As an ERISA compliance specialist who has audited hundreds of retirement plans, I’ve seen how Section 404(c) protection and passively managed funds intersect in ways that impact both plan sponsors and participants. Let me break down the critical considerations in plain terms.
Table of Contents
Understanding the 404(c) Safe Harbor
ERISA Section 404(c) provides liability protection to plan fiduciaries when:
- Participants exercise control over their accounts
- The plan offers a broad range of investment options
- Participants receive sufficient information to make informed decisions
Key requirements include:
- At least three diversified investment options
- Opportunity to change investments at least quarterly
- Disclosure of investment-related information
- No restrictions on accessing participant-directed investments
Why Passively Managed Funds Matter for 404(c)
Passively managed funds (index funds) have become the default recommendation for 404(c) plans because:
- Lower fiduciary risk – No manager selection risk
- Transparent performance benchmarks – Easy to monitor
- Cost efficiency – Meets fiduciary duty of prudence
- Simpler participant education – Easier to explain than active strategies
The Fiduciary Advantage of Index Funds
| Fiduciary Concern | How Index Funds Address It |
|---|---|
| Investment selection | Benchmarked to recognized indices |
| Performance monitoring | Automatic comparison to benchmark |
| Fee reasonableness | Typically lowest-cost options |
| Participant understanding | Straightforward “market-matching” concept |
Building a 404(c)-Compliant Menu with Passive Funds
A model core lineup might include:
- Capital Preservation
- Stable value fund (if available)
- Money market fund
- Fixed Income
- Total bond market index fund
- Inflation-protected securities fund
- Domestic Equity
- Large-cap index (S&P 500)
- Small/mid-cap index
- Total stock market index
- International Equity
- Developed markets index
- Emerging markets index
- Target Date Series (index-based)
Documenting Your Process
To maintain 404(c) protection, sponsors should:
- Document fund selection criteria emphasizing:
- Low costs
- Broad diversification
- Recognized benchmarks
- Record monitoring procedures showing:
- Regular expense ratio comparisons
- Tracking error reviews
- Peer group analysis
- Maintain education materials explaining:
- How index funds work
- Appropriate use in portfolios
- Long-term investment philosophy
Common 404(c) Pitfalls with Passive Funds
- Assuming passive means “set and forget” – Still requires monitoring
- Overlooking share classes – Not all index funds are equally cheap
- Ignoring participant behavior – Some investors may need guidance
- Failing to document – Protection depends on process evidence
Action Items for Plan Sponsors
- Review current lineup – Identify actively managed funds that could be replaced
- Benchmark expenses – Compare to DOL’s 2023 fee study averages
- Update IPS – Clarify passive fund selection standards
- Educate participants – Explain index investing benefits
- Document decisions – Create paper trail for fiduciary protection
The combination of 404(c) compliance and passive management creates a powerful fiduciary defense while serving participants’ best interests. By focusing on low-cost index options and maintaining proper documentation, plan sponsors can fulfill their duties while reducing litigation risk.
