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404(c) regulations: the choice is yours.

The DOL'S newly proposed regulations offer relief from fiduciary responsibility to sponsors of savings and pension plans that provide participant-directed investments. Compliance is not mandatory.

The newly revised proposed Section 404(c) regulations the Department of Labor issued earlier this year have attracted considerable attention. Much of this attention results from a commonly held belief that 11 sponsors of private pension and savings plans will be required to comply with the regulations when they become final, This is not true. Plan sponsors will have the option of adopting the regulations, with no penalty should they choose not to.

But plan sponsors need to decide whether to comply with the regulations once they are final, and service providers need to determine how the regulations will affect their product design, plan administration, and marketing strategies. And sponsors and service providers also need to consider how their systems and operations may change in light of the regulations. So, even though compliance will not be mandatory, anyone involved with these types of plans needs to know what the regulations will and will not do, and plan sponsors need to know what they will have to do if they wish to take advantage of the relief from fiduciary responsibilities and liability the 404(c) provision provides.

Section 404(c) statutory provision

Section 404(c) of the Employee Retirement Income Security Act of 1974 relieves pension plan fiduciaries of some fiduciary responsibility and liability for defined contribution plans that permit plan participants or beneficiaries to exercise control over the investment of assets in their individual accounts.

When Congress passed ERISA in 1974, it recognized that some fiduciary relief is appropriate for sponsors of participant-directed investment plans. But it also wanted to protect participants by making certain that they have the opportunity to make informed decisions based on a broad range of investment options. Congress also recognized the potential for abuse in such plans, particularly with employers' attempts to pressure participants to buy or hold employer securities. As a result, Congress directed the DOL to develop regulations to establish the conditions under which such a plan would qualify for fiduciary relief under ERISA's Section 404(c).

DOL's 404(c) regulations

In August 1987, the DOL proposed regulations that addressed these conditions. But during two days of public hearings in early 1988, plan sponsors and others who had an interest in the matter roundly criticized the DOL's proposal. They felt the regulations were overreaching and inappropriate for the standards of plan design and administration prevalent at the time.

Most heavily criticized were the proposed requirements that plans provide at least five investment options and that participants be allowed to make investment directions at least once every three months; the exclusion of employer securities from 404(c) relief; and the DOL's failure to address specifically GICs, BICs, and similar types of investment contracts. Plan sponsors were also concerned that the courts might decide to apply the standards established by the regulations to all participant directed investment plans subject to ERISA. So the DOL went back to the drawing board.

On March 13, 1991, the DOL issued new proposed regulations. The revised proposal addresses many of the concerns expressed about the original proposal and is clearly an improvement. But the public hearings the DOL conducted in july indicate that its latest version also contains controversial provisions that need to be addressed before the regulations become final.

What the latest proposal includes

Under the new proposed regulations, participants and beneficiaries must be provided a "broad range of investment options" from which to choose, and they must have the ability to control their account "in fact." The DOL provides some guidance on how these standards are to be interpreted. For example, participants and beneficiaries must be given at least three investment options other than employer securities from which to choose. All investment options and plan activities must not discriminate against any group of participants. And, unlike the regulations proposed in 1987, the new proposal gives plan sponsors the responsibility and authority to select individual investment options, such as equities, corporate bonds, government securities, GICs, money market funds, real estate, and venture capital.

The options the plan fiduciary selects must fit within the overall framework provided under the reproposed regulations. Each of the three required options must provide materially different risk and return characteristics. They must also meet certain standards when they are combined. And, taken together, investment options must 1) provide participants the opportunity to affect their risk and return from the assets over which they have control; 2) enable participants to achieve a portfolio having aggregate risk and return characteristics that are in a range normally appropriate for participant; a each of the three required investment options, when combined with an investment from either of the other two, minimizes the overall risk of a participant's portfolio at any level of expected return. (There are those who question the appropriateness of the third of these standards. First, they are concerned that it cannot be met as it is currently written and, second, they question if it is even necessary, given the other standards.)

The proposed regulations also require that participants with small account balances be offered "look-through investment vehicles," such as pooled-investment vehicles and Mutual funds, so they can achieve adequate diversification within asset classes. In addition, an independent fiduciary would have to select or approve any look-through investment vehicles that are offered to participants, a requirement that has been criticized as being overreaching, inappropriate, and unnecessary.

Participants and beneficiaries must be able to allocate their account balances between the three required investment options at least every three months. The frequency with which participants and beneficiaries must be able to allocate their account balances to and from an options beyond the three required would depend on the volatility of each option. Some options, such as commodities contracts, would require more frequent opportunity for investment direction, while others, such as restricted GICs or similar investment contracts, may require less frequent opportunity for investment direction.

Sponsors must provide plan participants and beneficiaries adequate information on the required investment options to assure they can make informed decisions. Sponsors will not, however, have any obligation to provide investment advice to participants. And, in fact, they should not offer investment advice: doing so would increase their exposure to participant suits.

Finally, any attempt to pressure or unduly influence participants' investment decisions would result in the loss of 404(c) protection for the investment involved.

Regulations for GICs

The newly proposed regulations specifically address GIC and related investment contracts, such as BICS, because they are so popular with plan participants. In general, under the reproposed regulations, GICS can be offered as one of the three required investment options if the plan meets the other requirements. If the GIC options do not meet these requirements, they can be offered as an additional investment choice.

importantly, unlike the earlier proposal, the newly proposed regulations do not mandate investments that insurance companies would view as competing with GICS in a manner that could result in disintermediation and adverse selection. Rather, the plan fiduciary has the authority to decide which investment options the plan will offer. The options that plan fiduciaries choose will have an effect on whether and on what basis (for example, the interest rate provided under the contract) insurance companies and other contract providers will be willing to issue the contracts. in this regard, plan fiduciaries are becoming increasingly concerned about how to select, negotiate, monitor, and manage these contracts in light of recent insurance company insolvencies and the state of the insurance and banking industries. As a result, many fiduciaries are less willing to allow significant transfer restrictions and are seeking exit clauses, reinsurance arrangements, or other protections when negotiating these contracts.

Employer securities

The reproposed regulations will provide relief for employer security transactions that satisfy a number of conditions. The securities must be qualifying employer securities" under ERISA, they must be publicly traded, the sponsor must pass through information and voting rights to participants, and an independent fiduciary must handle all purchases, sales, and proxy voting activities in a confidential manner.

These conditions have aroused considerable controversy. Critics feel the requirements for an independent fiduciary and confidentiality make the proposed extension of 404(c) protection to employer securities transactions illusionary. Few plans currently satisfy these requirements and generally cannot do so unless an independent third party performs all plan administration and recordkeeping.

No negative inference' for noncompliance

Importantly, the preamble to the reproposed regulations notes that pension and savings plans that provide for participant investment direction are not required to be "404(c) plans." Further, the DOL has included "no negative inference" language, noting that failure to comply with the 404(c) regulations does not mean that the plan's design or administration is necessarily flawed or that the plan is automatically in violation of ERISA. At the same time, if the plan sponsor wants to limit its fiduciary liability for participant-investment decisions, it must comply with all applicable provisions of the final regulations.

What does 404(c) cover and not cover? Plan sponsors should understand what Section 404(c) does and does not do, so they can make an informed decision as to whether or not to adopt it when the regulations are finalized. And plan fiduciaries also need to be aware of the nature and limitations of the protection afforded by Section 404(c).

In simple terms, Section 404(c) provides plan sponsors with a shield against fiduciary suits that might result from asset allocation and investment decisions by plan participants and beneficiaries. For example, if a participant in a 404(c) plan directed that all of his or her account be invested in an indexed equity fund just before a significant market decline, the plan sponsor and fiduciaries could use 404(c) as a defense should the participant sue.

Because Section 404(c) does not provide relief from ERISA'S fiduciary responsibility and liability provisions when investment choices are limited, the selection of the individual options offered to participants and beneficiaries is important. If a sponsor decides to seek 404(c) protection, plan fiduciaries will not only need to assure that the required investment options meet the minimum standards prescribed by the final regulations, but they will also need to assure that any specified options are prudent and not in conflict with ERISA's provisions for prohibited transactions, both at the time of their selection and periodically as long as they are offered.

Furthermore, Section 404(c) does not provide any protection in connection with the composition and management of certain pooled funds. For example, it does not provide protection in connection with the selection and management of individual contracts that comprise GIC funds. As a result, plan fiduciaries will need to take great care in selecting and monitoring pooled funds. Finally, Section 404(c) does not provide full relief for transactions prohibited by ERISA or any relief in situations where the conditions set forth in the regulations are not met either through omission (as, for example, failure to provide sufficient information to participants) or commission (such as pressuring participants to buy or hold a particular investment). Plans will need to have systems and safeguards to avoid these violations.

To adopt or not to adopt?

The relief provided by Section 404(c) is no panacea. it does not provide protection in connection with a number of important pl n matters, and it imposes a number of conditions and limitations on plan sponsors and fiduciaries.

Nonetheless, many plan sponsors are likely to comply with the final regulations if doing so involves modest costs and does not conflict with their overall benefit philosophy. Given the considerable amount of money involved, increasingly volatile markets, changes in the insurance and banking industries, and our litigious society, they will want to limit their exposure to participant litigation. After all, participants and beneficiaries in defined contribution plans bear the risk of adverse investment performance, and they very well may sue if things don't go well. It goes without saying that sponsors that decide not to adopt the final regulations will have to rely on the federal courts to determine if they will be held responsible for losses resulting from participant-directed investment decisions.

Time to get started

Plan sponsors, administrators, and service providers shouldn't ignore the 404(c) issue. It's not a matter of if but when the DOL will promulgate final 404(c) regulations. It is clear that the final regulations will not be any more restrictive than the reproposed regulations we've been discussing here. It is also clear that changes are both appropriate and likely to be made in the provisions covering employer securities and look-through investment vehicles. But it is highly unlikely that DOL will modify the minimum number of investment options, the minimum transfer requirements, and other fundamental provisions of the reproposed regulations.

Plan sponsors should begin to consider whether they want to adopt 404(c) based on the latest regulations. And plan service providers need to consider the impact of 404(c) on product design, plan administration, and marketing strategies. it will take time to make and communicate any related changes. The time to act is now ! Mr. Walker served as Assistant Secretary of Labor for Pension and Welfare Benefit Programs from 1987to 1989.
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Title Annotation:Corporate Reporting; Section 404C of the Employee Retirement Income Security Act of 1974
Author:Walker, David M.
Publication:Financial Executive
Date:Nov 1, 1991
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