457(b) and Participant Investing
The growth in popularity of participant-directed 457(b) plans creates an emerging fiduciary issue for the governments that set up the plans and for the officials and committees who oversee their operation. The issue is, who is legally responsible for the quality of the participant investing? That leads to a secondary issue of, what can be done to improve participant investing practices?
The private sector has struggled with this issue for years—because of the popularity of participant-directed 401(k) plans. Because of that history, 457(b) sponsors can look to the 401(k) community for ideas and solutions.
On the first point--who is legally responsible, the fiduciaries of private sector plans are governed by the rules in ERISA sections 404(a) and 404(c). Under 404(a), which include the prudent man rule, if participants invest badly, the fiduciaries may be legally responsible. However, if a 401(k) plan complies with approximately 20 requirements under ERISA section 404(c), the burden is transferred to the participants. That is, the fiduciaries have a defense to claims that participants made imprudent investment decisions.
But, what does that mean for public sector 457(b) plans? Unfortunately, in most states the answer is not clear. However, some states have enacted statutes that adopt ERISA's 404(c) principles. For example, California Government Code section 53213.5(b) provides:
"... participants choosing individually directed investments shall relieve the trustee and local agency of responsibility under the terms of the plan and trust. That relief shall be conditioned upon the local agency compliance with communication and education requirements similar to those prescribed in [404(c) of ERISA] ... for private sector employers."
States that adopt 404(c) give fiduciaries (that is, the officials and the committee members who oversee 457(b) plans) a roadmap for transferring legal responsibility from the government to the participant. Unfortunately, in our experience very few 457(b) plans take the steps necessary to accomplish that transfer.
While most states have not enacted statutes adopting the 404(c) standards, it is possible-—perhaps even likely-—that state courts will look to 404(c) to determine the type of information needed by participants to understand their responsibilities under 457(b) plans and to invest in an informed and, hopefully, successful manner. Because of that possibility, all 457(b) sponsors and fiduciaries are well advised to comply with 404(c).
To satisfy 404(c), 457(b) sponsors should work with benefits attorneys or consultants to fully understand and satisfy the 20 or so requirements. As a part of that process, I recommend that fiduciaries insist on a completed 404(c) compliance checklist for their due diligence files.
My second question was, what can be done to improve participant investing practices? That subject deserves its own article. But, for the moment, let me point out that various surveys and studies of participant-directed plans show that only one "solution" has really worked, that is, only one has materially affected large percentages of employees. That solution has been for the plan to offer professionally designed portfolios, like risk-based lifestyle funds, retirement age lifecycle funds, asset allocation models and managed accounts. When properly done--through enrollment meetings and investment education--it is possible to have 50% or more of the money contributed to the plan going into those vehicles.
In a sense, a good offense is also a good defense, that is, if the participants are well-invested through those portfolios, then those participants will not have a claim that the fiduciaries should be responsible for imprudent participant investing. However, it is also important for a team to have a good defense, like 404(c).
Any U.S. federal income tax advice contained in this communication (including any attachments) is neither intended nor written to be used, and cannot be used, to avoid penalties under the Internal Revenue Code or to promote, market or recommend to anyone a transaction or matter addressed herein.
© 2006
Reish Luftman Reicher & Cohen. All rights reserved. Government & Tax Exempt Plan Report is published as a general informational source. Articles are general in nature and are not intended to constitute legal advice in any particular matter. Transmission of this report does not create an attorney-client relationship. Reish Luftman Reicher & Cohen does not warrant and is not responsible for errors or omissions in the content of this report.
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