VOL. 25, NO. 2
SUMMER 2012
BENEFITS LAW
JOURNAL
From the Editor
The Designated Investor: Participants
Would Benefit by Expanding ERISA’s
404(c) Safe Harbor
W
ould an employer allow each of its employees to democratically invest his or her share of the company’s defined benefit
(DB) plan assets? Of course not. That would be a clear violation of
ERISA given that few workers have the expertise, time, or inclination
to manage investments. Yet, ERISA virtually requires that employees
control the investment of their own 401(k) or other defined contribution (DC) accounts. To do otherwise would invite being sued by participants and intense scrutiny from the Department of Labor (DOL).
ERISA correctly expects a high standard of expert care from the
fiduciaries managing retirement plan investments. For large DB
plans, employers usually outsource most investment responsibility
to a team of investment pros, with the employers’ principal duty to
prudently hire and fire those experts. Smaller employers do not have
the resources to customize their DB investments, but can still hire an
insurance company, mutual fund family, or broker to do the heavy
lifting. Significantly, except for outright thievery, there’s very little
litigation with participants or the DOL over poor pension investing
because the employer, and not the participant, is on the hook for
any DB plan underfunding. Investment losses do not directly affect
employees.
While the ERISA fiduciary rules also apply to DC plans, there are
two important exceptions that materially overshadow the rules. First,
under the ERISA 404(c) safe harbor, an employer is absolved of liability if participants make poor choices as long as: participants each
have their own account; are offered a choice of at least three different
From the Editor
diversified investment funds; actually make an investment election at
least once; can move their money between the funds at least quarterly; and receive proper disclosures and DOL-ordained magic words
about the funds, fees, and the like. With today’s sophisticated recordkeeping platforms and a huge selection of actively managed and
index funds, virtually any 401(k) or DC plan can go well beyond the
404(c) minimums and offer participants dozens of investments from
which to choose pretty much at will.
A second ERISA safe harbor insulates employers from being sued
by participants who fail to make any investment selection at all; the
employer is protected if the DC account is defaulted into a target
date, asset allocation, or similar blended investment fund (a so-called
qualified default investment alternative or QDIA), and the participant
is periodically reminded that he or she can reinvest the money among
any of the funds on the investment menu. With ERISA’s 404(c) and
QDIA rules, the employer’s only fiduciary duty is to prudently select
and monitor what’s on the menu and which fund is the QDIA. After
that, if participants choose poorly, lose a bundle, or don’t keep pace
with inflation, the employer is absolved.
So how are participants doing? By all accounts, not particularly
well. The big recordkeepers report that a significant percentage of
participants act counter to conventional investment wisdom, either
by failing to diversify (there are many single-fund investors), chasing performance (investing in last year’s winners), or being overly
conservative or aggressive. Also, despite the ability to rebalance their
investments virtually 24/7, a large number of folks never make a
change even after their portfolio gets out of balance because various
investments perform differently, or their situation changes, or they
approach retirement. Possibly, employees invested exclusively in the
plan’s money market or emerging markets fund have a very good reason for doing so; they may have a large diversified portfolio outside
of the plan covering the other asset classes, for example, but this is
extremely doubtful.
Most employees aren’t investment experts and many of those who
do manage to figure it out (perhaps by using the plethora of educational materials and programs most vendors offer) eventually lose
focus on their investments. Plus all participants are, after all, human
and subject to the irrational impulses and misguided investment
instincts that cloud decision making, especially concerning personal
finances.
And participants on average seem to be fine with letting their
employer choose their investments. A recent white paper by the
Pension Research Council on participant behavior in plans in the
Vanguard platform using a target date fund as the default investment,
showed that almost half of new participants invested in the target
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From the Editor
date fund. (Target Date Funds in 401(k) Retirement Plans, Mitchell &
Utkus, Mar. 2012.) Interestingly, the proportion of new and existing
participants actively choosing the target date fund increased significantly when that fund was the default investment. It appears that even
proactive participants are nudged into choosing the default fund simply because it is the default fund.
Since participants are not particularly adept at investing and many
seem to want direction, it would be expected that some employers
would decide to take complete charge of their employees’ DC plan
investments and not allow any choice. For example, all DC funds
could be invested in a prepackaged target date or other blended fund.
Larger plans could even use a DB-type approach by creating a customized assets allocation and hiring institutional managers to invest
in the various asset classes. But by not giving participants a choice,
the employer loses the ERISA 404(c) and QDIA safe harbors. Thus,
only an exceedingly courageous or foolhardy company would take
full investment responsibility from DC participants.
Even if the DC’s investments were jointly managed by Warren
Buffett, Peter Lynch, and Adam Smith, without the ERISA protections,
an employer and/or the money managers would be almost guaranteed
of getting sued. In any given year, some asset classes and investment
strategies are going to do better than others. In up markets, employees
would complain that the plan invested too heavily in fixed income;
in down markets, the problem would be too much in equities. Or not
enough emerging markets, or value stocks or whatever investment
happened to have recently outperformed.
It’s easy to find fault in hindsight. The employee stock ownership
plan (ESOP) universe illustrates the point. When the employer stock
price declines, the employer can be hit with a “stock drop” suit. Even
when a stock outperforms, employers have been sued for having too
little invested in stock, for example, because the ESOP maintained
a small cash reserve to smooth out administration. Or consider the
outcry from the DOL and Congress during the great recession when,
“shockingly,” target date funds declined in value. Fortunately, the
ERISA safe harbors insulated employers and managers from litigation,
but ironically the DOL steered employers into using target date funds
as a QDIA and then acted surprised that they had an allocation to
equities, which cratered with the rest of the market.
ERISA pushes employers to give inexperienced and distracted drivers the keys to the car rather than hiring a designated professional
driver.
The solution is simple, but requires an act of Congress: ERISA
Section 404(c) should be updated to allow employers to reasonably
take full charge of DC plan investing. This expanded safe harbor
should cover an employer wishing to designate a target date fund or
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From the Editor
other QDIA-worthy vehicle, or to create a bespoke investment fund
as the exclusive plan investment. After all, what’s good for a pension
plan should be good for a 401(k).
David E. Morse
Editor-in-Chief
K & L Gates LLP
New York, NY
Copyright © 2012 CCH Incorporated. All Rights Reserved.
Reprinted from Benefits Law Journal Summer 2012, Volume 25,
Number 2, pages 1–3, with permission from Aspen Publishers,
Wolters Kluwer Law & Business, New York, NY, 1-800-638-8437,
www.aspenpublishers.com