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Exercising Fiduciary Authority and Control over the Investment Menu in ERISA 403(b) Plans

Many employers sponsoring 403(b) plans recently modified their arrangements as a result of the final regulations under Section 403(b) of the Internal Revenue Code (New IRS Regulations), which generally became effective on January 1, 2009.

By PS | August 03, 2010
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In accordance with one of the requirements under the New IRS Regulations, plan sponsors must adopt a written 403(b) plan document.[1]  Before these rules became effective, employers were only required to adopt plan documents to the extent the 403(b) plan was covered by the Employee Retirement Income Security Act of 1974, as amended (ERISA).  The U.S. Department of Labor (DOL) has clarified that the adoption of a 403(b) plan document to comply with the New IRS Regulations will not automatically cause the plan to become subject to ERISA.[2]  However, in the course of modernizing their arrangements to comply with these new tax rules, various 403(b) plan sponsors have assumed greater control over their plans, thereby becoming subject to ERISA.  

Prompted by the New IRS Regulations, many tax-exempt organizations investigated and made changes to their 403(b) arrangements with the assistance of their service providers.  As a result of this process, a substantial number of employers decided to transform their 403(b) plans from a “no cost” perk offered as a convenience for employees, to a meaningful benefit program designed to help employees through their retirement years.  For example, sponsors implemented automatic enrollment features, added matching contributions, and initiated communication campaigns to promote retirement savings.  However, with this added level of involvement in plan design and administration, these employers in effect enlisted to serve their plans as ERISA fiduciaries.  

403(b) plans are generally subject to ERISA if the plan is “established or maintained” by a tax-exempt organization on behalf of its employees.[3]  As provided under a regulatory safe harbor, a 403(b) plan will be not deemed to be established or maintained by the employer if (1) employee participation is completely voluntary, (2) all rights under the 403(b) plan’s annuity contracts or custodial accounts are enforceable solely by the employee, (3) the involvement of the employer is limited to publicizing the program without endorsement and to collecting contributions through payroll deductions, and (4) the employer receives no compensation, other than reasonable reimbursements for payroll deduction costs.[4]    

Conversely, a plan will become subject to ERISA if the employer encourages participation, makes non-elective employer contributions, or exercises any kind of discretionary authority with respect to plan operation (e.g., determining eligibility for hardship distributions).  As a consequence of their providing meaningful 403(b) plan benefits to their employees, a large number of tax-exempt organizations have converted their 403(b) arrangements into ERISA plans, and they are now subject to the fiduciary requirements and standards of care under ERISA.  

Under ERISA 403(b) plans, the plan sponsor and other fiduciaries are responsible for the management of the plan and its investments in accordance with the demanding standards of ERISA Section 404.  There are four central duties under this provision, which require fiduciaries to act:  (1) for the exclusive purpose of providing benefits and paying reasonable plan expenses, (2) in accordance with the “duty of prudence,” (3) by diversifying plan investments so as to minimize the risk of large losses, and (4) in accordance with the plan’s documents.  In the case of an ERISA 403(b) plan, the plan’s participants are typically permitted to make the investment allocation decisions for their personal accounts.  But even though investments may be participant-directed, the plan sponsor remains responsible for these investment allocation decisions, unless the conditions of ERISA Section 404(c) are met.[5]  Once these conditions are satisfied, the plan fiduciary is responsible for the prudence and diversification within the plan’s investment menu, but is not responsible for the actual investment allocation of participants’ accounts.    

To foster compliance with these fiduciary standards, it is customary for plan sponsors to appoint fiduciary committees to oversee the management of the plan’s investment menu.  It is also a recommended practice for the committee to have a written charter to provide guidance on its composition and designated duties.  Since the procedural aspects of the duty of prudence contemplate an objective process for selecting, monitoring and changing the plan’s investment line-up, the DOL encourages the adoption of an investment policy statement (IPS) to assist the investment committee or other plan fiduciaries to discharge these duties solely in the interests of the participants and beneficiaries of the plan.[6]  To comply with the substantive aspects of this duty, which is sometimes called the “prudent expert” rule, plan sponsors should seek the assistance of a qualified adviser, such as a registered investment adviser (RIA), if it lacks the necessary expertise and experience to carry out a prudent evaluation of the investment menu.[7] 

[1] Adoption of the 403(b) plan document was permitted to be delayed until December 31, 2009, provided the plan sponsor operated the plan during 2009 in accordance with the requirements of IRS Notice 2009-3.  

[2] Field Assistance Bulletin 2007-02. 

[3] 403(b) plans can also be sponsored by, or on behalf of, public schools and churches.  However, governmental plans are automatically exempt from ERISA, and church plans are similarly exempt unless ERISA coverage is elected. 

[4] Section 2510.3-2(f) of DOL regulations. 

[5] To satisfy the requirements under ERISA Section 404(c), participants must have an “opportunity to exercise control” over their accounts, which also requires sufficient investment-related disclosures, and the plan must offer a “broad range of investment alternatives” within the meaning of the related DOL regulations. 

[6] DOL Interpretive Bulletin 08-2, Interpretive Bulletin Relating to the Exercise of Shareholder Rights and Written Statements of Investment Policy, Including Proxy Voting Policies or Guidelines, 29 CFR 2509.08-2. 

[7] See, e.g., Liss v. Smith, 991 F.Supp. 278 (S.D.N.Y.1998).