails to meet these requirements, section 404(c) protection is lost only with respect transactions involving the employer security investment alternative.