KEYWORD:

EMPLOYEE BENEFITS MEMORANDUM

Date:	May 1, 2001
Re:	Fiduciary Duties Under 401(k) Plans

This memorandum sets forth, in general terms, the following:

a summary of recent literature questioning whether 401(k) plans are providing sufficient retirement savings for workers;

a summary of fiduciary duties under ERISA as they apply in general and in particular to 401(k) plans;

the role of ERISA § 404(c); and,

my recommendations concerning compliance with § 404(c) and ERISA's fiduciary duties.

I. The Questionable Ability of 401(k) Plans to Provide Enough for Retirement

There is a fair amount of evidence that 401(k) plans may not be producing the savings or investment growth necessary to provide adequate retirement income to employees. The concerns created by this conclusion are compounded by the dramatic increase in the number of 401(k) plans and the corresponding decrease in the number of traditional defined benefit plans.

In 1983, 3% of American workers participated in a 401(k) plan. In 1994, 47% of workers participated in a 401(k) plan. In 1992, 38% of families with retirement plans had a 401(k) plan only. In 1998, 57% of families with a retirement plan had a 401(k) plan only. In 1985, there were 170,000 employer-sponsored defined benefit plans. By 1997, that number had dropped to 53,000. Today, 401(k) plans outnumber defined benefit plans by 4 to 1.

In general, it appears that the median 401(k) account balance across all age groups is $14,000. The average account balance, by contrast, is higher - $50,000. The consensus in the literature is that the latter number is of limited usefulness in analyzing broad implications for 401(k) plans because of the relatively few, more highly compensated employees, who have accumulated very large 401(k) plan balances.

When broken out across age groups, the picture of median 401(k) account balances - for participants whose only retirement plan is a 401(k) plan - looks like this :

35 & under		$4,500
35-44		$15,000
45-54		$25,000
55-64		$22,000

For the oldest age group, this yields a retirement income of $2,600 per year for 20 years, assuming a total return of 10% per year until retirement.

Three-fifths of 401(k) plan participants report that their sole investments in stocks, bonds, annuities, or mutual funds are through their 401(k) plans. The average allocation of 401(k) plan assets, which in virtually every case are self-directed by participants, is as follows :

Stock Funds		46%
Money Market, Bond, Stable Value Funds		20%
Employer Stock Funds		18%

Three-fifths of 401(k) plan participants report that they have not reallocated contributions or plan assets since joining the plan.

The above numbers show improvement from those reported by the New York Times in a 1994 article about 401(k) plans. At that time it was reported that 80% of all participant contributions going into the Texaco 401(k) plan, which covered 18,000 employees, were used to purchase Texaco common stock or a money market fund. Only 20% of contributions were invested in a menu of mutual fund offerings.

There is evidence that participants in 401(k) plans are under performing professional investors. From 1992 to 1997, defined benefit plans returned an average of 2 percentage points more than defined contribution plans, most of which are 401(k) plans. Over a 35 year working career, this gap produces a 28% difference in replacement income at age 65.

II. Fiduciary Duties under ERISA

A fiduciary is "someone acting in the capacity of a manager, administrator, or financial advisor to a 'plan'." Peagram v. Herdrich, __ U.S. __, 120 S. Ct. 2143, 2151 (2000). An employer is a fiduciary under ERISA when engaged in such activities.

In general, ERISA imposes two broad fiduciary obligations.

The first obligation, the duty of prudence, requires fiduciaries to discharge their duties "with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of like character and with like aims."

The second obligation, the exclusive benefit rule, requires fiduciaries to discharge their duties "solely in the interest of the participants and beneficiaries . . . [and for the] exclusive purpose of providing benefits to participants and their beneficiaries."

Two points should be noted about the duty of prudence. First, it is largely a procedural obligation. That is, in order for a fiduciary to demonstrate compliance with the duty of prudence, the fiduciary must show that it took the same steps that a reasonably knowledgeable prudent person would have taken under the same circumstances. The fiduciary is not required to guarantee results. Second, the duty of prudence creates a more or less objective standard of conduct. The fiduciary's subjective state of mind or intent is largely, if not entirely, irrelevant.

ERISA also creates co-fiduciary liability in two primary circumstances. First, if a fiduciary's breach enables another fiduciary to commit a breach, the first fiduciary is liable for the breach by the second fiduciary. Second, if a fiduciary knows of a breach by another fiduciary and fails to take reasonable steps to correct it, the first fiduciary is liable for the second fiduciary's breach.

ERISA permits fiduciaries to delegate non-trustee fiduciary functions among themselves if the plan expressly provides a procedure for doing so. So long as the proper procedures are followed, fiduciaries are not liable for breaches by other fiduciaries, except to the extent provided for by the co-fiduciary rules discussed above.

With very limited exceptions, ERISA does not permit the delegation of trustee responsibilities. Pursuant to ERISA § 403(a), a trustee has, and must exercise, the "exclusive authority and discretion to manage and control the assets of the plan." ERISA § 403(a) provides for two exceptions to this rule of non-delegation. First, a trustee may be subject to the direction of a "named fiduciary." And second, the trustee may be subject to the direction of an investment manager. In both cases, the trustee is relieved of its "exclusive authority . . . to manage and control the assets of the plan," and is permitted to follow the directions of another fiduciary. Stated differently, in these two situations it is clearly permissible for the trustee to function as a directed trustee - acting solely on the instructions of another fiduciary. While there is some judicial authority supporting the proposition that 401(k) plan participants may function as named fiduciaries for purposes of proxy voting and tender decisions related to employer stock, the Department of Labor has stated that participants cannot serve as named fiduciaries for purposes of giving investment directions to the trustee.

ERISA § 404(c), while not phrased in the law as an exception to the non-delegation rule for plan trustees, essentially functions as such. Section 404(c) provides - as interpreted in Department of Labor ("DOL") regulations - that a fiduciary will not be liable for a loss which is the direct and necessary result of the participant's exercise of control over his or her account. Section 404(c) is the only section of ERISA that deals with participant self direction. It is the only provision of ERISA that protects fiduciaries from claims of breach of fiduciary duty arising from poor investment decisions by 401(k) plan participants.

As interpreted by DOL, full compliance with § 404(c) is difficult. Many employers do not fully comply with § 404(c).

Given (i) the general rule against non-delegation of investment management duties by trustees, and (ii), the apparent role of § 404(c) as the only source of protection under ERISA for fiduciaries who allow participants to direct the investment of their 401(k) account balances, what legal exposure is there, if any, to fiduciaries who permit participant self-direction in a 401(k) plan without complying with ERISA § 404(c)? The most likely answer - and the one favored by DOL - is that the trustee and all other fiduciaries remain bound by the duty of prudence.

Thus, in a self-directed 401(k) plan that does not comply with ERISA § 404(c), fiduciaries must determine whether compliance with participant investment directions is consistent with the duty of prudence. This principle, although easy to state in the abstract, is difficult to apply. Some questions raised by it are as follows:

Does the fiduciary have a duty to assess the quality and diversity of the investment options made available under the plan?

Does the fiduciary have a duty to assess the quality of participant education that the plan sponsor has given to participants?

Does the fiduciary have a duty to determine the level of investment sophistication among plan participants?

Does the fiduciary have a duty to review participant self-directions, and to question - or perhaps refuse to implement - those that would fail to meet the duty of prudence if the fiduciary him or herself were making the investment decisions?

There is no clear answer to these fundamental questions. But it is possible that courts could answer these questions affirmatively - reasoning that the duty of prudence requires a high level of supervision and review of participant investment directions. Should that occur, sponsors of self-directed 401(k) plans could find themselves exposed to unanticipated potential liabilities.

Courts are currently expanding employers' fiduciary obligations. In a September 14, 2000, Request for Information, DOL noted as follows:

Recent court decisions have found that plan fiduciaries have a duty to disclose information not expressly required to be disclosed under Part 1 of Title I. These cases have involved the fiduciary duty to act solely in the interest of plan participants and beneficiaries and the issue of the extent to which this fiduciary duty encompasses a collateral duty to provide participants and beneficiaries with information they need to exercise their rights effectively under the plan, to protect their rights under ERISA, or otherwise to make informed decisions about their future. These decisions have differed with respect to their approach, and the law appears to be evolving. As a result of the differing judicial rulings, the rules applicable to fiduciaries regarding these obligations at present appear to vary according to the federal judicial circuit that has jurisdiction over the case.

Examples of such cases include the following:

Farr v. U.S. West, 151 F.2d 908 (9th Cir. 1998), where the court held that an employer had an obligation to provide information to participants about the adverse tax consequences of a lump sum distribution from a non-qualified plan. The court stated as follows:

In re Unisys Savings Plan Litigation, 74 F.3rd 420, 442 (3d Cir. 1996), where the court stated as follows in the context of a claim for breach of fiduciary duty arising out of a self-directed 401(k) plan:

In re Ikon Office Solutions, Inc. Securities Litigation, 86 F. Supp. 2d 481 (E.D. Pa. 2000), where, in the context of a self-directed plan allowing investment in employer stock, the court refused to dismiss claims for breach of fiduciary duty against the officers of the employer for failure to disclosure material relevant information affecting the value of the employer's stock

Barker v. American Mobil Power Corp., 64 F.3d 1397, 1403 (9th Cir. 1995), where the court suggested that under some circumstances a fiduciary may have an affirmative duty to disclose information. The court stated that, a "fiduciary has an obligation to convey complete and accurate information material to the beneficiary's circumstance, even when a beneficiary has not specifically asked for the information."

III. The Role of ERISA § 404(c)

Section 404(c) of ERISA provides as follows:

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.

DOL 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. As noted earlier, 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.

Broad Range 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 § 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, which includes mutual funds, 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."

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. 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 § 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, § 404(c) protection is lost only with respect transactions involving the employer security investment alternative.

Limitations on Protection from § 404(c)

It should be noted that there are limitations to the protection that an employer obtains by complying with § 404(c). 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 § 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 § 404(c) plan is not a direct and necessary result of a participant's exercise of control, then § 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 § 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 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 § 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 § 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 § 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 § 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, § 404(c) does not relieve any liability for payment of excise taxes.

IV. My Recommendations

My recommendations, based on the foregoing, are as follows:

An employer should give serious consideration to complying fully with the requirements of § 404(c). I realize, in reaching this conclusion, that compliance with § 404(c) can be difficult. I also realize that compliance with § 404(c) does not protect fiduciaries from all exposure to fiduciary liability. Nonetheless, § 404(c) does protect fiduciaries from a large part of the fiduciary exposure created in self-directed 401(k) plans. Given the relatively low level of investment sophistication among 401(k) plan participants, this protection could be significant.

An employer should review the procedures that it has in place for selecting 401(k) plan providers and the investment alternatives that are made available under the plan.

An employer should institute procedures for monitoring the performance of the investment alternatives made available under the plan.

An employer should be knowledgeable about the costs of mutual funds under its 401(k) plan and should document that the cost of those funds is reasonable in relationship to other comparable funds.

An employer that makes its own stock available as an investment under a 401(k) plan should review its compliance with disclosure and reporting obligations under the federal securities laws.

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Please note that this memorandum is no more than a general discussion of the law, and does not constitute legal advice.