Limiting 401(k) plan fiduciary liability: investment safe harbors

What’s more, recent litigation and the requirement to provide participant fee disclosures have drawn attention to the importance of plan investment structures.  

Fortunately, ERISA provides clear instruction on the processes a fiduciary should follow after an investment has been prudently selected to protect him or her from investment loss liability. These protections are called safe harbors, and there are three that can help reduce a fiduciary’s liability for losses resulting from investments. And while not required, an investment policy statement (IPS) can provide a fiduciary with valuable documentation on the investment selection and monitoring process. 

Safe harbor 1: limit liability by complying with ERISA Section 404(c)

ERISA Section 404(c) may relieve plan fiduciaries from liability on losses resulting from participants’ direction of investments, such as when a participant invests in a stock fund that subsequently  loses value.  

While not mandatory, if you want the fiduciary relief Section 404(c) offers, you must comply with the following provisions:  

• Provide all employees with the disclosures and notifications outlined under the ERISA  Section 404a-5 regulation. 
  
• Notify employees that the plan is designed to comply with Section 404(c); therefore, the fiduciary may not be liable for losses resulting from participant investment choices. 
  
• Provide employees with the ability to: 
  
  • choose from a broad range of investment alternatives consisting of at least three core diversified investment options with materially different risk-and-return characteristics; and 
    
  • make changes to their investment selections at least quarterly, or as frequently as the market volatility of their particular investment option dictates. 
    

Many plan sponsors state explicitly in an IPS or other plan document that they’re in compliance with ERISA Section 404(c)’s requirements. While not required to enjoy the protections of Section 404(c), such language is viewed as an inexpensive way of putting regulators and participants on notice.  

Safe harbor 2: limit liability with an ERISA QDIA

When participants don’t provide instructions for investments in their plan accounts, such as during auto-enrollment, plan fiduciaries can limit their liability for investment losses by investing participant contributions in a qualified default investment alternative (QDIA), as described in ERISA Section 404(c)(5).

There are three qualified default investments covered by this safe harbor: 

Note the similarities: Each type is based on a generally accepted investment theory, diversified and suitable for a wide range of investor objectives.¹^,²  

Of course, QDIAs must be selected and monitored prudently, just like any other  investment alternative.  

The QDIA safe harbor requires that participants receive notice 30 days prior to making an investment and annually thereafter. It also mandates that they be given the opportunity to direct their investments elsewhere.  

Safe harbor 3: limit liability with fund mapping

When a plan’s investment options change, such as when a plan switches recordkeepers or fund menus, plan fiduciaries may need to direct, or map, assets from old funds to new ones. 

In such situations, plan sponsors must specify mapping, providing direction on how monies invested in existing funds will be allocated among new funds.  

If they take the following steps, fiduciaries may be able to rely on the fiduciary relief offered under ERISA to limit their liability for investment performance following the mapping: 

• Ensure the plan satisfies all Section 404(c) requirements before the transfer. 
  
• Ensure the new investments’ characteristics (e.g., risk and rate of return) are reasonably similar to those of the existing investments. 
  
• Ensure the participant or beneficiary is given: 
  
  • 30-day advance notice regarding the change in investment options, 
    
  • information regarding the existing and new investment options, and 
    
  • an explanation that, if the participant doesn’t make an investment selection, the existing investment will be transferred or mapped into a reasonably similar investment. 
    

The IPS 

An IPS is typically a written document that spells out plan goals, constraints, and processes. It may also assign various responsibilities, such as for provider selection and monitoring, and provide guidelines for decision-making.  

Although not required by ERISA, an IPS can help fiduciaries demonstrate selection and monitoring prudence. This may be beneficial in the event of a plan audit or litigation. 

A well-drafted IPS can provide structure, ensuring that prudent processes are followed. Once an IPS is in place, you should be sure to: 

• Follow it to the extent that it doesn’t conflict with ERISA or other plan documents
  
• Monitor compliance by regularly reviewing all appropriate investment options based on your evolving employee demographics
  
• Monitor the performance of the underlying investment managers, replacing them as required
  
• Modify the IPS as needed and maintain your documentation, including relevant reports and reasons for your decisions, in a due diligence file
  

A plan sponsor should explicitly state its intention to comply with ERISA Section 404(c) and the QDIA safe harbor in its IPS.  

In summary 

• Plan sponsors should consider taking advantage of ERISA’s investment safe harbors and further protect themselves by adopting and following an IPS. 
  
• Safe harbors provide fiduciaries with a form of insurance. If they follow the safe harbor rules, they may be protected from claims arising from participant investment choices.  
  
• Safe harbors don’t relieve sponsors of the requirement that investment selection, monitoring, retention, and replacement be conducted according to a reasonably prudent process.  
  
• An IPS can ensure that this process is clear and structured. To be effective, however, the IPS must be followed, and decisions should be documented in the form of comprehensive meeting notes. 
  

For more information, please visit the U.S. Department of Labor’s dedicated fiduciary website. 

1 The target date is the expected year in which a participant plans to retire and no longer make contributions. The investment strategy of a target-date portfolio is designed to become more conservative over time as the target date approaches (or, if applicable, passes) the target retirement date. Investors should examine the asset allocation of the fund to ensure it is consistent with their own risk tolerance. The principal value of the investment as well as the potential rate of return are not guaranteed at any time, including at, or after, the target retirement date. 2 Neither asset allocation nor diversification guarantees a profit or protects against a loss. There is no guarantee that any investment strategy will achieve its objectives.