A decision recently handed down by the U.S. Supreme Court should give employers pause for concern. The highest court in the land unanimously ruled that participants in defined contribution retirement plans, such as 401(k) plans, can sue employers for losses in their individual accounts resulting from a breach of fiduciary duties. (LaRue v DeWolff, Boberg & Associates, 06-856, 2/20/08)

The new case marks an about-face from previous rulings in the lower courts that limited such lawsuits to actions initiated on behalf of the retirement plan itself. Employers are now on notice.

Facts of the case: A participant in a 401(k) plan filed a lawsuit in 2004 against his former company, a consulting firm based in Texas. The former employee alleged that he directed the company to switch the investments in his account to more conservative options in 2001 and 2002. However, the company did not carry out his instructions. As a result, he incurred investment losses of $150,000.

The participant of the 401(k) plan argued that the failure to follow his directions constituted a breach of the employer's fiduciary duty under the Employee Retirement Income Security Act of 1974 (ERISA).

But both the district court and the Fourth Circuit disagreed. Reason: The participant was seeking monetary relief, instead of equitable relief for the plan, due to a violation of ERISA. This conflicted with the ruling in a 23-year-old Supreme Court case involving a defined benefit plan (Massachusetts Mutual Life Insurance Company v. Russell, 473 U.S. 134,1985)

Faced with the case at hand, the Supreme Court acknowledged the differences between defined benefit plans, such as traditional pension plans, and defined contribution plans, including 401(k)s:

"As its names imply, a 'defined contribution plan' or 'individual account plan' promises the participant the value of an individual account at retirement, which is largely a function of the amounts contributed to that account and the investment performance of those contributions. A 'defined benefit plan,' by contrast, generally promises the participant a fixed level of retirement income, which is typically based on the employee's years of service and compensation."

Due to the differences, the Supreme Court stated, the law should be applied differently to 401(k)s and other defined contribution plans.

Accordingly, in an opinion written by Justice John Paul Stevens, the Court held that a participant in a 401(k) should be able to sue for recovery of lost personal assets under Sec. 502(a) (2) of ERISA. A separate opinion by Chief Justice John G. Roberts expressed the view that participants might be limited to a narrower remedy under ERISA Sec. 409. This section imposes duties of proper management, administration and investment of plan assets.   

Because the case had not proceeded to trial, the plan sponsor may still raise various defenses to the charges. For instance, the sponsor might assert that the participant did not provide proper instructions or that he did not exhaust other administrative remedies.

In any event, it is advisable for employers to consider taking steps to reduce potential liability. These might include:

·         Reviews of ERISA compliance standards and plan procedures for discharging participant directions, along with imposition of controls for reducing possible errors.

·         Reviews of fiduciary liability insurance coverage.

·         Revisions to investment policies and procedures for ensuring that plan investment options are prudent

·         Provisions that give plan participants more access to investment advisers.

·         Analysis and documentation of advisory fees charged by professionals relating to administration of the plan.

Automatic Enrollment
Options Widen

    Uncle Sam is making it easier for employers to use an "automatic-enrollment" feature in 401(k) plans. This recent innovation is designed to encourage greater participation among the rank-and-file. Added bonus: Higher-ups can also benefit indirectly from this option.
    Background: In a typical 401(k) plan, each participating employee affirmatively elects to defer part of his or her salary. The company may agree to provide matching contributions to the employee's account up to a stated percentage. But non-electing employees don't benefit from salary deferrals or matching contributions.
    All contributions for a participating employee may grow and compound tax-free in the account until distributions are made, usually at retirement when employees are in a lower tax bracket.
    It may not be hard to convince a middle-age employee with a family to join a 401(k). But single employees in their 20s are a different story. If they don't choose to participate in a plan, many employees miss out on the potential benefits. Furthermore, the highest-earning employees may be constrained by nondiscrimination rules that prohibit them from receiving a disproportionate portion of benefits under a plan.
    This is where the automatic-enrollment feature comes into play. Instead of making an election to participate in the 401(k), employees must elect to opt out of the plan. Otherwise, they are automatically included. As you might imagine, this generally results in a higher percentage of overall participants.
    The Pension Protection Act of 2006 liberalized the rules for automatic enrollment plans. For instance, it establishes rules for safe-harbor plans that are treated as having satisfied all the nondiscrimination requirements. Under a safe-harbor plan, employees must be notified in writing about the auto-enrollment feature.
    To further encourage use of auto-enrollment plans, the government issued proposed regulations (described below). The IRS also released a sample notice for employers to use in 2008.
    Under the safe-harbor plan, an employee has a 90-day window to withdraw the contributions tax-free. The sample notice explains that the employee will have to pay federal income tax on the funds, but not the 10 percent tax that generally applies to early withdrawals from a 401(k) plan.

New Regs Relax the Rules

    The IRS Sample notice follows proposed regulations issued in late 2007 that establish special nondiscrimination rules for a plan's "qualified automatic contribution arrangement" (QACA). Here are some highlights.
    Safe harbor plans: QACAs will be treated as having satisfied the actual deferral percentage and actual contribution percentage tests that would otherwise apply to employee elective deferrals and employer matching contributions. These plans are also generally exempt from the top-heavy rules for tax-qualified plans.
    Matching contributions: Employers with a QACA have the choice of providing either matching or non-elective contributions. Employees fully vest in any employer contribution after two years of service.
    Notice requirements: The proposed regulations require that each eligible employee under a QACA receive a safe-harbor notice within a "reasonable period" before each plan year.
   The new proposed regulations are effective for plan years beginning on or after Jan. 1, 2008 and may be relied upon pending the issuance of final regulations.