Central among ERISA's fiduciary responsibility provisions is the rule prohibiting a loan of plan assets to parties in interest to the plan, such as plan fiduciaries and plan participants. Thus, in the absence of either a statutory or an administrative exemption, participant loans clearly are prohibited transactions under ERISA subject to administrative sanctions and excise taxes imposed by the Internal Revenue Service ("IRS").

Recognizing the need to allow participants the ability to borrow from their retirement accounts in limited circumstances, Congress included in ERISA express language authorizing participant loans, if such loans meet the following general conditions:

The Final Regulations provide relief from certain ERISA provisions prohibiting

The Final Regulations do not, however, provide relief from ERISA's rule precluding a fiduciary from receiving amounts from a third party dealing with the plan in a transaction involving plan assets (footnote 8).

The Final Regulations, however, do not provide relief from the ERISA rule prohibiting a fiduciary from receiving amounts from a third party dealing with the plan in a transaction involving plan assets (footnote 9). Nevertheless, fiduciaries who are plan participants are permitted to receive loans under a participant loan program.

Fiduciaries will be relieved from liability only if loans are available on a reasonably equivalent basis to all plan participants. Fiduciaries may, however, consider factors which would be considered in a normal commercial setting by an entity in the business of making similar loans.

It is advisable to notify all participants of a loan program upon its adoption so that, to the extent funds are set aside for loans (e.g., in a profit sharing plan), all participants are given an equal opportunity to borrow from the plan (footnote 10). Whereas, fiduciaries of 401(k) plans may apparently avoid liability, in this instance, since the loan is effectively a self-directed investment within a participant's account and thus not subject to limited funds set aside by the fiduciary.

Loan programs must not be unreasonably withheld from a participant both in form and in actual operation. Thus, the Final Regulations prohibit the practice of applying different terms to different loan applicants by, for example, offering lower interest rates to certain applicants without commercial justification or informally restricting access to loans to certain participants. Further, loan programs which have uniformly applied loan requirements but which in operation exclude large numbers of plan participants from receiving loans under the program arguably would not be available on a reasonably equivalent basis.

DOL has therefore taken the position that loans must be made available to former employees and their beneficiaries and not only to active participants. Loan programs may, however, take into account valid economic differences, which commercial lenders may legally recognize for purposes of loan availability, existing between active participants and other participants and beneficiaries. Treating former workers the same as employees puts the employer "at risk" in collecting loan repayments since loans are generally repaid by payroll deductions. ERISA's prudence requirement would clearly impact upon a decision to lend to former workers. Suffice it to note that, based on the facts and circumstances of any particular loan program, the administering fiduciary must decide which factors need to be considered in order to administer the program in a prudent manner. The so-called "prudent man" rule applies since DOL is treating loans as plan investments and thus fiduciaries are required to act with the care, skill, prudence and diligence that a prudent man familiar with the circumstances would act, resulting in a high standard of care (footnote 11).

A participant loan program may establish a minimum loan amount of up to $1,000, without failing to make loans available on a reasonably equivalent basis. Thus, DOL has established a "safe harbor" and any minimum exceeding the safe harbor may cause the plan to be in non-compliance if a significant number of plan participants are prevented from using the loan provisions (footnote l2). Loan programs may charge fees for processing and thus fiduciaries may contract out and charge borrowers for loan administration if this practice does not limit the availability of loans to large numbers of plan participants.

Participant loans must not be available to highly compensated employees, officers or shareholders in an amount greater than the amount made available to other employees. Nevertheless, loan programs may provide for either a maximum dollar limitation or a maximum percentage of a participant's vested account balance. Thus, it is permissible for a loan program to have outstanding loans which vary in proportion to the size of a participant's vested account balance.

Regarding this nondiscrimination requirement, DOL has made an effort to coordinate its regulations with the Internal Revenue Code (Code) restrictions on participant loans for tax purposes. It might be noted that under section 72(p) of the Code, a participant loan is treated as a taxable distribution from the plan unless, among other things, the loan does not exceed the lesser of (1) $50,000 or (2) one half of the present value of the nonforfeitable accrued benefit of the employee under the plan. It is DOL's view that a participant loan program amended to satisfy section 72(p) of the Code will not fail, by virtue of those provisions, to satisfy the condition in the Final Regulations that the program not be discriminatory in operation.

More importantly, DOL notes that a determination that a particular loan program meets the requirements of nondiscrimination under its regulations will not determine the status of the loan program under the nondiscrimination rules under the Code essential to tax-favored treatment.

Despite the ability to include loan provisions in ancillary plan documents, it may be advisable to include them in the actual plan so as to avoid disputes and encourage compliance. There is a greater probability that loan provisions will be followed and updated if made part of the plan.

Loans must bear a reasonable rate of interest. In accordance with DOL's view that a participant loan is a plan investment, the Final Regulations continue the controversial requirement contained in the proposed regulations that a reasonable rate of interest is one which provides the plan with a return commensurate with the prevailing interest charged on similar commercial loans by persons in the business of lending money. Despite numerous comments on the proposed regulations arguing that less than commercial rates should be permitted for participant loan programs in individual account type plans (e.g., 401(k) plans), and that a "reasonable rate" doesn't have to be the prevailing market rate of interest, the DOL has decided to adhere to its long-standing position.

DOL has taken the position that participant loans should be treated as plan investments, whether the investment return is used to provide benefits to one participant (e.g., credited to the borrower's plan account) or to all participants. The primary purpose of a pension plan, in DOL's view, is to provide retirement benefits and not to make participant loans. This is significant since many plans (particularly 401(k) plans) encourage participation by offering participant loans, which are viewed as an incidental benefit of plan participation. DOL has specifically rejected this incidental benefit theory, arguing that it would constitute a major departure from the purpose of pension plans - to provide retirement income.

DOL's approach to participant loans does not take into account actual plan operation by comparing participant loans to other investments of plan assets. No plan sponsor has ever provided a participant loan program in order to provide the trustee with an alternative investment. Rather, plan sponsors arguably provide participant loan programs to offer an incidental benefit to plan participants (similar to disability provisions or hardship withdrawal provisions). A loan program is usually designed to provide plan participants with access to all or part of their own contributions in their account under, for example, a 401(k) plan.

Moreover, DOL specifically declined to establish a standard "safe harbor" interest rate such as the applicable Federal rate, a GIC rate or a prime plus rate. DOL believes that no one particular standard will consistently reflect the appropriate risk/return ratio for all plans and all participant loans. Thus, DOL suggests that plan administrators conduct the same type of inquiry that would be prudent prior to making any other type of investment. As a practical matter, a safe harbor may be difficult for plans to implement considering factors such as creditworthiness of the borrower, the security given for the loan and geographical differences. Moreover, the Final Regulations provide relief to plan sponsors by allowing loan programs covering employees nationally to use a single interest rate under certain circumstances to reduce administrative expense, even though the rate must be based on the prevailing market rate for similar loans (footnote l4)

Thus, DOL requires that loans to participants from their funds (such as 401(k) accounts) be at prevailing market-interest rates, not discounted rates. The authors see most current participant loans being pegged at lower prime or benefit-related rates. Accordingly, the Final Regulations will require fiduciaries to monitor market rates and, thus, make more frequent loan-rate changes.

Loans to participants need to be adequately secured. Based upon similar Treasury regulations, the Final Regulations provide a test for the adequacy of the security similar to that which would be required by a commercial lender. Thus, in the event of default, the security must provide participants with retirement income. In an effort to balance these two important interests, the Final Regulations provide that a portion of a participant's vested accrued benefit under the plan be used as security. Specifically, the Final Regulations permit up to 50% of the present value of a participant's vested acccrued benefit (or account balance under a 401(k) plan) to be used as security for participant loans and taken into account in determining whether the security is adequate. Thus, the remaining account balance would not be encumbered as security for the plan loan.

A participant loan program may grant participant loans which require adequate security in excess of the 50% cap if the plan receives additional collateral, the value of which equals or exceeds the amount required in excess of the cap.

In accepting security, fiduciaries should note the rules prohibiting sales between the plan and a party in interest. For example, fiduciaries should not accept as collateral property which could only be sold to the participant.

Interest at less than the prevailing rate apparently cannot be charged on a participant loan even if the lesser interest is commensurate with the rate of return the plan is realizing on its other investments.

The Final Regulations provide relief since the participant's account balance need not be subject to immediate distribution in the event of default if the account will completely protect against loss of principal and interest on the loan, given a discount for the time value of money. This is presumably analogous to commercial lenders who will make loans even though the borrower will not repay the loan given, for example, an account that more than covers the loan and interest. Absent this regulatory relief, a participant's account balance may not have been treated as adequate security given Code restrictions on in-service distributions, or 401(k) distributions prior to the termination of employment or in the absence of hardship.

Loan programs have a positive impact on participation rates in 401(k) plans and generate employee goodwill in all ERISA-covered plans. Employees are willing to save through a 401(k) plan if they have access to their contributions without a penalty or without the payment of income tax. Loan programs provide one clear advantage over other popular retirement plan alternatives, such as Individual Retirement Accounts (IRAs).

In the event of financial hardship, even a loan program may not be a viable solution if the employee is unable to withstand payroll deductions to repay the loan (footnote 16)

Fiduciaries and their advisors need to review existing loan arrangements to make certain they conform to the Final Regulations to avoid penalty taxes, a clear risk of plan disqualification as well as a breach of the enforcement and fiduciary responsibility provisions of ERISA. The Final Regulations provide definitive, albeit restrictive, guidelines and thus represent current DOL thinking, and consequently its position in any enforcement action.

FOOTNOTES

1. Final Regulations on Loans to Plan Participants and Beneficiaries under section 408(b)(1) of the Employee Retirement Income Security Act of 1974 (ERISA), 54 Fed. Reg. 30520 (7/19/89) (to be codified at 29 CFR Part 2550.408b-1) (Final Regulations); See also, IRC Sec. 4975 (d) (1), a parallel provision to ERISA Sec. 408 (b) (1).

2. See generally Employee Benefit Cases, Vols. 1-9 (The Bureau of National Affairs, Inc.)

3. See Preamble to Final Regulations (Preamble).

4. See Conf.. Rep. No. 1280, 93rd Cong., 2d Sess. at 310-11 (1974) (Conf. Rep.); See also Subcomm. on Labor, Senate Comm. on Labor and Pub. Welfare, Legislative History of ERISA, 457778.

5. ERISA Sec. 406 (a) (1) (B).

6. ERISA Sec. 406 (b)(1).

7. ERISA Sec. 406 (b) (2).

8. The definition of an ERISA fiduciary is extraordinarily broad and goes beyond traditional trust law concepts to include (i) the trustees, (ii) all individuals active in the administration of the plan having discretionary authority (e.g., officers), (iii) the members of a plan's investment committee, (iv) the persons who elect these individuals (generally the board of directors of the employer), and (v) investment advisors who receive direct or indirect compensation for their investment advice. Attorneys, accountants and actuaries who act only as such will not ordinarily be deemed to be fiduciaries. A registered broker who executes securities transactions pursuant to specific instructions from a responsible fiduciary is not ordinarily deemed to be a plan fiduciary. See ERISA Sec. 3 (21); See Conf. Rep. at 323 (1974); DOL Reg. Sec. 2509.75-8 (1978) (Q&A's D-4 and FR-17); DOL Reg. Sec. 2510.3-21 (c) (1978); DOL Reg. Sec. 2509.75-5; DOL Reg. Sec. 2509.75-5 (1978) (Q & A D-1); DOL Reg. Sec. 2510.3-21 (d).

9. ERISA Sec. 406 (b) (3).

10. See Final Regulations Sec. 2550.408b-1 (b) (3) (Example 3).

11. See ERISA Sec. 404 (a) (1) (B).

12. See Final Regulation Sec. 2550.408b-1 (c) (4) (Example 2).

13. See ERISA Sec. 102.

14. See Preamble.

15. ERISA Sec. 404 (a) (1) (A).

16. See generally Geller and Miller, The Application of New 401 (k) Rules Isn't An Easy Task, 25 Pen. Wld. No. 1, Jan. 1989, pp. 31-33.