ERISA Section 404(c) turns forty this year. Here is a common sense proposal for meaningful reform.

Section 404(c) is a great idea, but is poorly understood by most plan sponsors and too vague to give reliable relief from plan liability issues. After 40 years in 404(c) purgatory, it is high time for clarity.

In summary, 404(c) may relieve plan fiduciaries of liability for investment losses suffered by employee participants. To qualify for relief under 404(c), the plan fiduciary must:

• Select investments in a prudent manner that allows participants to diversify investments; and
• Allow participants to exercise control over assets in their individual accounts.

Two issues – What is a “prudent” standard for investment selection? When is the ability to diversify deemed to be met? Regulators have no definitive answers. The result is a cacophony of well-intentioned opinions on how to comply. It is a confusing issue for some of the largest employers. And it is an absolute mental quagmire for small business 401(k) plans.

Here is our proposal to answer both questions. We’ll tackle diversity first.

Step 1 – Clearly define diversity

Define investment diversity to mean the availability of investment options in each of a few key investment benchmarks. To get at those benchmarks look no further than the Federal Thrift Savings Plan (TSP), the nation’s largest retirement savings plan. The TSP offers only five investment options, but they provide a sound basis for allowing inexperienced investors access to investment markets. The options are:

• G Fund – Short-term US treasuries fund. Benchmark/objective: capital preservation
• F Fund – Bond fund. Benchmark: Barclays US Aggregate Bond Index
• C Fund – Large cap equities fund. Benchmark: S&P 500 Index
• S Fund – Small cap equities fund. Benchmark: Dow Jones Completion Total Stock Market Index (all of the other stocks in the US that are not in the S&P 500
• I Fund – International equities fund for developed countries. Benchmark: MSCI EAFE Index

One can quibble with the above, but if we define those five asset classes as those required to meet the diversity standard, we have a simple, clear core of investments that just about any novice investor can wrap her head around.

Step 2 – Rethink the idea of the “prudent” standard

Under current 404(c) regulations, plan sponsors have a lot of leeway in defining a prudent investment selection standard. Many sponsors’ prudent approach involves a steak dinner or nodding after a confusing sales pitch. Here’s how to bypass that process.

Thanks to the Pension Protection Act of 2006 (PPA), plan fiduciaries receive relief from their fiduciary liability for default investments, as long as they comply with the DOL’s Qualified Default Investment Alternative (QDIA) regulations.

Why not expand the safe harbor concept to include “core” investment selection? To qualify as a Qualified Core Investment Alternative (“QCIA” – my invention), an investment option would need to meet the following standards:

• Benchmarked to one of the five asset class benchmarks described above.
• Pay no revenue sharing, 12b-1 fees, load fees or redemption fees.
• Pay no compensation to any plan service provider.

While I am a proponent of low cost index investing, I believe that any fund, active or passive that complies with the above “prudence” requirements should be allowed.

If the plan sponsor chooses the plan’s core options under these guidelines, he or she will be granted safe harbor protection. No ambiguity. Meet these rules and you’re in.

But what about other investment options in a safe harbor 401(k) plan?

I propose that once the 404(c) safe harbor is met, the plan sponsor is free to choose any additional non-core investment options deemed appropriate. Just one simple rule: All plan participants must make a positive affirmation, or “opt-in,” in order to gain access to any non-core investments outside the safe harbor core investments described above.

An opt-in to non-core investments will provide check to any novice investor thinking of taking on additional risk in order to chase return. My take is that behavioral economics will keep the least experienced investors safely in the core, and be of little hindrance to the more experienced investors who value choice.

Every employee gets a fully-disclosed transparent core of diversified investments. Employers get the safe harbor, and advisors and investment managers have the ability to compete for either core or non-core funds – or both.

Call it the “semi-strong form of frugal paternalism.” Thoughts?