Employers offering 401(k) plans to their employees assume significant responsibilities under the Employee Retirement Income Security Act. As the federal law designed to protect employee retirement plans, ERISA imposes strict standards of care upon those who establish and administer such plans. Unfortunately, many employers fail to understand the true scope of their obligations, as well as the consequences for failing to live up to them. Since wrongful acts can result in significant liability, employers must understand precisely what the law requires and what the law prohibits.
Employers looking for additional motivation to take their obligations seriously need only consider that ERISA violations may result in personal liability. Specifically, ERISA provides that “any person who is a fiduciary with respect to a plan who breaches any of the responsibilities, obligations, or duties…shall be personally liable to make good to such plan, any losses to such plan resulting from each such breach.
In addition to covering 401(k) plans, ERISA’s broad definition of “employee benefit plan” means that many different types of employee plans may be covered by ERISA, including various health plans, short- and long-term disability plans, deferred contribution plans, SIMPLE plans, TOP HAT plans, pension and profit sharing plans, employee stock ownership plans, and flexible benefit plans. Given ERISA’s broad applicability, employers offering various employee benefit plans must confirm ERISA’s applicability to such plans.
It is important to establish ERISA’s applicability, whether to a 401(k) plan or some other covered employee benefit plan, because of the strict standards of care imposed upon those deemed “fiduciaries” of the plan. Although a plan must have at least one named fiduciary, if a person uses discretion in administering and managing the plan, or controlling the plan’s assets, then that person may be deemed a fiduciary of the plan by virtue of taking control of the plan. Indeed, fiduciary status is based on the functions performed for the plan, not just a person’s title with respect to the plan.
The significance of being a fiduciary comes from the responsibilities and standards of conduct associated with the designation. Fiduciaries are subject to standards of conduct because they act on behalf of participants in a retirement plan and their beneficiaries. Under ERISA, a fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.
In the context of serving a plan, a fiduciary’s responsibilities include:
- Acting solely in the interest of plan participants and their beneficiaries and with the exclusive purpose of providing benefits to them;
- Carrying out their duties prudently;
- Following the plan documents (unless inconsistent with ERISA);
- Diversifying plan investments; and
- Paying only reasonable plan expenses.
Although all of a fiduciary’s responsibilities must be observed, the duty to act prudently is one of a fiduciary’s central responsibilities under ERISA. It requires expertise in a variety of areas, such as investments. Lacking that expertise, a fiduciary will want to hire someone with that professional knowledge to carry out investment and other functions. Prudence focuses on the process for making fiduciary decisions. Therefore, it is wise to document decisions and the basis for those decisions.
Diversification—another key fiduciary duty—helps to minimize the risk of large investment losses to the plan. Fiduciaries should consider each plan investment as part of the plan’s entire portfolio. Once again, a fiduciary will want to document their evaluation and investment decisions.
In addition to establishing minimum standards of behavior, fiduciary obligations also prohibit specific behavior. For example, fiduciaries are prohibited from engaging in self-dealing and must avoid conflicts of interest that could harm the plan. Moreover, ERISA prohibits specific parties (parties-in-interest) from doing business with the plan, such as employers, unions, plan fiduciaries, and service providers. Some prohibited transactions are:
- A sale, exchange, or lease between the plan and a party-in-interest;
- Lending money or other extension of credit between the plan and a party-in-interest; and
- Furnishing goods, services, or facilities between the plan and a party-in-interest.
As previously mentioned, fiduciaries may face personal liability to restore any losses to the plan, or restore any profits made through improper use of the plan’s assets. So, fiduciaries should limit their liability exposure wherever possible. One way fiduciaries can control liability is by demonstrating that they have carried out their responsibilities properly by documenting the processes used to carry out their fiduciary obligations.
Another way to limit potential liability is by giving plan participants control over the investments in their accounts. Importantly, this option does not eliminate a fiduciary’s duties, it only limits the scope. For participants to have control, they must be given the opportunity to choose from a broad range of investment alternatives. Under the Department of Labor’s regulations, there must be at least three different investment options so that employees can diversify investments within an investment category, such as through a mutual fund, and diversify among the investment alternatives offered. Additionally, participants must be given sufficient information to make informed decisions about the options offered under the plan. Participants also must be allowed to give investment instructions at least once a quarter, and perhaps more often if the investment option is extremely volatile.
If an employer sets up their plan in this manner, a fiduciary’s liability is limited for the investment decisions made by participants. However, a fiduciary retains the responsibility for selecting the providers of the investment options, the options themselves, and monitoring their performance.
A fiduciary can also hire a third-party administrator, or service provider, to handle fiduciary functions, setting up the agreement so that the person or entity then assumes liability for those functions. If an employer appoints an investment manager that is a bank, insurance company, or registered investment advisor, the employer is responsible for the selection of the manager, but is not liable for the individual investment decisions of that manager. However, an employer is required to monitor the manger periodically to assure that it is handling the plan’s investments prudently.
It is important to specifically address an employer’s potential liability as a fiduciary when a third-party administrator is retained to handle an employer’s plan. Many employers believe that retaining a third-party administrator absolves the employer of any fiduciary obligations. This is wrong. Although retaining a third-party administrator may limit the scope of an employer’s fiduciary obligations, it does not eliminate them.
Hiring a third-party administrator is in and of itself a fiduciary function, so an employer must exercise appropriate care in its selection. A reasonable number of candidates must be interviewed and the entire process must be documented. At a minimum, the following information should be requested from each potential third-party plan administrator:
- Information about the firm itself, including the financial condition and experience with retirement plans of similar size and complexity;
- Information about the quality of the firm’s services, including the identity, experience, and qualifications of professionals who will be handling the plan’s account, any recent litigation or enforcement action that has been taken against the firm, and the firm’s experience and performance records;
- Information about business practices, including how the plan’s assets will be invested and how participant investment directions will be handled, the proposed fee structure, and whether the firm has fiduciary liability insurance.
An employer’s fiduciary responsibilities extend beyond the selection of a third-party administrator, and include the duty to monitor the performance of a third-party administrator. This scenario provides yet another example in which an employer can face a breach of its fiduciary responsibilities even though a third-party administrator was retained.
Compliance with the duty to monitor a third-party administrator requires, at a minimum, formal reviews at reasonable intervals to decide whether to retain the third-party administrator or look for a replacement. Monitoring efforts should include:
- Reviewing the third-party administrator’s performance;
- Reading any reports they provide;
- Checking actual fees charged;
- Asking about policies and practices (such as trading, investment turnover, and proxy voting); and
- Following up on participant complaints.
In addition to complying with all fiduciary obligations, a plan is required to obtain a fidelity bond to protect the plan’s assets. A fidelity bond is a type of insurance that protects the plan against loss resulting from fraudulent or dishonest acts of those covered by the bond. Such bonds do not typically protect the fiduciary from personal liability; rather, it only protects the assets of the plan.
Those seeking to protect against the personal liability of fiduciaries may obtain fiduciary liability insurance. Fiduciary liability insurance generally covers the discretionary decisions made by fiduciaries which may be the source of litigation. Since retirement plans are often targets for litigation, fidelity liability insurance is a necessity in today’s environment, especially considering that the frequency and costs of such claims are increasing at a staggering pace.
Given the importance of 401(k) and other employee benefit plans in today’s workplace, it is unlikely that employers will stop making such plans available to their workforce. As a result, employers will continue having to deal with ERISA’s obligations and liabilities. This means that the risks associated with being a fiduciary must be considered and controlled. Otherwise, significant personal liability could result.
Setnor Byer Insurance & Risk’s 401(k) Division is available for a complimentary ERISA compliance assessment. If you would like to take advantage of this benefit, please contact Katie Grimmer.
The average premium for a mid-sized fiduciary liability bond is $1,000. Download anERISA Fiduciary Bond application.