Small Business Owners’ Obligations in Offering a 401(k) Plan
At a certain size, a business is expected to offer its employees a retirement plan. Federal law does not require companies to offer such plans, but, currently, 15 states require employers to offer a plan once they reach a certain number of employees (ranging from 5 to 25, depending upon the state). Many other states have adopted such requirements that remain pending, and still more are considering legislation mandating a plan. However, a company offering and operating a retirement plan incurs significant legal obligations and potential liability. The company – known as the “plan sponsor” – is a fiduciary to the plan and its participants, which is the most stringent of legal duties. Fiduciary status means the company must (1) act prudently and with sufficient care, (2) avoid, mitigate, or disclose conflicts of interest, or satisfy certain prohibited transaction exemptions, and (3) serve the best interests of the plan and its participants, never putting its own interests ahead of theirs in matters touching upon the plan.
The 401(k) plan is the most common type of retirement plan offered by for-profit businesses. A 401(k) plan is a “defined contribution plan"* where an employee can make contributions from his or her paycheck – generally before tax – up to an annual limit. The contributions go into a 401(k) account, with the employee then choosing from the investment options the plan offers. In some plans, the employer contributes to employees’ 401(k) accounts, often matching the employees’ contributions up to a certain percentage.
*“Defined contribution” means that the employee and, potentially, the employer contribute amounts to an investment account, with these contributions and investment performance determining the ultimate benefit the employee receives; this is contrasted with “defined benefit” plans where the employer guarantees certain fixed payments at retirement.
The plan sponsor determines the structure of the plan and creates its foundational governing documents with the help of a lawyer. With counsel and potentially other advisers, the plan sponsor also creates the disclosure document (the “plan summary”) describing the plan and the plan investment election forms that it sends to participants. The plan sponsor must also create committee documents for an investment committee and an investment policy statement (the “IPS”). The IPS governs the types of investments the plan may make, including exclusions of certain investments and limitations on others by investment or per class of investments. For example, an IPS could put limits on the amount of investment in any one or a small number of securities to ensure diversification, limitations evidencing the plan’s risk tolerance, and the criteria for selecting investment advisers, if applicable.
The plan sponsor also hires service providers for the plan (directly or through a committee created for that purpose). These generally include a recordkeeper, administrator, broker of record, and, often, one or more investment advisers to either recommend investments or to exercise discretionary trading authority over the plan’s account (i.e., the adviser can make trades for the plan without first seeking the sponsor’s approval). The plan sponsor must approve the arrangements with these providers, including their fees, and must initially and annually approve their continued service. The service providers that provide investment advice are also fiduciaries of the plan and have heightened duties to the plan. The plan sponsor is not liable in instances where it reasonably relied on such co-fiduciaries. If advisers are properly used, the role of the plan sponsor becomes one of administration and oversight. It is responsible for transferring employee contributions for the account and selecting and then overseeing the work of the recordkeeper, administrator, and brokers or advisers.
The plan sponsor must monitor the service providers’ conflicts of interest on an ongoing basis. In many cases, one or more of the service providers may receive compensation from third parties relating to the services rendered to the plan. Such providers must disclose such compensation and other conflicts to the plan sponsor or appropriate plan committee. For example, a recordkeeper or broker might receive compensation from mutual fund sponsors or investment advisers for recommending such investments or advisory services to the plan. These and other sources of compensation may create a financial incentive for the service provider to recommend or employ the services of certain service providers.
The investment advisers are helpful in selecting the plan’s investment options. A “3(21)” fiduciary provides recommendations as to the investment lineup of a plan, while a “3(38)” investment manager (also a fiduciary) has the authority to select investment options and invest plan assets without consulting the plan. An investment lineup could include mutual funds, closed-end funds, target date funds, and other options. The Department of Labor recommends twenty to thirty options to offer sufficient diversity, but not too many options, which might overwhelm participants. The plan sponsors (and advisers) must act prudently in evaluating investment options and perform sufficient due diligence. The test is process-focused, meaning that the due diligence and analysis performed are more important than the ultimate financial outcome of an investment choice. The Department of Labor (the “DOL”) has issued a proposed rule that would provide a safe harbor such that, if a plan sponsor considered six factors, it would not face liability in including certain alternative designated investments in its options; this generally means riskier options with the potential for higher return, such as private equity- or private credit-focused interval funds. This proposed safe harbor would open the accepted realm of plan investment options greatly, as it would allow alternative investment types (private equity, private credit, etc.) without the current significant risk of liability.
The focus of the analysis in selecting investments must be focused on financial returns to the plan within the risk tolerance provided in the IPS. The ability to include environmental, social justice, or governance best practices as considerations is a complicated topic that remains amorphous. Recent litigation has brought into question the previously assumed ability to include such factors in investment option decisions. The investment options must be reviewed at least annually.
Maintaining a retirement plan requires time and attention to satisfy the stringent fiduciary duties imposed on a plan sponsor. Service providers can assist and take liability from the plan sponsor, but ultimately, the plan sponsor remains a fiduciary, and consultation with counsel is essential.
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