As a small business owner, you know that a qualified plan can make a big difference in your ability to attract and retain desirable workers. At the same time, you may or may not be aware that sponsoring a qualified plan requires the fulfillment of several fiduciary responsibilities, as spelled out in Section 404 of ERISA (Employee Retirement Income Security Act of 1974, as amended). In fulfilling your responsibility as plan sponsor relating to investments, you may want to take diversification into account.
First Things First
Not all qualified plans are the same, yet the rules that govern fiduciary responsibility under all plans are essentially the same, with some minor exceptions. For instance, two common types of qualified plans are the traditional defined benefit pension plan and the 401(k) plan. One of the main differences between these plans is how they are funded. Employers fund defined benefit plans and direct investments in order to provide a benefit to each participant at their retirement that is determined by the plan’s benefit formula. On the other hand—under a 401(k) plan—employees make their own contributions and usually determine how their contributions are invested. However, the plan sponsor of the 401(k) decides the array of investments from which the participants can choose. Here is a quick look at how diversification can help.
Defined Benefit Plans
Generally speaking, plan investments should be diversified in order to help mitigate the risk of large losses, unless it is clearly not prudent to do so. How, then, can a plan sponsor ensure that a defined benefit pension plan is diversified? In general, a well-diversified portfolio includes a broad range of investments with different risk and return characteristics. The more you concentrate your investments in one type of asset, stock, or mutual fund, the less diversified the portfolio and the more vulnerable it may become to a large loss.
Apart from this general directive, there are no rules or set percentages to follow in developing a diversified portfolio. Instead, a plan sponsor should take into account the plan’s particular circumstances. Some factors to consider include:
- the plan’s objectives, especially regarding such givens as investment quality, liquidity, risk and return;
- the defined benefit that will be provided to employees;
- the dollar amount invested;
- the variety of potential investment choices;
- the need to diversify across multiple companies, industries, and geographical locations; and
- the current economic and market conditions.
What About a 401(k)?
A 401(k) plan differs from a traditional defined benefit pension plan in that the amount received by a 401(k) participant is the amount in his or her account based on the investments—the benefit amount is not pre-determined. Section 404(c) of ERISA provides a way for plan sponsors to reduce their fiduciary liability for the investment decisions of the participants, provided certain requirements are met. The plan sponsor must provide participants with a broad range of investment alternatives, including at least three core choices. These investment options should have materially different risk and return characteristics. In addition, the plan must also allow participants to exercise control over their accounts with the opportunity for at least quarterly transfers. In some situations, such as in a highly volatile market, more frequent transfers may be necessary. Participants must also be presented with sufficient information to make informed investment decisions.
These are just a few of the requirements under ERISA Section 404(c). If a 401(k) plan meets all of the 404(c) requirements, the plan sponsor will generally not be liable for the performance of assets controlled by participants or their beneficiaries. However, a plan sponsor is still responsible for determining the plan’s investment options.
Clearly, your fiduciary responsibility is not something that should be taken lightly. For defined benefit plans, it may be worthwhile to hire a professional investment manager and a third party defined benefit professional. That’s because, unlike 401(k) plans, which often are generically marketed together with outside administrative assistance and guidance, a defined benefit plan typically requires customized design and actuarial calculations. Either way, it is important for you, as a plan sponsor, to have a solid understanding of your company’s investment responsibility under your qualified plan.
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.
Investing involves risks including possible loss of principal.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
This article was prepared by Liberty Publishing, Inc.
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