Investment Restrictions in 401(k) Plan

[Guest notapensiongeek]

I had a broker call me and ask the question, "in a participant-directed 401(k) plan, is a participant allowed to make option trades?"

I don't know retirement plans well enough to know if this is a plan document or Investment Policy issue, or if it ERISA related.

Any thoughts on this?

Thanks in advance!!

[QDROphile]

All three. The easiest to address are plan document and then administrative rules and procedures. If the option trades are not disallowed by the plan design and administrative limits, you have to go to various legal standards. Hint: covered call options are OK.

[Guest notapensiongeek]

Thanks - good call - so I'm wondering if there is there anything specifically in ERISA that says you can't make option trades? Our BPD and Investment Policy statements do not specifically prohibit them...

[QDROphile]

No blanket proscription, but you have to look at what is being proposed. A plan cannot write uncovered call options, for example, because the potential obligation could exceed the balance of the account. I don't see any problem with publicly traded options because the maximum exposure is the amount invested -- the option could expire unexercised.

My personal opinion is that these sort of investments are inappropriate for retirement plans unless they are part of a sophisticated professional hedging strategy. Not stuff for individual participants. But those who want to do such things can seldom be advised.

How much is the broker going to make on the trading? Rhetorical question.

[masteff]

Here's an older but not out of date article off of Findlaw. http://library.findlaw.com/1999/Sep/1/128801.html It raises some good issues to consider.

QDROphile raises what I recall as a key question... is this a prudent investment option or should a brokerage window be restricted from the more inherently risky securities like options and futures as those generally-speaking should only be traded by sophisticated investors? It's a genuine fiduciary question and not just a philosophical one.

[Guest mjb]

Here's an older but not out of date article off of Findlaw. http://library.findlaw.com/1999/Sep/1/128801.html It raises some good issues to consider.

QDROphile raises what I recall as a key question... is this a prudent investment option or should a brokerage window be restricted from the more inherently risky securities like options and futures as those generally-speaking should only be traded by sophisticated investors? It's a genuine fiduciary question and not just a philosophical one.

If you think there is a fiduciary issue why not have the plan require any participant who wants to trade in options and futures to retain his or her own investment advisor who will be a fiduciary of the participant, not the plan, as permitted under the 404© regs.

[Kevin C]

If you think there is a fiduciary issue why not have the plan require any participant who wants to trade in options and futures to retain his or her own investment advisor who will be a fiduciary of the participant, not the plan, as permitted under the 404© regs.

The fiduciary issues here are the selection and monitoring of the plan's investment options. The DOL has repeatedly stated that 404© protection does not apply to those fiduciary obligations. Who is going to monitor the brokerage window to insure that it is and continues to be an appropriate investment option for the plan?

[Guest mjb]

If you think there is a fiduciary issue why not have the plan require any participant who wants to trade in options and futures to retain his or her own investment advisor who will be a fiduciary of the participant, not the plan, as permitted under the 404© regs.

The fiduciary issues here are the selection and monitoring of the plan's investment options. The DOL has repeatedly stated that 404© protection does not apply to those fiduciary obligations. Who is going to monitor the brokerage window to insure that it is and continues to be an appropriate investment option for the plan?

Kevin:

Where is it stated that options and futures permitted in a 401k plan (protected puts and covered calls) are imprudent investments? We are not talking about naked calls and other other exotic strategies which require that the participant personally guarantee losses. Please explain why protected puts and covered calls are risky investments for a plan participant.

[masteff]

Please explain why protected puts and covered calls are risky investments for a plan participant.

Please explain why short-term risk hedging activity is appropriate in a long-term investment vehicle.

[Guest mjb]

Please explain why protected puts and covered calls are risky investments for a plan participant.

Please explain why short-term risk hedging activity is appropriate in a long-term investment vehicle.

there is no risk of loss in the protected puts and covered calls.

[Kevin C]

MJB,

Where does it say that options trading is an appropriate investment option for all self directed plans?

You referred to 404© as if it would eliminate all fiduciary issues related to allowing the proposed investment. The DOL says otherwise. It may or may not be an appropriate investment option for a given plan. My point is that this decision has to be made by a fiduciary and the fiduciary has a potential liability related to that decision. If the fiduciary decides it is appropriate now, it still needs to be monitored to make sure it remains appropriate in the future. There is no 404© protection for the selection and monitoring of investment options for a plan.

[QDROphile]

Within the 404© playing field, I understand the statement that a fiduciary is responsible for monitoring the investment options that the fiduciary selects, and is responsible for the choice of particular investments that are "offered" by a plan. The fiduciary is also responsible for making a reasonable number of reasonable investment options available. Mort Klevan of the DOL once commented that he could not see how offering an unrestricted window could comply with 404© regulations.

Are you saying that an unrestricted window is an option selected by the fiduciary in the same way that a fiduciary might construct a menu of mutual find investment options? Or are you saying that the window is outside of the 404© protections (or merely outside of the 404© regulations -- if that makes a difference)? If the window is outside of 404©, do the 404© protections still apply within the menu? Or is the the window not an investment that is designated by the fiduciary (see, e.g. references to "designated alternatives" in regulation section 404©-1(b)(2)(B)(1)(ii)), so different standards apply?

Where the lines are drawn is interesting and important. It would help to be more precise about what is meant by statements about liabiity and how the responsibilities relate to the more traditional framework of a limited menu of options designated by a fiduciary, and more important, to provide reference to authority that speaks to fiduciary responsibilities outside of that framework.

[masteff]

Here's the DOL's amicus brief in Hecker et al v Deere. It doesn't speak directly to some of QDROphile's broader questions on application to windows (although partial answers could be inferred). It does illustrate the point Kevin made above about the DOL's position on selection and monitoring. See starting on document page 11, which is physical page 18. http://www.plansponsor.com/uploadfiles/dee...cker7thcirc.pdf

[Guest mjb]

MJB,

Where does it say that options trading is an appropriate investment option for all self directed plans?

You referred to 404© as if it would eliminate all fiduciary issues related to allowing the proposed investment. The DOL says otherwise. It may or may not be an appropriate investment option for a given plan. My point is that this decision has to be made by a fiduciary and the fiduciary has a potential liability related to that decision. If the fiduciary decides it is appropriate now, it still needs to be monitored to make sure it remains appropriate in the future. There is no 404© protection for the selection and monitoring of investment options for a plan.

reg. 1.2550.404c-1(b)(3)© states that a plan provides a broad range of investment alternatives if the beneficiary is provided with a reasonable opportunity to diversify investment risks so as to minimize the risk of large losses. Why arent PPs and CCs appropriate for the plan under © since they minimize the risk of large losses?

[J Simmons]

Here's the DOL's amicus brief in Hecker et al v Deere. It doesn't speak directly to some of QDROphile's broader questions on application to windows (although partial answers could be inferred). It does illustrate the point Kevin made above about the DOL's position on selection and monitoring. See starting on document page 11, which is physical page 18. http://www.plansponsor.com/uploadfiles/dee...cker7thcirc.pdf

It will be interesting to see what the 7th Circuit does with this. Personally, I think the federal district court got it right, and the DoL is overreaching on this one. The employees there were given a brokerage window and could choose from among 2,600 investment options, some of which Deere highlighted for consideration by the employees in making their investment directives. The employees complain now that the fees associated with the highlighted short-list were too high. The district court basically said that there were lower fee investment options among the 2,600 and thus it was each employee's decision to invest in a higher fee investment option, albeit highlighted by Deere for employees to consider, that resulted in the higher fee. Those higher fees weren't required by or the result of Deere's decisions and acts, to offer a broad window and highlight certain options. The complaining employees could have, but did not, choose lower fee options among the 2,600.

The Deere case is, I understand, the only one of the Schlicter cases that has been dismissed at the district court level, but is also the only one that had a broad window.

The DoL's briefing on appeal suggests that an employer that gives an employee choice as broadly as did Deere should have no protection under 404c. If the employee chooses the higher fee option rather than a lower fee one, the excessive fees are the result of the employer's failure to pare down the options rather than the employee's choice of the high fee option rather than a low fee option. I disagree. Those excessive fees are more naturally and more closely the result of the employee's decision of which of many investment options rather than the more attenuated decision of the employer to give employees a broad selection. An employer should be potentially liable only to the extent it limited the commercially available investment options.

[Kevin C]

Are you saying that an unrestricted window is an option selected by the fiduciary in the same way that a fiduciary might construct a menu of mutual find investment options?

Yes, that is what I am saying. It is a fiduciary's decision about whether or not to make it available. Even if the brokerage window satisfys 404©, the fiduciary still has some potential liability for selecting it as an option. If they make the window available, they need to monitor it to make sure it remains an appropriate option. With some of the huge investment losses I've seen in individuals' brokerage window accounts, I think it would be difficult to try to argue the brokerage window continued to be an appropriate investment option for those particular plans.

If you look on page 10 of the brief masteff posted, The DOL says they are not commenting on the merits of the case. They just want to point out that 404© relief does not apply to the selection of investment options. They also say that even though there is currently no statutory requirement for disclosure of revenue sharing to participants, the general fiduciary duties of ERISA may require such disclosure.

MJB, There is no way you can determine whether or not options trading would be an appropriate investment option unless you have information about the plan and its participants. An investment option that may be appropriate for a plan covering investment advisors is not necessarily an appropriate investment option for a paving company. It's up to the fiduciaries to act in the best interest of the participants. It's not a one-size-fits-all question.

[QDROphile]

If you think an unrestricted window is a designated option then you must have to conclude that it is an inappropriate option, with only a handfull of exceptions in the universe of particpant directed plans. Surely you cannot conclude that it is appropriate in up markets and inappropriate in down markets. No reasonable fiduciary could make such calls. So your position is that a fiducairy must resrtict the window. That is a rather daunting task unless the restriction is so severe that the fiduciary personally picks each option. Or do you think there is a middle ground? Except for limitation to domestic publicly traded securities how can a fiduciary limit the options to categories of investments? Some elements in each category are likely to be inappropriate.

Perhaps the best arrangement is a reasonable menu of investment options, for which the fiduciary is responsible. If, in addition, an open window is available for the multitude of investment experts out there (who have been trained by Money magazine and golfing partners and believe they have a constutional right to direct investments), the participants are on ther own, withoust recourse to the uninvolved fiduciary when they get unlucky. But we don't have solid legal support for that proposition.

The wiser course for most plans is not to allow participant direction at all.

[Kevin C]

QDRO, Whoa! slow down. You are claiming thoughts in my head that aren't in there.

As I said before, it is not a one-size-fits-all question. The answer may vary from plan to plan depending on the circumstances. I'm not trying to give my opinion on how to construct a proper brokerage window. I'm trying to point out that you don't magically get relieved of all fiduciary responsibilities and liabilities just because you offer a brokerage window.

Actually, the losses I was referring to happened as much during the up markets as during the bad. The worst case example lost over 90% of his account balance from 1998-2007. There were others with bad results, too. I said it would be difficult to argue that the brokerage account continued to be an appropriate option for those particular plans. I didn't say it wasn't appropriate for any plan.

[Guest mjb]

MJB, There is no way you can determine whether or not options trading would be an appropriate investment option unless you have information about the plan and its participants. An investment option that may be appropriate for a plan covering investment advisors is not necessarily an appropriate investment option for a paving company. It's up to the fiduciaries to act in the best interest of the participants. It's not a one-size-fits-all question.

Kevin:

For once will you provide some citation of authority for your claims. As I as repeatedly stated I am only discussing protective puts and covered calls as permissible options under a plan and have provided a citation under the 404c regs to their appropirateness in a self directed plan while all you provide is speculation and specious opinion. Either come up with a basis under the law that make PP and CC options imprudent because they increase the risk of large losses or prevent diversification of risk or find some reputable authority for your position. Tell me what makes a covered call a risky investment for any participant.

[Kevin C]

MJB,

ERISA section 404

Act Sec. 404.(a)(1)

Subject to sections 403© and (d), 4042, and 4044, a fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and --

Unless you have something constructive to add, I will ignore your future comments.

[Guest mjb]

MJB,

ERISA section 404

Act Sec. 404.(a)(1)

Subject to sections 403© and (d), 4042, and 4044, a fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and --

Unless you have something constructive to add, I will ignore your future comments.

I gave you the cite in the 404c regs. How is providing additional way for a participant to avoid large losses by using the above options not acting in the interest of participants? What is the risk?

I am not saying employer must allow it but can allow it.

You want to ignore my posts because you dont know how the options I discussed work to protect the particpant's investment in the plan.