Setting up retirement plans for your business clients can be risky. Nevertheless, there's a recipe for protecting yourself from unpleasant surprises.
In the past two decades, registered reps have helped business clients establish thousands of 401(k) plans, operating under the erroneous assumption that giving employees investment control shields the client and the rep from liability. These plans often can lead unsuspecting clients and their reps into liability from lawsuits when the employees' investment decisions result in losses. The current round of Enron litigation will shine a spotlight on this trap for the unwary.
The key to protecting yourself and your clients from these unpleasant surprises is to understand how to fully transfer investment responsibility from the rep and his clients to the employees who make the decisions.
Start by clearly understanding your responsibility. Federal pension law (ERISA) gives you and your business clients legal responsibility and potential liability for all investments in a 401(k) plan if the client and the rep are fiduciaries. If you directly or indirectly receive a fee and your advice forms the principal basis of 401(k) plan investment decisions, you are a fiduciary, even if you are merely selecting investment choices.
Even if your client makes the ultimate decisions, they may expect you to be involved in designing the investment alternatives. If you are a 401(k) plan fiduciary, you will be responsible for the suitability, prudence and diversification of the plan assets unless you qualify for an exemption, usually a 404(c) exemption.
Detailed Department of Labor regulations must be strictly followed to win an exemption. Even if the exemption is fully satisfied, it provides no protection with respect to the design of investment alternatives or with respect to employees who fail to make elections resulting in their accounts being invested by default.
An exemption will only be awarded if the employee is given an opportunity to exercise investment control and is also provided with a sufficiently broad range of investment choices.
How does an employee get investment control?
Nine requirements must be satisfied:
An explanation that the plan is intended to meet the requirements of the exemption and that fiduciaries will be relieved of liability from losses resulting from the participant's election of his own investments.
A description of the investment alternatives available under the plan, including the objectives, risks and return characteristics of each alternative, including the type and diversification of assets comprising the portfolio of each alternative.
Identification of any designated investment managers.
Explanation of investment direction powers, including rights to vote, tender and other ownership rights, and any related restrictions.
Description of transactions, fees and expenses, including commissions, sales loads, deferred sale charges, redemption and exchange fees.
The identity, address and phone number of the plan fiduciary who will provide more detailed information (specified in the regulations) regarding each investment alternative upon request.
Special rules and procedures if employer stock is one of the investment alternatives.
A copy of applicable prospectus for securities immediately prior to or immediately following a participant's initial investment.
Description of voting, tender and similar rights applicable to any investment alternative held in the participant's account provided subsequent to the participant's investment in such alternative.
Some of these requirements are mechanical and can, with requisite care, be clearly and cleanly met. However, others are highly subjective providing no clear certainty. An example of a highly subjective requirement, easily given to 20/20 hindsight, is the requirement that the availability of investment alternatives be described, including the investment objectives, the risk and return characteristics and the type of diversification of assets of the investment alternative. Care should be taken to clearly meet the objective and subjective standards.
Similarly, the requirement that the plan must have a sufficiently broad range of investment alternatives to be able to materially affect the potential return and degree of risk in his account with materially different risk and return characteristics within a normally appropriate range for the employee and provide overall adequate diversification of the employee's portfolio, is subjective.
The participant will not be treated as having exercised investment control unless he is treated as having exercised independent control, in fact, which will be determined under all of the facts and circumstances of the case. The regulations specifically note that if a plan fiduciary exercises improper influence, independent control will not be treated as having been exercised. Accordingly, relatively innocent advice to an employee as to how to exercise investment control could eliminate the 404(c) exemption.
It should be clear that a rep take great care to assure both the objective and subjective standards of the regulations are met. Further, regardless of the level of care, there are a range of subjective standards that will only be judged based upon the facts and circumstances of a particular situation and, unfortunately, often with the benefit of hindsight.
Of course, one way to assure that the requirements of the 404(c) exemption have been satisfied is to allow the employees to select among virtually any publicly available investment. However, this may not be a practical alternative.
If the 401(k) plan limits the employees' investment choices, and if the rep and his client are fiduciaries, they would be responsible for the suitability, prudence, and diversification of the choices. The exemption would only protect them as to employees' choices among the alternatives, not for the alternatives themselves.
For example, if the 401(k) plan investment choices are limited to a family of five or six mutual funds providing a broad range of investment characteristics, the registered rep and his client would have no responsibility or liability for investment choices actually made by employees among the alternatives. However, because the employee, in fact, exercises no control over the investment choices, the rep and his client would have responsibility and liability for the appropriateness and prudence of the funds themselves as proper and prudent choices which are prudently managed.
Furthermore, when employees fail to make investment elections, the investment representative and his client are responsible for the suitability, prudence, and diversification of the resulting default investments. It should be noted that this responsibility not only applies to prudence, suitability, and diversification as of the date the investment alternatives are selected, but also on a continuous basis, taking into account changes in the alternatives themselves.
While somewhat difficult, it may be possible to limit your assistance to your clients to broad information regarding investment alternatives and their characteristics without actively assuming the role of fiduciary. The best way for a registered rep to avoid fiduciary responsibility is to not become a fiduciary. That is best done by not helping select plan investment alternatives. It is also helpful to have a written agreement with the client that specifies that the client is the fiduciary and makes all investment decisions.
Roger C. Siske is chairman of the employee benefits and executive compensation department at Sonnenschein Nath & Rosenthal and chairman of the American Law Institute/American Bar Association pension and executive compensation conferences.