Poor Defined Benefit Pension Plan Investments: May Plan Participants Sue?

Fiduciaries of defined benefit pension plans should not to be lulled into comfort by a recent federal court decision that participants could not sue the fiduciaries of a defined benefit plan for a claim of poor investments and excessive investment fees. In David v. Alphin, (4th Cir. January 14, 2013), participants in a Bank of America pension plan sued plan committee members for breach of fiduciary duty and prohibited transactions caused by selecting and retaining Bank-affiliated mutual funds as plan investments. The participants alleged that many better investment options were available, and that most of the Bank’s affiliated mutual funds offered participants poor performance and high fees, causing multimillion dollar losses to the plan.

The court found that the participants lacked standing to sue because the defined benefit pension plan was overfunded and the plan would retain any surplus plan assets. The court concluded this was unlike a defined contribution plan, where excessive fees cause direct harm to participant accounts, because “the risk that … benefits will at some point in the future be adversely affected as a result of the alleged ERISA violations is too speculative.” For support, the court cited a U.S. Supreme Court decision, stating that “misconduct by the administrators of a defined benefit plan will not affect an individual’s entitlement to a defined benefit unless it creates or enhances a risk of default by the entire plan.” La Rue v. DeWolff, Boberg & Associates, Inc., 552 U.S. 248, 255 (2008).

For the following reasons, defined benefit pension plan fiduciaries should not assume that the David decision protects them from potential liability for poor investment management or excessive investment fees:

• This decision addressed a plan that was overfunded when the claim was filed.  Very few defined benefit plans are currently overfunded.
• The court acknowledged that the U.S. Department of Labor (DOL) would have standing to sue for a breach of ERISA, even if the participants would not. ERISA section 408(b)(2) fee disclosure and review requirements could provide basis for DOL enforcement action in this type of case.
• This decision did not consider a plan where funding more directly affects participant costs or benefits, such as (a) a contributory pension, where excessive plan expenses may lead to an increase in required employee contributions, or (b) a pension COLA or other benefit that is directly related to plan funding.

One-Time Irrevocable Elections Under Code Section 403(b) Plans—Error in 2007 Regulations Should be Corrected

Tax regulations must follow the terms of the Internal Revenue Code and must be internally consistent. These rules were violated in 2007 tax regulations defining a “one-time irrevocable election” for purposes of 403(b) plans. The 2007 regulations require an employee to make the election “on or before … first becoming eligible to participate under the employer’s plans.” This wording is more restrictive than the Internal Revenue Code and previously issued regulations, which allow an employee to make an irrevocable 403(b) election “at the time of initial eligibility to participate in the agreement.” The IRS should address this error in the 2007 regulations as part of the guidance the IRS is expected to provide for 403(b) plans in 2013. The following paragraphs explain the issue in more detail.

Use of the “One-Time Irrevocable Election” Definition. The “one-time irrevocable election” offers a useful option in retirement plan design. It allows an employee to commit to making employee pre-tax contributions to a retirement plan without regard to complex rules and limits that apply to “elective” 403(b) or 401(k) contributions. A “one-time irrevocable election” under a 403(b) plan may be a particularly attractive option for government 403(b) plans, where contributions are not subject to discrimination testing. Defining a “one-time irrevocable election” is critical to the use of this approach to 403(b) plan contributions.

Code Section 402(g) and Regulations Clearly Defined a “One-Time Irrevocable Election” for 403(b) Plans Before the 2007 Regulations. Internal Revenue Code section 402(g)(3) includes the following definition of a “one-time irrevocable election” for 403(b) plans:

…[a contribution to a 403(b) plan] shall not be treated as an elective deferral…if under the salary reduction agreement such contribution is made pursuant to a one-time irrevocable election made by the employee at the time of initial eligibility to participate in the agreement [emphasis added] or is made pursuant to a similar arrangement involving a one-time election specified in regulations.

Treasury Regulation section 1.402(g)-1(c) follows the Code provision, stating:

(c) Certain one-time irrevocable elections. An employer contribution is not treated as an elective deferral under paragraph (b) of this section if the contribution is made pursuant to a one-time irrevocable election made by the employee:

(1) In the case of an annuity contract under section 403(b), at the time of initial eligibility to participate in the salary reduction agreement [emphasis added].

2007 Regulations Contradict the Code and Prior Regulations. In contrast to the Code and regulations cited above, 403(b) regulations issued in 2007 redefine a “one-time irrevocable election” under a 403(b) plan. The 2007 regulations state that a “one-time irrevocable election” must be made “on or before the employee’s first becoming eligible to participate under the employer’s plans” [emphasis added]. Treasury Regulation 1.402(g)(3)-1(b). The 2007 regulations incorrectly use the same definition for 403(b) plans as Treasury Regulation 1.401(k)-1(a)(3), which defines a “one-time irrevocable election” for purposes of 401(k) plans. Applying the 401(k) definition to 403(b) plans contradicts the clear terms of Internal Revenue Code section 402(g)(3). Treasury Regulation 1.402(g)(3)-1(b) is invalid and should be corrected to state that a one time irrevocable election must be made “at the time of initial eligibility to participate” in the 403(b) agreement, not before eligibility to participate “under the employer’s plans.”