Fundamental Unfairness: ERISA Section 404(c) Is Not Working

“404(c) is not working. It does not provide participants with the information they need to make informed and reasoned investment decisions…But it can work, it must work.”1

This quote came from the 2006 testimony of Fred Reish, one of the nation’s most respected ERISA attorneys, before the DOL Advisory Council. Reish went on to suggest several improvements that he felt were needed to improve ERISA section 404(c), including

  • participant investment education that focuses “on the right issues;”
  • education programs that teach ERISA fiduciaries about their fiduciary duties, including the proper selection and monitoring of plan investment options;
  • the need to provide plan participants with material and meaningful information to allow them to make “fully informed decisions” as described in Section 404(c).

With regard to the need to provide plan participants with meaningful information and the “informed decisions” promise, Reish specifically mentioned the need to provide plan participants with information that would provide them with

“an understanding of basic investment concepts-such as asset classes, correlation, strategic asset allocation and re-balancing-which most participants lack.”2

While Reish’s testimony was made in 2006, the sad fact is that the same problems exist today. Even worse is the fact that in too many instances the courts seemingly fail to acknowledge that such problems persist, that 404(c) still does not work for plan participants, their beneficiaries or plan fiduciaries. Why?

Shifting Risk to Plan Participants
Prior to the creation of defined-contribution plans, defined-benefit plans were the primary pension plans. But employers did not like defined-benefit plans because the employer bore the investment risk in such plans. Pension payments had to be made, regardless of the investment performance of the plan’s portfolio.

Defined-contribution plans are now the primary form of employee pension plans, as they allow employers to shift investment risk totally to the plan participants if certain requirements are met. In his testimony, Reish opined that based on his more than twenty-five years of experience, many 404(c) plans mistakenly believe that they are in compliance with 404(c)’s requirements. As the Enron court pointed out,

“If a plan does not qualify as a §404(c) [plan], the fiduciaries retain liability for all investment decisions made, including decisions by the plan participant.”3

Plans and the plan advisers have eagerly pointed to recent cases in which the court dismissed the plaintiff’s excessive fees and/or breach of fiduciary duty claims. Having reviewed said dismissals, I would strongly suggest that plans and plan advisers temper such celebrations, as I believe that there are valid grounds for reversing most, if not all, of such decisions..

For instance, in the recent dismissal of the NYU 403(b) action, the court decision seemed to rely heavily on the fact that the court applied the prudence standards for defined-benefit plans, even though the court openly acknowledged that the NYU plans were defined-contribution plans. There is a significant difference between the two, resulting in serious questions about the court’s entire thought process behind the court’s decision.

Since employers bore the risk in defined-benefit plans, they were given more flexibility in choosing investments for their pension plans. The prudence of investments in a defined-benefit plan is evaluated in terms of the portfolio as a whole. However, since plan participants bear the investment risk in defined-contribution plans, the prudence of the investments in a defined-contribution plan is evaluated in terms of the each individual option in the plan.

Sufficient Information to Make Informed Decisions
Section 404(c) provides that an ERISA section 404(c) plan is

an individual account plan …that (i) provides an opportunity for a participant or beneficiary to exercise control over assets in his individual account; and (ii) provides a participant or beneficiary an opportunity to choose, from a broad range of investment alternatives, the manner in which some or all of the assets in his account are invested…4

The regulation then defines the “control” requirement by stating that

a plan provides a participant or beneficiary an opportunity to exercise control over assets in his account only if:…(B) The participant or beneficiary is provided or has the opportunity to obtain sufficient information to make informed decisions with regard to investment alternatives available under the plan,…5

In discussing the importance of providing sufficient  information to 401(k) participants, the preamble to the final 404(c) regulations (“Preamble”) stressed the need

to ensure that participants and beneficiaries in ERISA section 404(c) plans have sufficient information to make informed investment decisions….[as] the investment decisions made by participants and beneficiaries in ERISA 404(c) plans will directly affect the funds available to such individuals at retirement. For this reason, participants and beneficiaries should be assured of having access to that information necessary to make meaningful investment decisions.6

Building on the importance of the provision of “sufficient information,” at least two courts have suggested that if participants are not provided with the material information necessary to protect their interests, then the participants cannot be said to have exercised the control over their 404(c) account.7.

So what constitutes “sufficient information to make an informed decision?” Two consistent themes of ERISA are cost-control and risk management. In Part I, we discussed the cost control issue and noted that the Restatement (Third) of Trusts (Restatement) states that actively managed mutual funds should not be recommended or used in trusts and plans unless they are cost-efficient.

The Importance of Effective Portfolio Diversification
With regard to risk management, various academic studies and the Restatement emphasize the value of effective diversification within a portfolio. The DOL and the courts have adopted Modern Portfolio Theory (MPT) as the accepted model for portfolio diversification/risk management.

The cornerstone of MPT is the inclusion of the correlation of returns between investments as part of the portfolio construction process. Nobel laureate Harry Markowitz, the father of MPT, has stated that

“[to] reduce risk it is necessary to avoid a portfolio whose securities are all highly correlated with each other. One hundred securities whose returns rise and fall in near unison afford little protection than the uncertain return of a single security.”8

The Restatement reiterates Markowitz’s warning, stating that

“Diversification is fundamental to the management of risk and is therefore a pervasive consideration in prudent investment management.”

“Effective diversification depends not only on the number of assets in a trust portfolio but also on the ways and degrees in which their responses to economic events tend to cancel or neutralize one another.”9

A number of courts have overlooked the significance of correlation of returns by suggesting that the sheer number of investment options within a retirement plan satisfies ERISA’s diversification requirement. Many of these courts reference the court’s decision in Hecker v. Deere & Co.,10 which suggested the “sheer number of options” theory.

However, what many attorneys and courts conveniently overlook is that the Hecker court went back and issued a “clarification” of their “sheer number” language in response to the Secretary of Labor’s strong reaction to their decision.11 The court stated that their “sheer number” language was limited to the specific facts of the Hecker case. The court went on to address the Secretary’s concerns by stating that

The Secretary also fears that our opinion could be read as a sweeping statement that any Plan fiduciary can insulate itself from liability by the simple expedient of including a very large number of investment alternatives in its portfolio and then shifting to the participants the responsibility for choosing among them. She is right to criticize such a strategy. It could result in the inclusion of many investment alternatives that a responsible fiduciary should exclude. It also would place an unreasonable burden on unsophisticated plan participants who do not have the resources to pre-screen investment alternatives. The panel’s opinion, however, was not intended to give a green light to such ‘obvious, even reckless, imprudence in the selection of investments.’12 (emphasis added)

There are those in the legal community, myself included, that the Hecker court’s self-described “clarification” was actually a reversal of their earlier “sheer number of investment options” position.13  And yet attorneys for the investment industry and a number of courts still try to assert the “sheer number” theory against plan participants.

The Hecker court stressed the need for plan sponsors to fulfill their fiduciary duties by properly investigating and evaluating the investments options chosen for a plan. The court also noted that that it would be inappropriate to place that burden on plan participants, to require them to detect fiduciary breaches by their plans. Since plan sponsors are fiduciaries to their plans, the Hecker court’s argument is consistent with the established legal standard that a fiduciary relationship

“creates [a] climate of trust in which facts which would ordinarily require investigation may not excite suspicion, and same degree of diligence is not required.”14

Furthermore, section 404(c) places upon a plan sponsor the affirmative duty to provide the required sufficient information to plan participants and their beneficiaries.

The DOL and the Information Tease
The DOL has released a bulletin outlining various types of investment information that may be provided to plan participants without incurring any additional fiduciary liability. Interestingly enough, the bulletin states that plan sponsors can provide generic information on general investment topics such as historical investment returns, historical investment risk and correlation of returns.15

So the DOL says plans can educate plan participants on the importance and benefits of correlation of returns information, but apparently they do not allow plans to provide plan participants with the actual correlation of returns data for the plan’s investment options, thereby denying participants the opportunity to effectively diversify their retirement accounts and minimize the risk of large losses. This would seem to be totally inconsistent with ERISA’s stated purpose, to help protect pension plan participants and their beneficiaries.16

It can, and should, be argued that correlation of return data is analogous to the historic return and risk data allowed under the DOL’s release, as such data does not advise plan participants as to which investments to choose. Correlation of returns data simply gives investors material information on which investments not to choose in order to minimize their investment risk. Again, this would seem to be totally consistent with both ERISA’s promise of “sufficient information” to allow “meaningful control” over the assets in their account, as well as ERISA’s stated purpose to help protect pension plan participants and their beneficiaries.

Plan Sponsor’s Duty to Investigate
The importance of a proper investigation of a plan’s investment options by an ERISA fiduciary cannot be overstated.

A fiduciary’s independent investigation of the merits of a particular investment is at the heart of the prudent person standard…..17

In determining whether an ERISA fiduciary breached their duty of prudence, the courts assess the fiduciary’s actions in terms of both procedural prudence and substantive prudence.18  In evaluating procedural prudence, the courts look at the methodology that the fiduciary used, not the eventual investment results.19  In evaluating substantive prudence, the courts base their decision on what the fiduciary knew or should have known, and how they applied, or should have applied, such information.20 An ERISA fiduciary that conducts an independent investigation and evaluation, but imprudently evaluates, selects, and monitors a plan’s investments is also guilty of breaching their fiduciary duties.21

Since the Department of Labor and the courts have adopted MPT as the standard of prudence for ERISA fiduciaries, and the key factor in MPT analysis is consideration of the correlation of returns among investments as part of the portfolio construction process, it can be argued that the failure of an ERISA fiduciary to consider the correlation of returns among the investment options being considered for their plan constitutes a breach of their fiduciary duty.  Therefore, the prudent ERISA fiduciary will always obtain and factor in the correlation of returns of the various investment options being considered as part of their plan’s portfolio selection process..

The “Sufficient Information” and “Control” Requirements
Under ERISA, an ERISA plan fiduciary is generally responsible for any losses incurred by the plan and/or plan participants that are due to the fiduciary’s failure to meet the applicable ERISA fiduciary standards.  ERISA does provide one exception to this rule if the plan qualifies as a Section 404(c) plan.

Section 404(c) provides that a plan fiduciary shall not be responsible for the losses suffered by a plan participant to the extent that such losses are due to the control of the account by the plan participant.22 While a full review of all of the requirements required to qualify as a Section 404(c) plan is beyond the scope of this white paper, I want to focus on an area that is often overlooked and, consequently, ripe for litigation.

I included the lengthy quote from the Hecker decision for a reason, specifically the statement that

“It also would place an unreasonable burden on unsophisticated plan participants who do not have the resources to pre-screen investment alternatives.”23

I would argue that that is exactly why ERISA included the “sufficient information to make an informed decision” requirement. I would also argue that based on the unquestionable importance of correlation of returns in portfolio risk management, the failure to provide plan participants with such information effectively denies them control over their 404(c) accounts and, thus, is grounds for denial of protection under 404(c)’s safe harbor provisions.

The courts have consistently ruled that a plan participant does not have the requisite control over their 404(c) account when a plan fails to meet the “sufficient information” requirement.24 The obvious question for both plan fiduciaries and plan participants is what constitutes “sufficient information to make informed decisions.”

There are various factors that are used in determining whether a plan participant exercised the requisite control over his account.  The first question that must be addressed is whether the plan provided participants with the required broad range of investments.25  In order to satisfy the “broad range of investments” requirement, the plan must provide investment alternatives “with materially different risk and return characteristics” that allow participants to effectively diversify their investment account so as to reduce the risk of large losses, i.e., utilize MPT.26 Plan sponsors cannot be sure that they have met this requirement unless they factor in the correlation of returns between the investments chosen for their plan.

If so, the next question is “whether the plan provided the participants with ample information, including adequate information to understand and assess the risks and consequences of alternative investment options.” 27 In order to qualify as Section 404(c) plan, the plan must provide the participants with “sufficient information to make informed decisions with regard to investment alternatives available under the plan….”28 The “sufficient information” requirement is not met unless the participants is given various information, including a description of the investment alternatives available under the plan, including risk and return characteristics of each such alternative.29

Three consistent themes run through ERISA: disclosure, avoidance of large losses and the importance of controlling costs. These three requirements are imposed upon plan fiduciaries in order to further the purposes and goals of ERISA, protecting and promoting the interests of employees.

Consequently, it would only seem natural and equitable that the same information that ERISA fiduciaries need to use in fulfilling their duties should be required to be disclosed to plan participant in order to meet Section 404(c)’s “informed decisions” requirement.  Since an ERISA fiduciary should have this information in order to fulfill their duty of prudence, providing same to participants should not prove to be overburdening the plan fiduciary.

It can be anticipated that ERISA fiduciaries might object to the suggested disclosure requirement, claiming that plan service providers do not provide such information to the plan. Such objections are without merit.

As discussed earlier, ERISA fiduciaries have an obligation to conduct an independent investigation of all investment options being considered. In assessing the prudence of a fiduciary’s investigation, ERISA states that one factor is determining whether the fiduciary has given “appropriate consideration to those facts and circumstances that…the fiduciary knows or should know are relevant,”30 and that “appropriate consideration includes the composition of the portfolio with regard to diversification,” thus MPT and correlation of returns data.31

ERISA fiduciaries might also object to the suggested disclosure requirement on the grounds that ERISA does not explicitly require the disclosure of such information.  Once again, such an objection is without merit. In enacting ERISA, Congress chose to invoke the common law of trust to define the general scope of an ERISA fiduciary’s responsibilities rather than explicitly enumerate such duties.32 “Thus, [ERISA’s articulation] of a number of fiduciary duties is not exhaustive.”33

It is a well accepted principle that a fiduciary’s duty to furnish material information to a beneficiary is a fundamental concept under the common law of trusts.34 As discussed earlier, both the Restatement and ERISA would support the disclosure of such information, especially since the fiduciary should already have considered such information in assessing the prudence of the proposed investment or investment course of action.

Disclosure of such information would also be consistent with ERISA’s purposes and goals, especially since this information would prove more valuable to preventing large losses and controlling unnecessary costs and expenses than a prospectus, which few investors read or understand.  If a fiduciary does not have the education, experience and/or skill to determine the needed information on their own, then ERISA requires that they retain experts who can provide such information to the plan and its participants.35

In his testimony before the Department of Labor, Reish offered his opinion that

“In my experience, the vast majority of plans do not satisfy the conditions for obtaining 404(c) protection. As a result, for the vast majority of plans, the fiduciaries retain responsibility for the prudence of all investment decisions made, including participant-directed investment decisions.”36

As have outlined herein, I believe that most plan sponsors fail to comply with section 404(c)’s “sufficient information” and “control” requirements. I believe that plan sponsors must have that information in order to (1) comply with their fiduciary duty to conduct an independent investigation and evaluation of a plan’s investment options, and (2) to ensure that the plan options provide plan participant with the opportunity to effectively diversify their retirement account and minimize the risk of large losses.

I will always remember something that a plan sponsor once told me. As we discussed the importance of correlation of return data as part of a meaningful employee education program, for both plan fiduciaries and plan participants, he told me that they would never voluntarily provide plan participants with such information. When I asked him why, given section 404(c)’s requirements, his response -“because then they would know how bad our plan really is and probably sue us.”

1. “Written Comments for Testimony of C. Frederick Reish,” (Reish testimony)
2. Reish testimony, supra.
3. Tittle v. Enron Corp, 284 F. Supp.2d 511, 547-48 (S.D. Tex. 2003)
4. 29 C.F.R. §§ 2550.404c-1(b)(1)(i), (ii).
5. 29 C.F.R. § 2550.404c-1(b)(2)(i)(B).
6. Preamble to 404(c) Final Regulations, 57 Fed. Reg. 46906, 46909-46910.
7. In re Regions Morgan Keegan ERISA Litigation, 692 F.Supp.2d 944, 957 (W.D. Tenn. 2010); In re Sprint Corp. ERISA Litigation, 388 F. Supp. 2d 1207 (D. Kansas 2004).
8. Harry Markowitz, “Portfolio Selection: Efficient Diversification of Investments”, 2d ed., (Malden, MA: Basil Blackwell Publishers, Inc., 1991), 5.
9. Restatement Third, Trusts, § 90 (Prudent Investor Rule), cmt f. Copyright © 2007 by The American Law Institute. Reprinted with permission. All rights reserved.
10. Hecker v. Deere & Co., 556 F.3d 575 (2009).
11. Hecker v. Deere & Co., (Hecker II) 569 F.3d 708, 711 (2009).
12. Hecker II, 711 (2009).
13. Fred Reish, “Hecker v. Deere Revisited,” publications/2009/09/hecker-vs-deere-revisited.
14. Johnston v. CIGNA Corp., 916 P.2d 643, (1996).
15. Department of Labor Interpretive Bulletin 96-1.
16. Shaw v. Delta Air Lines, Inc., 463 U.S. 85, 90 103 S.Ct 2890.
17. Fink v. National Sav. and Trust, 772 F.2d 951, 957 (D.C. Cir. 1985).
18. Howard v. Shay, 100 F.3d 1484, 1488 (4th Cir. 1996).
19. Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983).
20. Fink, at 957.
21. In re Regions Morgan Keegan ERISA Litigation, 692 F.Supp.2d 944, 957 (W.D. Tenn. 2010).
22. 29 C.F.R. § 2550.404c-1(a)(1).
23. Hecker II, supra, 711.
24. Enron, at 578-79; In re AEP ERISA Litigation, 327 F.Supp.2d 812, 829 (S.D. Ohio 2004).
25. In re Unisys Sav. Plan Litigation,  74 F.3d 420, 442 (1996).
26. Unisys, at 447; 29 C.F.R. § 2550.404c-1(b)(3)(i)(A), (B)(2), (B)(4) and (C).
27. AEP, 829; Enron, at 576, 578-79.
28. 29 C.F.R. § 2550.404c-1(b)(2).
29. Unisys, at 447; 29 C.F.R. § 2550.404c-1(b)(3)(i)(B)(2).
30. 29 C.F.R. § 2550.404a-1(b)(1)(ii).
31. 29 C.F.R. § 2550.404a-1(b)(2)(ii)(A).
32. Central States, Southeast and Southwest Areas Pension Fund v. Central Transport, Inc., 472 U.S. 559, 570 (1985).
33. Glaziers & Glassworkers v. v. Newbridge Securities, 93 F.3d 1171, 1180 (3d Cir. 1996).
34. Glaziers & Glassworkers, at 1180.
35. Donovan v. Bierwirth, 680 F.2d 263, 272-73.
36. Reish testimony.

Copyright © 2018 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice as such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

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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