Publications

November 1999

Legal and Fiduciary Issues in Participant-Directed 401(k) Plans

By Sheldon M. Geller, Esq., Geller Group Ltd.

Service providers of 401(k) plans are permitting sponsors to augment their plans with self directed brokerage accounts. In this way, plan participants may customize their retirement portfolios, and plan sponsors can satisfy their fiduciary responsibility to provide diversified investment alternatives.

These self-directed brokerage accounts offer plan participants a broad range of investments, including listed and over-the-counter stocks, fixed income instruments, money market funds, and many mutual funds. A plan participant with a self-directed brokerage account, however, may not be able to invest in all of the same investment vehicles that are available in a retail brokerage account.

The legislative history, statutory construction, and labor regulations make it clear that plan fiduciaries continue to retain significant fiduciary responsibility and liability, which restricts the range of investments that may be offered in a self-directed brokerage account. The plan sponsor has a fiduciary duty of prudence in the selection and retention of investment choices, including those in a self-directed brokerage account.

Compliance with ERISA section 404 (c) only protects plan fiduciaries from any loss that results from the plan participant's exercise of control over the assets in their account. An employer's designation or limitation of investment options is a fiduciary function. Plan fiduciaries not only have an obligation to prudently select investment choices but also have a residual obligation to evaluate the performance of these vehicles to determine whether they should remain available under the plan.

The preamble to the Department of Labor regulations makes it clear that the plan sponsor needs to review the investments actually purchased in the self-directed brokerage account. It would appear that the prudent fund selection and retention duties continue to apply, even if the plan sponsor places no limits on the investment universe in the account.

The common-law concept of investment prudence, codified by ERISA, would appear to require a trustee (and thus a fiduciary) to review the entire portfolio of each self-directed brokerage account.

The plan sponsor needs to have a procedure to conduct periodic reviews to ensure that inappropriate investment options are eliminated in a self-directed brokerage account. The plan sponsor's investment policy should establish criteria for the selection and ongoing due diligence of the investment vehicles under such accounts.

The plan sponsor should make certain that the self-directed brokerage account provider is liable for consequences of its failure to satisfy any agreed-upon limitation on permitted investment vehicles. The plan sponsor should also determine whether the self-directed brokerage arrangement will increase its recordkeeping and plan audit fees. The Department of Labor conducted a study of 401(k) plan fees which showed that fees paid by a typical 401(k) plan compare favorably with retail investments when the additonal services provided by plans are taken into account. The study further concluded that participants are likely to pay most or all fees charged for investment management and are increasingly likely to pay administrative fees as well.

Although some plan sponsors would like to reserve self-directed accounts for participants who are sophisticated investors by establishing a minimum account balance, the use of such thresholds may discriminate in favor of highly compensated employees. Such discrimination would jeopardize the tax qualificafion and tax exemption of the plan and trust.