Increased Flexibility for 401(k) Plan Sponsors

In the first half of this decade, a series of events wreaked havoc on pension plans. Enron and other major corporations collapsed with the result that employees and other investors lost billions of dollars in savings, including in many cases significant pension investments. Sept. 11 accelerated and deepened the fall of the financial markets. Lower securities prices, coupled with low interest rates, resulted in modest investment returns and increased funding obligations for sponsors of traditional defined benefit plans. In turn, major legacy air carriers and other historical industry leaders struggled (sometimes without success) to avoid bankruptcy. In response to these and other upheavals, Congress enacted the Pension Protection Act ('PPA') on Aug. 17, 2006, only three weeks after its introduction in the House of Representatives, in an effort to reform outdated aspects of federal pension laws and to provide greater stability and overall protection to pension plan members.

Pension Protection Act

Understandably, given its roots in the financial troubles that preceded its enactment, the PPA concentrated much of its attention on remedying shortfalls in employer funding of defined benefit pension plans. However, the PPA also acknowledged the growing significance of defined contribution plans (e.g., '401(k)' plans) as the primary ' and in many cases, the sole ' source of retirement savings for a growing number of Americans. Accordingly, the PPA also made significant changes affecting diversification rights, automatic enrollment, and default investment options under such plans. In particular, the PPA established exemptions for fiduciaries, so that they could more freely provide investment advice to plan participants who wield increasing control over their plan investments. This article summarizes those changes.

Corporate collapses, like that at Enron, had particularly disastrous effects on participants in pension plans that were ily invested in the sponsoring employer's securities. The PPA addresses the potential risks of over-investment in an employer's securities by requiring such plans to offer diversification. Pursuant to '901 of the statute, defined contribution retirement plans holding publicly traded employer securities must offer applicable participants the right to diversify out of their employer's securities. Subject to certain limitations, an employer must offer no fewer than three investment options, other than employer securities, into which applicable participants may direct the proceeds of their divestment of employer securities. Each such investment option must be diverse, with materially different risk and return characteristics, from the others. So that plan participants may take full advantage of these diversification opportunities, '507 of the PPA requires that employers give notice to any participants or beneficiaries that have diversification rights at least 30 days before the first day that such rights become effective.

Promoting Employee Participation

While the diversification provisions serve a primarily protective function, the PPA also made significant changes to facilitate and promote employee participation in defined contribution plans. For example, the PPA encourages plans to enroll participants automatically by explicitly creating plan qualification incentives under the Internal Revenue Code ('IRC'). To take advantage of these incentives, the plan must automatically enroll all participants who had not previously provided a written election of their desire to participate or not to participate, must provide an initial contribution rate of at least 3-10% (to gradually increase, if necessary), and must provide for matching contributions from the employer at specified levels.

The statute also directs the Department of Labor ('DOL') to issue regulations offering plan fiduciaries protection when they select default investments into which retirement funds of plan participants will be placed. To qualify for fiduciary relief for default investments under these regulations, promulgated by the DOL on Sept. 27, 2006, a plan fiduciary must: 1) invest assets in a 'qualified default investment alternative' ('QDIA') (as defined in the regulations); 2) provide an opportunity for participants to direct the investment of assets in their accounts; 3) furnish a notice to participants at least 30 days in advance of the first investment, and within at least 30 days in advance of each subsequent year; 4) provide any material that was provided to the plan relating to a participant's or beneficiary's investment in a QDIA; 5) afford participants the opportunity to transfer such assets to any other investment alternative available under the plan without financial penalty; and 6) offer a 'broad range of investment alternatives' (as defined under '404(c) of ERISA). DOL Reg. '2550.404c-5(c). In general, the statute and its implementing regulations seek in each of these provisions to encourage participation and investment in pension plans while at the same time promoting the ability of plan participants to safeguard their assets.

Greater Freedom to Offer Investment Advice

In order to further advance the goals of protecting participants and simultaneously encouraging them to invest, the PPA allows plan sponsors and fiduciaries greater freedom to offer investment advice to plan participants. To allow plan sponsors and fiduciaries to do so without exposure to fiduciary breach claims, the PPA amended portions of both ERISA and the Internal Revenue Code.

Section 3(21)(A)(ii) of ERISA defines a 'fiduciary' to include any person that renders investment advice for a fee or other compensation, directly or indirectly, with respect to any monies or other property of an ERISA plan, or has the authority or responsibility to do so. Under '404 of ERISA, fiduciaries must act prudently and for the benefit of plan participants and beneficiaries. Under '406, fiduciaries must also avoid prohibited transactions involving self-dealing and conflicts of interest. Section 4975(c) of the Internal Revenue Code operates to the same effect. Before the enactment of the PPA, neither ERISA nor the Internal Revenue Code provided an exemption from the prohibited transaction rules for fiduciaries with respect to any investment advice that would result in the payment of additional fees to the fiduciaries or their affiliates. Plan sponsors and fiduciaries were left highly vulnerable. If they provided investment advice, they ran the risk of incurring potential liability for fiduciary breaches or appearing to have engaged in prohibited transactions. On the other hand, if they refused to provide investment advice, they were just as likely to be viewed as inattentive to the financial health of their plan participants.

The DOL took some steps before the enactment of the PPA to clarify the steps plan sponsors and fiduciaries could take to provide investment advice to participants. In Interpretive Bulletin 96-1, DOL Reg. '2509.96-1, the DOL determined that furnishing educational materials to participants regarding: 1) plan information, 2) general financial and investment information, 3) asset allocation models, and 4) certain interactive investment materials would not constitute investment advice. The offset approach, approved in DOL Adv. Op. 97-15A and DOL Adv. Op. 2005-10A, allowed a fiduciary adviser to invest in mutual funds that pay additional fees to the advising fiduciary, if the fiduciary used such fees to offset fees that the plan was otherwise legally obligated to pay the fiduciary. In DOL Adv. Op. 2001-09A, the DOL concluded that a financial services firm could serve as a fiduciary and offer an investment advisory program without breaching its fiduciary duties, if the investment recommendations were the result of methodologies developed, maintained, and overseen by an independent financial expert. Taken together, these DOL pronouncements allowed plan sponsors to put in place limited participant investment education and advice programs. However, many viewed these limited programs as inadequate, particularly with respect to plans implemented under '404(c) of ERISA that shift much of the responsibility for particular investment decisions to individual plan participants.

In general, ERISA '404(c) relieves a trustee, a named fiduciary or other fiduciary from liability as a result of a participant's control over the investment of assets allocated to the participant's account. This fiduciary protection applies only to individual account plans that: 1) permit participants and beneficiaries the opportunity to exercise control over the assets of their own accounts; and 2) provide participants the opportunity to choose from a broad range of investment alternatives, give investment instruction with appropriate frequency, diversify investments, and obtain sufficient information to make informed investment decisions. DOL Reg. '2250.404c-1(a)-(c). Consequently, plan sponsors and fiduciaries could derive the protections that '404(c) offers only if they gave plan participants a high level of control over their investments. However, if that control came with only limited access to information and advice on the investments in question, these participants could ultimately suffer.

The PPA addressed this problem by amending the prohibited transaction sections of ERISA and the IRC to exempt the provision of investment advice, the investment transaction entered into based on the advice, and the direct or indirect receipt of fees or other compensation by the fiduciary investment adviser from the prohibited transaction rules, if the investment advice is provided in the context of an 'eligible investment advice arrangement.' Such an arrangement can arise under one of two circumstances: 1) the adviser's compensation (including commissions) is level (and does not change based on the investments selected); or 2) the advice is provided solely through a computer model that is certified to be unbiased by an unrelated third-party expert (i.e., the software must not be biased in favor of recommending investments offered by the fiduciary adviser). Use of a computer model qualifies for the prohibited transaction exemption so long as the only investment advice provided is the advice generated by the computer model, and the transactions occur solely at the direction of the participant. The PPA also requires detailed disclosures regarding fees received in connection with the advice provided. It further requires an annual independent audit and a written report to the authorizing fiduciary.

On Feb. 2 of this year, the DOL issued Field Assistance Bulletin No. 2007-01 to assist with the interpretation and implementation of the PPA's amendments to the prohibited transaction rules. In this Bulletin, the DOL addressed three basic questions raised by the amendments.

First, the DOL expressed its view that its previous guidance related to investment advice, including the guidance provided in the advisory opinions discussed above, remained valid. The relevant provisions of the PPA simply allow the provision of investment advice in a greater range of circumstances.

Second, the DOL emphasized that, notwithstanding the new exemptions, plan fiduciaries still have the duty to prudently select and periodically monitor any investment advice provider tasked with the responsibility of providing advice to its plan participants. With regard to the prudent selection of service providers generally, the DOL recommends that a fiduciary, such as the Plan Committee, follow objective procedures appropriate for assessing the investment advice provider's qualifications, the quality of the services offered, and the reasonableness of the fees charged for the service. Furthermore, the procedures chosen must ensure that the fiduciaries avoid self-dealing, conflicts of interest, and any improper influence. With respect to the monitoring of investment advisers, the DOL recommends that a fiduciary periodically review the extent to which there have been any changes in the information upon which the initial selection of the investment adviser was based, including whether the adviser continues to maintain the requisite qualifications and whether the adviser furnishes investment advice grounded in generally accepted investment theories.

Finally, the DOL expressed its expectation that parties offering investment advisory services will maintain policies and procedures designed to ensure that any fees or compensation paid to fiduciary advisers will not vary depending on the investment option selected. On the other hand, affiliates of such advisers will not be covered by the level fee requirement, as long as that affiliate does not itself provide investment advice to a plan.

Thus, like the PPA itself, the DOL Field Assistance Bulletin No. 2007-01 underscored the need for plan sponsors and fiduciaries to play a greater role in the provision of investment advice and related services, while maintaining adequate protections for plan participants.

Conclusion

Given the increasing prevalence of and dependence upon participant-directed 401(k) arrangements as a primary source of retirement savings, encouraging plan participation and enhancing participant investment advice programs are increasingly critical to helping participants meet their pension investment goals. The Pension Protection Act offers plan sponsors greater flexibility in advancing these goals in a manner that should both benefit and protect plan participants. In particular, the PPA's exemption for 'eligible investment advice arrangements' and the DOL's recently issued Field Assistance Bulletin in that area should provide plan sponsors and fiduciaries with greater flexibility in implementing helpful investment advisory services without risking exposure to liability under ERISA.

Karl Nelson, a member of this newsletter's Board of Editors, is the partner-in-charge of Gibson, Dunn & Crutcher LLP's Dallas office and a member of the firm's Labor and Employment, Employee Benefits, and Executive Compensation Practice Groups. Mark Whitburn is an associate in the firm's Dallas office, whose practice focuses on appellate and ERISA litigation matters. Chad Mead is an associate in the firm's Dallas office, who practices primarily in the areas of employee benefits and executive compensation.

In the first half of this decade, a series of events wreaked havoc on pension plans. Enron and other major corporations collapsed with the result that employees and other investors lost billions of dollars in savings, including in many cases significant pension investments. Sept. 11 accelerated and deepened the fall of the financial markets. Lower securities prices, coupled with low interest rates, resulted in modest investment returns and increased funding obligations for sponsors of traditional defined benefit plans. In turn, major legacy air carriers and other historical industry leaders struggled (sometimes without success) to avoid bankruptcy. In response to these and other upheavals, Congress enacted the Pension Protection Act ('PPA') on Aug. 17, 2006, only three weeks after its introduction in the House of Representatives, in an effort to reform outdated aspects of federal pension laws and to provide greater stability and overall protection to pension plan members.

Pension Protection Act

Understandably, given its roots in the financial troubles that preceded its enactment, the PPA concentrated much of its attention on remedying shortfalls in employer funding of defined benefit pension plans. However, the PPA also acknowledged the growing significance of defined contribution plans (e.g., '401(k)' plans) as the primary ' and in many cases, the sole ' source of retirement savings for a growing number of Americans. Accordingly, the PPA also made significant changes affecting diversification rights, automatic enrollment, and default investment options under such plans. In particular, the PPA established exemptions for fiduciaries, so that they could more freely provide investment advice to plan participants who wield increasing control over their plan investments. This article summarizes those changes.

Corporate collapses, like that at Enron, had particularly disastrous effects on participants in pension plans that were ily invested in the sponsoring employer's securities. The PPA addresses the potential risks of over-investment in an employer's securities by requiring such plans to offer diversification. Pursuant to '901 of the statute, defined contribution retirement plans holding publicly traded employer securities must offer applicable participants the right to diversify out of their employer's securities. Subject to certain limitations, an employer must offer no fewer than three investment options, other than employer securities, into which applicable participants may direct the proceeds of their divestment of employer securities. Each such investment option must be diverse, with materially different risk and return characteristics, from the others. So that plan participants may take full advantage of these diversification opportunities, '507 of the PPA requires that employers give notice to any participants or beneficiaries that have diversification rights at least 30 days before the first day that such rights become effective.

Promoting Employee Participation

While the diversification provisions serve a primarily protective function, the PPA also made significant changes to facilitate and promote employee participation in defined contribution plans. For example, the PPA encourages plans to enroll participants automatically by explicitly creating plan qualification incentives under the Internal Revenue Code ('IRC'). To take advantage of these incentives, the plan must automatically enroll all participants who had not previously provided a written election of their desire to participate or not to participate, must provide an initial contribution rate of at least 3-10% (to gradually increase, if necessary), and must provide for matching contributions from the employer at specified levels.

The statute also directs the Department of Labor ('DOL') to issue regulations offering plan fiduciaries protection when they select default investments into which retirement funds of plan participants will be placed. To qualify for fiduciary relief for default investments under these regulations, promulgated by the DOL on Sept. 27, 2006, a plan fiduciary must: 1) invest assets in a 'qualified default investment alternative' ('QDIA') (as defined in the regulations); 2) provide an opportunity for participants to direct the investment of assets in their accounts; 3) furnish a notice to participants at least 30 days in advance of the first investment, and within at least 30 days in advance of each subsequent year; 4) provide any material that was provided to the plan relating to a participant's or beneficiary's investment in a QDIA; 5) afford participants the opportunity to transfer such assets to any other investment alternative available under the plan without financial penalty; and 6) offer a 'broad range of investment alternatives' (as defined under '404(c) of ERISA). DOL Reg. '2550.404c-5(c). In general, the statute and its implementing regulations seek in each of these provisions to encourage participation and investment in pension plans while at the same time promoting the ability of plan participants to safeguard their assets.

Greater Freedom to Offer Investment Advice

In order to further advance the goals of protecting participants and simultaneously encouraging them to invest, the PPA allows plan sponsors and fiduciaries greater freedom to offer investment advice to plan participants. To allow plan sponsors and fiduciaries to do so without exposure to fiduciary breach claims, the PPA amended portions of both ERISA and the Internal Revenue Code.

Section 3(21)(A)(ii) of ERISA defines a 'fiduciary' to include any person that renders investment advice for a fee or other compensation, directly or indirectly, with respect to any monies or other property of an ERISA plan, or has the authority or responsibility to do so. Under '404 of ERISA, fiduciaries must act prudently and for the benefit of plan participants and beneficiaries. Under '406, fiduciaries must also avoid prohibited transactions involving self-dealing and conflicts of interest. Section 4975(c) of the Internal Revenue Code operates to the same effect. Before the enactment of the PPA, neither ERISA nor the Internal Revenue Code provided an exemption from the prohibited transaction rules for fiduciaries with respect to any investment advice that would result in the payment of additional fees to the fiduciaries or their affiliates. Plan sponsors and fiduciaries were left highly vulnerable. If they provided investment advice, they ran the risk of incurring potential liability for fiduciary breaches or appearing to have engaged in prohibited transactions. On the other hand, if they refused to provide investment advice, they were just as likely to be viewed as inattentive to the financial health of their plan participants.

The DOL took some steps before the enactment of the PPA to clarify the steps plan sponsors and fiduciaries could take to provide investment advice to participants. In Interpretive Bulletin 96-1, DOL Reg. '2509.96-1, the DOL determined that furnishing educational materials to participants regarding: 1) plan information, 2) general financial and investment information, 3) asset allocation models, and 4) certain interactive investment materials would not constitute investment advice. The offset approach, approved in DOL Adv. Op. 97-15A and DOL Adv. Op. 2005-10A, allowed a fiduciary adviser to invest in mutual funds that pay additional fees to the advising fiduciary, if the fiduciary used such fees to offset fees that the plan was otherwise legally obligated to pay the fiduciary. In DOL Adv. Op. 2001-09A, the DOL concluded that a financial services firm could serve as a fiduciary and offer an investment advisory program without breaching its fiduciary duties, if the investment recommendations were the result of methodologies developed, maintained, and overseen by an independent financial expert. Taken together, these DOL pronouncements allowed plan sponsors to put in place limited participant investment education and advice programs. However, many viewed these limited programs as inadequate, particularly with respect to plans implemented under '404(c) of ERISA that shift much of the responsibility for particular investment decisions to individual plan participants.

In general, ERISA '404(c) relieves a trustee, a named fiduciary or other fiduciary from liability as a result of a participant's control over the investment of assets allocated to the participant's account. This fiduciary protection applies only to individual account plans that: 1) permit participants and beneficiaries the opportunity to exercise control over the assets of their own accounts; and 2) provide participants the opportunity to choose from a broad range of investment alternatives, give investment instruction with appropriate frequency, diversify investments, and obtain sufficient information to make informed investment decisions. DOL Reg. '2250.404c-1(a)-(c). Consequently, plan sponsors and fiduciaries could derive the protections that '404(c) offers only if they gave plan participants a high level of control over their investments. However, if that control came with only limited access to information and advice on the investments in question, these participants could ultimately suffer.

The PPA addressed this problem by amending the prohibited transaction sections of ERISA and the IRC to exempt the provision of investment advice, the investment transaction entered into based on the advice, and the direct or indirect receipt of fees or other compensation by the fiduciary investment adviser from the prohibited transaction rules, if the investment advice is provided in the context of an 'eligible investment advice arrangement.' Such an arrangement can arise under one of two circumstances: 1) the adviser's compensation (including commissions) is level (and does not change based on the investments selected); or 2) the advice is provided solely through a computer model that is certified to be unbiased by an unrelated third-party expert (i.e., the software must not be biased in favor of recommending investments offered by the fiduciary adviser). Use of a computer model qualifies for the prohibited transaction exemption so long as the only investment advice provided is the advice generated by the computer model, and the transactions occur solely at the direction of the participant. The PPA also requires detailed disclosures regarding fees received in connection with the advice provided. It further requires an annual independent audit and a written report to the authorizing fiduciary.

On Feb. 2 of this year, the DOL issued Field Assistance Bulletin No. 2007-01 to assist with the interpretation and implementation of the PPA's amendments to the prohibited transaction rules. In this Bulletin, the DOL addressed three basic questions raised by the amendments.

First, the DOL expressed its view that its previous guidance related to investment advice, including the guidance provided in the advisory opinions discussed above, remained valid. The relevant provisions of the PPA simply allow the provision of investment advice in a greater range of circumstances.

Second, the DOL emphasized that, notwithstanding the new exemptions, plan fiduciaries still have the duty to prudently select and periodically monitor any investment advice provider tasked with the responsibility of providing advice to its plan participants. With regard to the prudent selection of service providers generally, the DOL recommends that a fiduciary, such as the Plan Committee, follow objective procedures appropriate for assessing the investment advice provider's qualifications, the quality of the services offered, and the reasonableness of the fees charged for the service. Furthermore, the procedures chosen must ensure that the fiduciaries avoid self-dealing, conflicts of interest, and any improper influence. With respect to the monitoring of investment advisers, the DOL recommends that a fiduciary periodically review the extent to which there have been any changes in the information upon which the initial selection of the investment adviser was based, including whether the adviser continues to maintain the requisite qualifications and whether the adviser furnishes investment advice grounded in generally accepted investment theories.

Finally, the DOL expressed its expectation that parties offering investment advisory services will maintain policies and procedures designed to ensure that any fees or compensation paid to fiduciary advisers will not vary depending on the investment option selected. On the other hand, affiliates of such advisers will not be covered by the level fee requirement, as long as that affiliate does not itself provide investment advice to a plan.

Thus, like the PPA itself, the DOL Field Assistance Bulletin No. 2007-01 underscored the need for plan sponsors and fiduciaries to play a greater role in the provision of investment advice and related services, while maintaining adequate protections for plan participants.

Conclusion

Given the increasing prevalence of and dependence upon participant-directed 401(k) arrangements as a primary source of retirement savings, encouraging plan participation and enhancing participant investment advice programs are increasingly critical to helping participants meet their pension investment goals. The Pension Protection Act offers plan sponsors greater flexibility in advancing these goals in a manner that should both benefit and protect plan participants. In particular, the PPA's exemption for 'eligible investment advice arrangements' and the DOL's recently issued Field Assistance Bulletin in that area should provide plan sponsors and fiduciaries with greater flexibility in implementing helpful investment advisory services without risking exposure to liability under ERISA.

Karl Nelson, a member of this newsletter's Board of Editors, is the partner-in-charge of Gibson, Dunn & Crutcher LLP's Dallas office and a member of the firm's Labor and Employment, Employee Benefits, and Executive Compensation Practice Groups. Mark Whitburn is an associate in the firm's Dallas office, whose practice focuses on appellate and ERISA litigation matters. Chad Mead is an associate in the firm's Dallas office, who practices primarily in the areas of employee benefits and executive compensation.