Fiduciary Rules Related to Automatic 401(k)s

By Robert J. Toth

An employer adopting an “automatic 401(k)” does so by either adding automatic features such as automatic enrollment to an existing 401(k) plan, or by newly adopting such a plan. Either way, the plan sponsor needs to be familiar with the fiduciary obligations that come with these arrangements, generally referred to as Automatic Contribution Arrangements (ACAs). Fortunately, Congress has simplified the manner in which some of these obligations can be met, making it more attractive to adopt an automatic 401(k) plan.

The fiduciary rules which apply to private employers maintaining a 401(k) plan—or a 403(b) plan, which is governed by ERISA—and and an automatic 401(k) for its employees can, at first glance, seem intimidating. However, the rules are based upon the exercise of sound business judgment, as opposed to a set of rigid standards. As long as plan fiduciary decisions are soundly made, and are made for the exclusive benefit of the plan participants, the fiduciary’s exercise of judgment will receive deferential treatment. If the decisions are made as part of a considered process, the fiduciary will likely be protected even if, in hindsight, the decision proves to be wrong.

It is also important to remember that not all decisions related to a defined contribution plan generally, or an automatic 401(k) plan specifically, are considered fiduciary decisions. For example, the decision to adopt a 401(k) plan, or the choice of the type of automatic 401(k) to use, are business decisions that can be made in the best interest of the employer—the interests of the plan participants do not have to be legally taken into account. On the other hand, the implementation of some aspects of that business decision, such as hiring service providers or choosing investments, often involve fiduciary decisions.

The following will assist the employer in sorting through these rules, and how they will apply.

Fiduciary Obligations Related to All Plans

Before discussing the particulars of the fiduciary rules as they apply to automatic 401(k) plans, it is helpful to first go over the workings of fiduciary rules generally.

Whether or not an employer decides to adopt an automatic 401(k) as part of their 401(k) or 403(b) plan, there are certain basic rules of conduct which apply to the way in which those plans are administered and the funds invested. These rules are called the “fiduciary “ rules under ERISA, and are based upon the ancient law of trusts. Under these rules, often described as the comprising the greatest legal duty one person can owe to another under law, one person is obligated to act only in the best interests of another when making decisions related to the plan.

The fiduciary rules that apply to all plans establish a “Prudent Person” standard of care. These prudence rules apply both to the administrative decisions made under the plan as well as to the decisions related to plan investments. There are four basic fiduciary rules. A fiduciary must:

1. Act for the exclusive benefit of the plan and its participants, and to defray the reasonable expenses of administering the plan. In making decisions under the plan, the fiduciary’s or the plan sponsor’s own interests cannot be taken into account, and plan costs must be reasonable. This means, for example, that a fiduciary decision with regard to the use of a certain service provider or of certain investments cannot be premised on some sort of financial benefit being provided to the employer by that service provider because of that decision. This rule also means that fees and expenses related to the administrative services and investment funds under the plan must be reasonable.
2. Act with the care, skill, prudence and diligence under the circumstances that a prudent person acting in a like capacity and familiar with such matters would use under such circumstances. This does not require a fiduciary to be an expert in making decisions related to plans. It requires that a fiduciary recognize when an expert needs to be consulted, to stay away from decisions which may create a conflict of interest and to have a sound basis (consistently applied) for any decision it makes.
3. With regard to investments, a fiduciary must diversify the investments of the plan so as to minimize the risk of large losses unless it is clearly imprudent not to do so. It is important to understand that this standard does not require that a fiduciary seek to maximize investment gains when selecting investment options for the plan.
4. Follow the plan documents, unless those documents are otherwise inconsistent with ERISA. It is considered a fiduciary breach to make a decision in a manner that is not supported by plan documentation.

These four rules are very broad, and are short on specifics. This is because they are designed to outline the manner in which a fiduciary’s judgment should be exercised, not to provide specific guidance as to what any particular decision should be under a plan. The rules rely heavily on—and defer to—an individual’s judgment, well exercised, and the process by which decisions are made.

As previously mentioned, the courts have called these ERISA’s fiduciary standards the highest standard of duty that one can owe to another under law, as plan fiduciaries must completely discount their own interests when making plan-related decisions. In return for being held to this high standard, however, the decisions of the properly acting fiduciary will be granted deference by the courts. The fiduciary’s decision can be wrong under this standard, but, as long as it is arrived at properly, the fiduciary will not be considered as breaching its duty.

Who Is a Fiduciary?

A fiduciary, generally speaking, is someone who exercises discretionary authority over a plan or its investments, or someone who regularly gives investment advice to a plan for a fee.

A person becomes a fiduciary in one of three ways:

• The ERISA statute identifies the position as a fiduciary one (such as a trustee, a plan administrator or an investment manager);
• The plan appoints someone as a fiduciary; or
• Even in the absence of being appointed a fiduciary, someone takes on discretionary authority under the plan.

Every plan must have a “Plan Administrator,” who has the fiduciary responsibility for administering the plan properly. It must also have a “chief” fiduciary (sometimes referred to as the “named fiduciary”) who has the authority to appoint all of the other fiduciaries to the plan, and who is responsible watching over plan investments. In the absence of the plan sponsor or appointing someone (or appointing a committee) to fulfill these responsibilities, the plan sponsor itself will be considered the fiduciary and be held to the fiduciary duties outlined above. This then means that corporate officers or members of the board of directors may be considered fiduciaries as well, because of their responsibilities to manage the company.

A fiduciary can also delegate its responsibilities to another willing party. For example, if the plan document states that the “plan administrator” is responsible for managing a plan’s assets, that administrator can delegate that responsibility to an investment manager. Likewise, a plan fiduciary that has little experience with investments can hire an investment advisor who will serve in that fiduciary capacity.

When these delegations of authority are assigned, it should be done in writing. Whenever fiduciary obligations are delegated to another party, the person delegating that authority still retains a “residual” responsibility to periodically look over the shoulder of the appointee to make sure they are properly fulfilling their delegated responsibility.

Personal Liability

It is important for plan sponsors to understand that fiduciary obligations under ERISA are generally considered to be personal obligations. This means that, even though the plan sponsor is a corporation which will be deemed to be considered the Plan Administrator (which is a fiduciary position), it is actually the officers or board members of the company who may bear that personal responsibility unless someone else is specifically delegated that authority. This makes it important that the company paperwork specifically identify the officer (or, at least, the title of the person) or appoints a committee which will be named the fiduciary. Failing to name the fiduciary could result in board members or senior officers being inadvertently labeled as fiduciaries.

The Value of Process and Documentation

ERISA’s prudence standards really boil down to process. If a fiduciary follows a good process when making a decision, the courts will generally defer to that decision even though in hindsight the decision may have been wrong¹. The elements of a sound ERISA process include:

• Following a diligent process when collecting information leading up to a decision.
• Establishing a reasonable and sound basis for making the decision.
• If the decision differs from similar decisions it previously made, establishing why this decision is different from those previously made.
• Ensuring that neither the plan sponsor’s nor the fiduciary’s own financial interests are taken into account when making the decision.
• Properly documenting any decision which is made.

The fiduciary standards do not require that a committee be appointed in order to follow this process, but a committee makes the process much easier to follow and for the decisions to be documented.

Role of the Advisor

The registered investment advisor can play an important role with regard to the plan’s investments. An advisor who regularly provides investment advice for a fee to another plan fiduciary, or one who has discretionary authority over the management of a plan’s assets, will be considered a fiduciary. An investment fiduciary will be personally liable for the prudence of the advice he or she gives, or for the management activities in which they engage. However, an investment advisor or manager who is appointed a fiduciary only has obligations to the extent of the authority it exercises. This means that an investment fiduciary will not be responsible for the fiduciary acts of, for example, the fiduciary who is responsible for making administrative decisions under the plan.

Prohibited Transactions

A fiduciary must avoid using a plan’s assets for its own personal benefit, and ERISA has a series of rules which are designed to prevent this. These rules are called the “prohibited transaction” rules. A fiduciary that uses the assets of a plan (such as taking a corporate loan for the plan sponsor’s business from the plan) is required to report such transactions and undo any transaction which was prohibited. A fiduciary that misuses plan assets can be subject to tax and civil penalties which can range up to 100 percent of the amount involved in the prohibited transaction.

DOL Fiduciary Resources

The United States Department of Labor has a number of resources that can be used by plan fiduciaries in meeting their fiduciary obligations including:

• Meeting Your Fiduciary Obligations, which addresses the scope of ERISA's protections for private-sector retirement plans.
• The ERISA Fiduciary Advisor, an interactive guide that asks plan sponsors specific questions about their own circumstances and provides fiduciary answers.

Additional fiduciary material published as part of the DOL’s ERISA fiduciary education campaign can be found at www.dol.gov/ebsa/fiduciaryeducation.html

Application of Fiduciary Rules to Automatic Contribution Arrangements

The fiduciary rules apply in a very particular way to ACAs. The rules are designed to help lessen the burdens and exposures which otherwise may apply to employers adopting these arrangements.

First of all, companies that have adopted—or are thinking of adopting—an automatic 401(k) should be aware of a key point: Not all decisions about ACAs are fiduciary decisions. For instance:

• An employer’s choice to adopt or terminate a 401(k) or 403(b) plan is a business decision of the plan sponsor which is not subject to fiduciary standards described above. These types of decisions are often called “settlor” decisions, referring to the company which establishes a pension trust as the “settlor” of the trust. This means that, in making such business decisions, the employer can act in its own interests and will not be held to the fiduciary standard of having to act for the exclusive benefit of the plan participants. The fiduciary rules only come into play when the employer acts to implement decisions related to the plan. Implementing the plan, or taking the steps to terminate a plan, often involve fiduciary decisions.
• An employer’s decision whether or not to adopt an ACA (or which type of ACA to adopt) is a business decision, not a fiduciary decision. The “Getting Started” part of this website outlines the basic steps an employer needs to take in order to set up an ACA, and three of those decisions are business decisions which are not subject to the fiduciary standards. These include determining the goals of your company’s 401(k) plan, evaluating the elements of an automatic 401(k) and determining a default contribution rate.

On the other hand, choosing the default investment for any ACA is a fiduciary act.

Choosing a Default Investment—a Fiduciary Decision

Default investment selection for an automatic 401(k) is a decision which must be made in accordance with the fiduciary standards described above. A financial advisor can assist you in properly choosing an appropriate default investment fund.

Fortunately, Congress considered this, and provided plan sponsors some fiduciary relief when adopting such a fund for an ACA. This protection takes the form of allowing the plan sponsor to adopt a certain type of default investment option which will be treated as if it were actually chosen by the plan participant. Under ERISA, this means that, as long as certain rules are met, the fiduciary will not be held responsible for investment losses from the default investment into which the automatic 401(k) contribution was placed.

With this rule, the fiduciary’s choice of a default investment will be deemed to be an investment choice made by the plan participant in an ACA if the contribution is invested in a Qualified Default Investment Alternative (or QDIA), as described below. This is meaningful protection for the fiduciary. Courts have recently ruled that plan participants who have suffered significant losses from a QDIA cannot hold a fiduciary liable for these losses as long as the above steps have been taken.

QDIA as a Default Investment

The plan sponsor may choose to use the QDIA as a default investment fund in order to take advantage of the fiduciary relief provided by Congress. However, the choice of which QDIA to use is a fiduciary decision which must be prudently made in accordance with the fiduciary standards described above. So even though the employee is treated as choosing the QDIA (with the employer not being held liable for that choice if it results in losses), the fiduciary’s choice of the actual QDIA is considered a fiduciary choice. If that choice is made imprudently, the fiduciary can be held liable for losses.

In addition to following the general fiduciary standards in choosing a QDIA, the QDIA must, according to the Department of Labor, also be one of these four types of investments:

• An investment product with a mix of investments that takes into account the individual’s age or retirement date (for example, a life-cycle or targeted-retirement-date fund);
• A professionally managed account (such as in a collective trust or in a group annuity contact investment account) that provides an asset mix that takes into account the individual’s age or retirement date;
• A balanced fund that takes into account the characteristics of the group of employees as a whole, rather than each individual; or
• A capital preservation investment (such as a stable value or money market fund), but only if the contributions can be invested for only the first 120 days of participation.

The following rules must also be met in order to qualify as a QDIA:

• Participants and beneficiaries must be given an opportunity to provide investment direction, but have not done so.
• Materials, such as investment prospectuses, which are provided to the plan for the QDIA must be given to participants and beneficiaries.
• An initial notice of the QDIA, with expense and fee information, generally must be provided at least 30 days in advance of a participant’s date of plan eligibility or any first investment in a QDIA. For new employees, the notice can be made generally on or before the date of first plan eligibility if those employees have the opportunity to withdraw their funds from the plan within 90 days, in accordance with the permissible withdrawal rules for ACAs. An annual notice also must be provided at least 30 days in advance of each subsequent plan year.
• Participants and beneficiaries must have the opportunity to direct investments out of a QDIA as frequently as from other plan investments, but at least quarterly.
• Withdrawal fees and restrictions cannot be imposed on a participant who “opts out” of participation in the plan or who decides to direct their investments.
• The plan must otherwise offer a broad range of investment alternatives.

The timing requirements of the QDIA notice are not identical to the timing requirements for an ACA notice, but an employer can satisfy both sets of rules simultaneously if carefully coordinated.

While it is not required that a QDIA be used as a default fund, should a fiduciary choose a default fund other than a QDIA, the participant will not be treated as being the person making that investment choice, therefore increasing the fiduciary’s potential liability.

Non-ERISA plans

Finally, the fiduciary rules described above only apply to automatic contribution arrangements, which are subject to ERISA. Governmental plans, some church plans and 403(b) plans that are not subject to ERISA are instead governed by state and local. Check in with a lawyer when dealing with non-ERISA plans to determine what fiduciary-like rules may be applicable to these arrangements.

Robert J. Toth, Retirement Made Simpler Legal Advisor, has practiced employee benefits law since 1983 with a focus on the design, administration and distribution of financial products and services for retirement plans, one which combines elements of ERISA, tax law, insurance law, securities law and investment law for both 401(a) and 403(b) plans.