How “Safe” Are ERISA 401(k)/404(c) Safe-Harbors?

Like so many others, I provide consulting services to pension plans. Unlike others, I focus on the risk management aspect of pension plans instead of the fundamental, or administrative, aspects of a plan.  I chose to focus on the risk management aspects of pension plans due to my securities background.

Bottom line, pension plans generally do a terrible job with regard to the risk management aspect of their plans.  In most cases, pensions plans would have a hard time successfully defending a claim by plan participants.

In my opinion, this liability exposure is due in large part to a misunderstanding regarding the protections offered by ERISA’s 401(k)/404(c) so-called safe-harbors. It has been my experience that plan sponsors confronted with potential liability claims immediately claim that they are absolutely immune from any liability due to said safe-harbors. The mood quickly changes when the truth about 401(k)/404(c) safe harbors is explained.

Over the past decade we have seen more pension plans opt to designate their plans as 404(c) plans in an effort to reduce the plan’s risk exposure and shift more liability to plan participants. However, in order to obtain the desired risk protection, plans must comply with all of the various requirements set our in Section 404(c) of ERISA.

I consider Fred Reish to be the foremost authority on ERISA plans. Mr. Reish has been quoted as saying that while “[t]he vast majority of plans believe that they are 404(c) compliant,…,very few of them satisfy all of the 404(c) requirements.”(1) Consequently, plan sponsors and other plan fiduciaries face potential liability to plan participants in connection with the plan’s investment options.

Even if a plan were able to comply with all of the 404(c) requirements, the courts and the Department of Labor have made it very clear that 404(c) does not protect plan sponsors from breach of fiduciary claims by participants based on allegations of imprudent selection of investments:

“The DOL has taken a clear position that Section 404(c) does not shield plan sponsors      from liability for claims of imprudent selection of plan investment options. The DOL has emphasized that a fiduciary has a continuing duty to monitor the prudence of investment options in a plan regardless of the scope of a participant’s control.”(2)

In my last post, I discussed some of the implications of the recent Tibble decision, some of which involve safe-harbor issues. The Tibble decision stated that plan sponsors cannot blindly rely on third-party advice and that the duty of a plan sponsor to conduct a thorough, independent and unbiased investigation and evaluation of investment options goes to the heart of the plan sponsor’s fiduciary duty of prudence.

I have always found it interesting that plan sponsors often hire experts to evaluate potential plan investment options because the plan sponsor properly realizes that they do not have the training or experience to evaluate the investment options themselves. Yet, in order to fulfill, their duty of prudence, they must continue to monitor and evaluate the ongoing prudence of the investments. In too many cases this is simply an accident waiting to happen.

One of the 404(c) requirements is that plan participants be provided with sufficient investment options to allow them to minimize the risk of large losses. On more than one occasion I have had plan sponsors attempt to justify their plan’s mix of investment options on the basis of Modern Portfolio Theory (MPT). In many cases they are quick to let me know they worked with their plan provider in using MPT and then suggest that I should study MPT.

Trust me, I understand MPT, including Markowitz’s little known warning to fiduciaries and advisers at the bottom of page vi and the top of page vii.  I am fully aware “that modern portfolio theory has been adopted in the investment community and, for the purposes of ERISA, by the Department of Labor.”(3)

Plan sponsors and other fiduciaries who intend to rely on MPT in justifying their plan’s mix of investment alternatives should review the DiFelice decision, which dealt directly with the implications of MPT and fiduciary duties. The Court rejected the notion that based on MPT, there were sufficient funds that a participant “may or may not” choose to create a prudent portfolio, stating that

“Standing alone, [MPT] cannot provide a defense to the claimed breach of the “prudent man” duties here. ‘Under ERISA, the prudence of investments or classes of investment offered by a plan must be judged individually….That is, a fiduciary must initially determine, and continue to monitor, the prudence of each investment option available to plan participants. Here the relevant “portfolio” that must be prudent is each available Fund considered on its own,…,not the full menu of Plan Funds. This is so because a fiduciary cannot free himself from his duty to act as a prudent man simply by arguing that other funds, which individuals may or may not elect to combine with [other investment options], could theoretically, in combination, create  a prudent portfolio…. This result would be perverse in light of the Department of Labor’s direction that selection of prudent plan options falls within the fiduciary duties of a plan administrator.”(4)

It should be noted that the Court went on to distinguish between a plan creating one ready-made portfolio for participants, where reliance on MPT could be proper, to the more common situation where the plan offers various investment options which possibly could theoretically be combined to create a properly diversified investment portfolio.

There are three consistent themes that run through ERISA – sufficient disclosure of information to plan participants and their beneficiaries, a proper number of investment options so as to allow participants to minimize potential investment risk, and proper control of investment costs and other expenses. Any hope of qualifying for the protection of a “safe-harbor” must properly address these key themes.

With regard to both the disclosure and the diversification requirements, I have previously posted an article addressing what I consider to be a common deficiency in 401(k)/404(c) disclosures, the lack of information being provided to participants regarding the correlation of returns between a plan’s investment options.  In my article, “A Curious Paradox,” I address the fact that while the  courts and the DOL have adopted MPT, the cornerstone of which is the consideration of the correlation of returns among investments, there is no requirement that plan participants be provided with such information. As a result, plan participants may inadvertently put together a portfolio consisting largely, or entirely, of highly correlated investment, thereby failing to provide the participants with the level of downside protection needed to achieve ERISA’s goal of protection from significant losses.

With regard to the cost control issues, my firm, InvestSense, has introduced a proprietary metric, the Active Management Value Ratio (AMVR), and made it freely available to both plan sponsors and plan participants to raise awareness of the cost-inefficiency of many actively managed funds.  While cases have argued against the absolute level of the high expenses ratios of funds within a plan, the true issue that needs to be addressed is the relative cost-benefit of such funds.

Various studies such as Standard & Poor’s Indices Versus Active annual reports show that many actively managed mutual funds fail to outperform similar index funds.  AMVR analyses only strengthen the argument against such actively managed fund by often showing that even on active funds that do manage to outperform similar index funds, the cost of such active management far exceeds the benefit gained, with the relative cost often exceeding the relative benefit by 300-400 percent.

The bottom line for plan sponsors and other plan fiduciaries is that it is difficult to qualify for many of the so-called 401(k)/403(b) safe-harbors and that many who believe that they are 404(c) compliant are not. Furthermore, there is no safe-harbor protection for plan sponsors with regard to their fiduciary duty to select prudent investment options for plan participants and to provide ongoing monitoring of the plan’s investment options to ensure the continued prudence of same.

Plan sponsors can use the AMVR to evaluate the cost-benefit aspect of actively managed mutual funds in their plans, with no cost to the plan. An AMVR analysis on actively managed mutual funds offered within a plan will generally show that the costs associated with such funds far exceed any benefit derived from such funds, raising valid beach of fiduciary claims against a plan and its sponsors. As a Moody Blues fan, I am reminded of the lyric, “there are none so blind, as they who will not see.”

1. Diane Cadrain, “Are you sure you’re 404 compliant? Meeting safe-harbor provisions to minimize liability for  401 losses may be harder than you think,” HR Magazine (September 2004)
2. Kanawi v. Bechtel Corp., 590 F. Supp.2d 1213, 1232 (2008)
3. DiFelice v. U.S. Airways, Inc., 497 F.3d 410, 423-24 (4th Cir. 2007)
4. DiFelice, 423

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors and investment fiduciaries on sound, proven investment strategies that will help them protect their financial security and/or avoid unnecessary fiduciary liability exposure.
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1 Response to How “Safe” Are ERISA 401(k)/404(c) Safe-Harbors?

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