Are 401k and 404c Plans Putting the Cart Before the Horse?

401k cart before horseThere has been increased talk about automatic enrollment of employees in company 401k and 404c plans and increasing required distributions to such plans. However, there is a basic flaw in such discussions.

As presently structured, 401k and 404c plans simply do not work. No less an expert than Fred Reish, considered by many to be the leading expert on ERISA in the country, has testified on that very point. In fact, it can be argued that 401k plans are set-up to benefit the investment industry and plan sponsors rather than to properly benefit and protect plan participants and their beneficiaries.

While most people are familiar with 401k plans, many are not familiar with so-called 404c plans. 401k plans can elect to be 404c, or participant-directed, plans. Many 401k sponsors are electing to become 404c plans since a 404c plan, if properly established, passes the risk of investment loss to plan participants rather than the plan.

The problem is that very few 404c plans meet all of the requirements for 404c plans. Since 404c plans pass investment risk to the plan participants, one of the key requirements is that plan participants must be provided with “sufficient information to make informed decisions,” thereby providing them with the opportunity to effectively diversify their portfolios in order to minimize the risk of significant losses.

Modern investment theory espouses the value of diversification in reducing investment risk. By properly diversifying a portfolio to include investments that react differently under various market conditions, an investor can hopefully reduce the overall risk of their portfolio.

Experience has shown that in far too many cases plan participants are being given investment options whose returns are highly correlated, meaning that they react similarly under various market conditions. As a result, investors are unable to obtain the downside protection against significant downturns in the stock market.

Not only are the investment options provided to plan participants highly correlated, the plan participants are not being provided with sufficient information to allow them to detect such problems. Both the Department of Labor and the courts have adopted modern investment theory, aka modern portfolio theory, as the applicable standard for assessing the prudence of a pension plan fiduciary’s acts and decisions. The cornerstone of modern portfolio theory is consideration of investments’ correlation of returns in constructing investment portfolios. Despite these facts, there is an express requirement that plan participants be provided with such valuable information.

Basic ERISA fiduciary law requires that a fiduciary always act in a client’s or beneficiary’s best interests and must always act prudently in making decisions on behalf of the client or beneficiary. Two of the consistent themes throughout ERISA are reduction of the risk of significant losses and adequate disclosure of material facts. Disclosure of the correlation of returns of a plan’s various investment options would be consistent with ERISA’s purpose and goals, would be consistent with the legal recognition of the materiality of such info, and would allow participants to properly protect their financial security.

The ongoing refusal to require disclosure of correlation of returns information could be considered a violation of both a pension plan fiduciary’s duty of loyalty and duty of prudence, as non-disclosure clearly is contrary to acting in the plan participants’ best interests. In fact, such non-disclosure arguably knowingly sets-up plan participants’ to fail by incurring significant losses during market downturns, given the fact that history shows that three out of four stocks generally follow the primary trend of the market and the market is cyclical.

With the proper amendments, 401k and 404c plans could work. Congress and the Department of Labor need to ensure the quality, rather than the quantity, of pension plans. By focusing on the quality of these plans, both Congress and the Department of labor could ensure that such plans provide participants with the information promised to and needed to make an informed decision, to allow them to “understand and evaluate the risks and consequences” of investing in each available investment option, allowing the plan participants to prevail in the ongoing 401k/404c battle of the best interests.

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