Supreme Court Deals Blow to Most 401(k) Plans

Do you own all or part of a business that sponsors a 401(k) plan for your employees? If so, this column is a must read.

You won't like the liability position the U.S. Supreme Court has hung over your head. But, as is often the case, adverse circumstances bring opportunity. The end of this column tells you how to take advantage of this opportunity.

On Feb. 20, 2008 our top court decided LaRue v. DeWolff. (Tell your professionals to see 128 S. Ct. 1020.) Bet not even one reader in 100 knows this landmark case exists. Yet it directly impacts every 401(k) plan that allows employees to choose their own investments.

In a nutshell, here are the facts and the court's ruling. The facts: LaRue sued his former employer, DeWolff, claiming a “breach of fiduciary duty because his interest in the [401(k)] was depleted by approximately $150,000.”

The ruling: In a long nine-page opinion full of technical jargon, the court clearly holds that LaRue can sue his employer stating, “When a participant sustains losses to his account as a result of a fiduciary breach … (the law) permits that participant to recover such losses …”

Simply put, the boss (you or your company) now can be sued by participants in the company's 401(k) plan.

A little history will clarify just how important the LaRue case's impact is and will become over time. Back in the ‘60s and ‘70s (when I was a kid and the highest income tax rates were in the 50% to 70% range) my CPA firm had a bunch of very busy campers who were creating new pension and profit sharing plans. There's no question about it, back then these plans were the No. 1 strategy for winning the income tax game.

Our firm's specialty remains closely held family businesses. (Read slowly now because here comes the connection to the LaRue case.) We always made the owners(s) of the business the plan trustee(s). Why? The reason was to save fees.

There is one problem, however. The trustee(s) could be sued and nailed for a breach of fiduciary duties. But the problem was easily solved. We had our clients hire professional money managers to invest the plan funds and then monitor their results. We created hundreds of plans and never had a client get sued.

In 1974 the Employee Retirement Income Security Act was passed. It made many significant changes to the law. It also gave birth to Section 401(k). It took a while, but over the years with the growth of mutual funds and advances in computer technology, the modern 401(k) plan was developed. The technical name for these plans is “self-directed plan” because each employee can direct his or her investments.

We call these plans “cookie-cutter plans” because the companies that sell them all have the same or similar pitch. They all claim three advantages: First, the plans have a low cost to start and maintain (in most cases a myth because of hidden costs). Second, employees have many investment choices (the fact is the typical plan allows only about 12 to 60 choices). The third supposed advantage is that the plans require no fiduciary responsibility (the employees cannot sue you.) Today, 401(k) plans — particularly the cookie-cutter type plans — dominate the retirement plan market. Nobody (including me) thought a participant could sue the boss or the company for a fiduciary breach — until now!

However, the LaRue case offers an opportunity for every business with a cookie-cutter plan. Actually, we have been taking advantage of this opportunity on behalf of our clients for years with a simple two-step process: First, amend the plan to make the business owner(s) the trustee(s), which is often called a “trustee plan,” to save on fees. Second, hire a professional money manager to invest the plan funds and eliminate the threat of being sued for a fiduciary breach.

It should be noted that most professional money managers have a minimum of $500,000 of funds to be managed. The total amount of the funds in the plan is what counts, not the smaller amounts in each participant's account. Typically, the pros will earn about 1% to 3% per year, on average, better than the Dow and S&P benchmarks.

If you already have a trustee plan, you deserve congratulations. You are already at the head of the class.

Irv Blackman, CPA and lawyer, is a retired founding partner of Blackman Kallick Bartelstein LLP and chairman emeritus of the New Century Bank, both in Chicago. He can be reached at 847/674-5295, email [email protected] or on the Web at www.taxsecretsofthewealthy.com.

Read more tax articles by Irving Blackman