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Considerations for Fiduciaries Choosing Target Date Funds As Qualified Default Investment Alternatives in 401(k) Plans

Tuesday, May 7, 2013
By Bernard T. King and Michael R. Daum, Blitman & King

Due to a regulatory safe harbor created by the Department of Labor in 2008, the use of target date funds (TDFs) has become commonplace in Section 401(k) plans and other defined contribution pension plans that allow participants to direct their own investments. Further, in most such plans, a TDF is the default investment option for participants and beneficiaries who fail to select their own investments. This is generally considered appropriate because TDFs are designed to build income throughout the participants' and beneficiaries' working years, while becoming more conservative upon their reaching retirement.

However, recent studies show that many assumptions underlying the appropriateness of TDFs in the employee benefit plan context do not always reflect reality. Because of this, there are steps that plan fiduciaries should take in connection with the selection and monitoring of TDFs so that they can ensure that they are satisfying their fiduciary duties and helping participants and beneficiaries secure sufficient funds for retirement.

Legal Framework

Fiduciaries of employee benefit plans governed by the Employee Retirement Income Security Act are generally required to invest the assets of the plan with the care, skill, prudence, and diligence under the circumstances then-prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.1 In addition, such fiduciaries must diversify the investments of the plan to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so.2

However, ERISA Section 404(c)(1)(A)(ii) provides that, in the case of a plan that provides for individual accounts and permits a participant or beneficiary to exercise control over the assets in his or her account, e.g., a 401(k) plan), no fiduciary will be liable for any loss, or by reason of any breach, that results from such participant's or beneficiary's exercise of control, if certain conditions are met.3 Pursuant to regulations promulgated by DOL in 1992, in order for plan fiduciaries to qualify for this protection, the plan must provide an opportunity for a participant or beneficiary to exercise control over assets in his or her individual account and to choose from a broad range of investment alternatives in exercising such control.4 Thus, such plans generally offer a broad lineup of mutual funds and other alternatives for participants to select from, and many engage a mutual fund platform provider to make such a lineup available and handle its administration.

The Pension Protection Act of 2006 expanded ERISA Section 404(c) by adding Section 404(c)(5). This subsection provides that, for purposes of ERISA Section 404(c)(1), a participant or beneficiary in an individual account plan will be treated as “exercising control” over the assets in the account even if that individual does not make an investment election, provided that the account is invested by the plan in a default investment in accordance with regulations prescribed by DOL.5

Under the corresponding regulations, in the event that a participant does not make an investment election, the fiduciaries of the plan are nonetheless protected under Section 404(c)(1), provided that the plan invests the participant's account in a qualified default investment alternative (QDIA) and satisfies certain notice requirements.6 Fiduciaries have an obvious incentive to comply with these regulations and offer a QDIA, as doing so affords them protection from investment-related liability in the often likely event that certain participants and beneficiaries do not take on active management of their accounts. In order to qualify as a QDIA, the investment must be made into one of three general types of investments: a TDF, a balanced fund, or a managed account.7

Target Date Funds

Of particular importance is DOL's inclusion of TDFs as qualified default investment alternatives. In 2011, the Government Accountability Office released a report titled Key Information on Target Date Funds as Default Investments Should be Provided to Plan Sponsors and Participants, which indicated that TDFs have been, by far, the most popular QDIA chosen by plan fiduciaries and have been consistently made available as part of plans' mutual fund lineups.8 According to a 2013 report published by Vanguard, nine out of every 10 plans administered by Vanguard with automatic enrollment use a TDF as the QDIA.9

The regulations define the concept of a TDF as:

“An investment fund product or model portfolio that applies generally accepted investment theories, is diversified so as to minimize the risk of large losses, and that is designed to provide varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed income exposures based on the participant's age, target retirement date (such as normal retirement age under the plan) or life expectancy. Such products and portfolios change their asset allocations and associated risk levels over time with the objective of becoming more conservative (i.e., decreasing risk of losses) with increasing age.… [A]sset allocation decisions for such products and portfolios are not required to take into account risk tolerances, investments or other preferences of an individual participant.”10

More specifically, the GAO report noted that a TDF is generally established as a mutual fund in a fund-of-funds structure.11This means that the TDF is made up of a group of underlying mutual funds in different asset classes, often with an equity and fixed income component, but occasionally also with real estate and other alternative investments.12 This structure generally gives participants and beneficiaries the opportunity to have their plan account invested with a diversified portfolio of securities without having to actively select and manage such securities. This concept seems particularly ideal for a participant or beneficiary who does not have the investment knowledge to actively manage a similar portfolio.

As described in the regulations, the general theory behind TDFs is that they are designed to change their asset allocations and risk levels over time to become more conservative as the participant or beneficiary approaches his or her retirement. To accomplish this, a TDF provider generally includes a series of funds designed for participants expecting to retire in different years, such as 2015, 2020, 2025, and so on.13 For instance, the QDIA for a participant who is 30 years old in 2013 may be a 2045 TDF, while the QDIA for a 55-year old participant would likely be a 2020 TDF.14 The idea is that the participant should choose, or be defaulted into, the TDF that corresponds most closely with that participant's projected retirement date.15

In general, a TDF accomplishes its goal of becoming more conservative closer to the participant's projected retirement date by shifting its portfolio from equities to fixed income investments as time moves closer to that date.16 This is because of the assumption that fixed income investments are more secure and less risky than equity investments. The GAO report describes the theory behind this shift as insurance for the retirement savings of an older plan participant who has a shorter time horizon, fewer opportunities to make contributions to savings, and less ability to recover from downturns in the market.17

Controversies Involving TDFs
In the Benefit Plan World
However, TDFs are not without controversy in the employee benefit plan context. As many small plans do not have sufficient investable assets to have bargaining power when negotiating with mutual fund platform providers, the mutual fund choices available to these plans are often limited. For example, to be cost-effective, the plan will often have to agree to offer only mutual funds, including the TDFs, managed by a single platform-provider. As a result, it becomes more important for the fiduciaries to understand the specific characteristics and assumptions of the TDFs in their lineup. This need is magnified because many of the assumptions about TDFs in general do not always reflect reality.

GAO conducted a review of eight TDF managers for purposes of its report, and uncovered considerable differences in their objectives and considerations. While each of the eight managers allocated at least 80 percent of the TDF's assets to equities 40 years before the retirement target date, the rate at which the equity component was decreased and the size of the equity component at the retirement target date differed considerably.18 For example, one TDF maintained an equity allocation of about 65 percent at the target retirement date, while another had an equity allocation of just 33 percent.19These differences are illustrated by a chart (reproduced in this article) included in GAO's TDF report outlining the so-called “glide path” of four of the TDF managers it observed.

Due to the differences between certain TDFs that even have the same target retirement date, it is likely that not all TDFs implement glide paths that are consistent with the assumptions of the plan fiduciaries who select the TDFs and the participants invested therein. The GAO report says that many participants were surprised when their TDFs were among the ones that lost considerable value during the financial market turmoil of 2008, even though the target date for such TDFs was soon approaching.20 For example, a 2009 report on TDFs prepared by the Special Committee on Aging of the United States Senate described that, while the Deutsche Bank DWS Target 2010 Fund fell just 4 percent in 2008, Oppenheimer's Transition 2010 Fund fell 41 percent.21

Furthermore, many participants may be unaware of the level of fees charged in connection with their investment in a TDF. While all fees associated with 401(k) plans can have a significant impact on participants' accounts, the impact is often increased with respect to an investment in a TDF. This is because, as noted in the Committee on Aging's report, as of late 2009, more than half of the TDF industry included funds with annual expense ratios exceeding 1 percent.22 The report also cited findings by BrightScope Inc., an independent provider of 401(k) rankings and financial intelligence, that TDFs have internal fees that are 10 percent to 25 percent more expensive than non-TDF mutual funds.23 This is important because studies have shown that even seemingly small increases in fees paid by participant retirement accounts can lead to significantly less retirement income when the money is withdrawn.

While recently-enacted DOL regulations require certain disclosures about all mutual fund fees to be made to participants in participant-directed plans,24 it is unclear how helpful such disclosures are to participants who are invested in a TDF by default. DOL has acknowledged that participants who invest in TDFs should receive more information than what was initially required under such regulations, as it has proposed an amendment requiring additional disclosures relative to TDFs.25

At the same time, it is unclear that the assumptions about the participants who are invested in the TDFs that underlie the funds are always consistent with the participants' expectations and actions. For instance, the Committee on Aging's report cited a study by Vanguard which concluded that only two out of every 10 households spent down their long-term retirement accounts on some type of systematic or regular payment program that extended through the equivalent of a full TDF “glide path.”26 Along these lines, the report also indicated that 54 percent of respondents to a survey took some or all of their retirement-account balance as a lump-sum distribution.27 Thus, the glide paths of many TDFs, which often do not assume early distributions or a lump-sum distribution at the target retirement date, do not reflect the true course of action followed by many participants. Therefore, the Committee on Aging's report concluded that participants, especially those who are less sophisticated and defaulted into a TDF, may lock in large losses if they take lump-sum distributions prior to the full glide path being implemented.28

Fiduciary Rules Relevant to TDF Investments
As indicated, employee benefit plans that offer TDFs to participants generally do so as part of a broader lineup of investment options intended for the plan fiduciaries to comply with ERISA Section 404(c)(1) and thus be shielded from fiduciary responsibility with respect to the participants' investment choices.29 These requirements are not strenuous; for instance, to qualify under Section 404(c)(1), the fiduciaries need just ensure that the plan allows a participant or beneficiary to exercise control over the assets in his or her individual account and to choose from a broad range of investment alternatives.30 Similarly, fiduciaries can qualify for the safe harbor from fiduciary responsibility with respect to a participant or beneficiary's default investment in a qualified default investment alternative (including a TDF) provided that the participant or beneficiary had an opportunity to direct the investment and failed to do so and received a notice about QDIA, which must include, among other information, a description of the QDIA's investment objectives, risk and return characteristics, and fees.31 Thus, assuming the requirements are satisfied, participants and beneficiaries who invest their plan assets in a TDF (or are defaulted into a TDF) generally cannot seek recourse against the plan fiduciaries under ERISA on account of a loss that occurs as a result of the investment in the TDF.

Similarly, the investment managers of the TDFs are usually not subject to ERISA's fiduciary rules with respect to the underlying investments of the TDF. This is because the TDF's underlying assets are not deemed “plan assets” under ERISA, and thus the TDF's investment manager is deemed not to be managing or controlling the plan's assets, which would trigger fiduciary status.32 Therefore, with respect to the TDF's actual investments, there is little fiduciary protection for a participant or beneficiary in the event the investment does not achieve optimum results. This concern can be magnified if a participant or beneficiary invested in a TDF due to being in the QDIA, because such individual ended up in the investment only because of a lack of choice to otherwise direct his or her account's investments.

However, this is not to say that plan fiduciaries have no fiduciary concerns when it comes to selecting TDFs or complying with ERISA Section 404(c) in general. DOL's regulations provide that nothing in the QDIA regulations will act to relieve a fiduciary from his or her duties under ERISA to prudently select and monitor any QDIA, or from any liability that results from a failure to satisfy such duties, including any liability for any resulting losses.33 Thus, prior to selecting a TDF to serve as a plan's QDIA, the plan fiduciaries must obtain sufficient information about the TDF to ensure that its selection is in the sole interest of providing benefits to participants and beneficiaries and prudent under the circumstances.34 To do so, the plan fiduciaries should be aware of the pertinent information concerning the TDF, such as the fees charged to participants' and beneficiaries' accounts, the glide path used by the TDF, and the assumptions about investors used by the TDF provider in establishing the investment fund.35

At the same time, the mutual fund platform provider36 may be a fiduciary when choosing the TDF in the plan's lineup to the extent the platform provider controls the TDF's selection on behalf of the plan. DOL has opined that a mutual fund platform provider will become a fiduciary with respect to a plan to the extent it has the authority to set the initial mutual fund lineup available to participants and beneficiaries or make any changes to the lineup without the prior authorization of the plan fiduciaries.37 In a recent amicus brief filed in connection with a case in the U.S. Court of Appeals for the Seventh Circuit, DOL has taken this position one step further. With respect to that case, DOL opined that a platform provider that exercises final discretion over the share classes of mutual funds that the plan offers is a fiduciary to the extent the plan fiduciaries were unaware of the selection and did not have the overriding authority to approve or reject the decision.38

DOL's position on the issue is especially important for smaller plans, which generally have less bargaining power with mutual fund platform providers. If the provider imposes its proprietary TDF on the plan, or certain other mutual funds in connection therewith, that may be enough to make the provider a fiduciary with respect to selection of the plan's investment lineup. If that is the case, the plan fiduciaries, participants, and beneficiaries will have the added protection of knowing that the provider is subject to the strict fiduciary responsibility standards of ERISA Section 404(a) and its prohibited transaction rules.

Conclusion
Regardless of whether the plan fiduciaries responsible for setting the plan's investment lineup comply with Section 404(c)(5), or whether the mutual fund platform provider would qualify as a fiduciary, the responsible fiduciaries must understand the underlying details about the TDFs they are selecting as the plan's QDIA. Although the fiduciaries can receive some protection from the QDIA safe harbor, they remain responsible for the prudent selection and monitoring of the TDF. Thus, at a minimum, the responsible fiduciaries should understand the TDF's glide path, fees, and underlying assumptions. Then, having a general idea about the projected actions and attributes of the plan's participants and beneficiaries, the fiduciaries should confirm that these characteristics are appropriate for the plan participants. For instance, the fiduciaries can assess whether the participants are better suited for glide paths that call for the TDF to be managed either only up “to” the target retirement date or continually for some period after that date, and whether the TDF's underlying investments are well suited for the plan's participants and their general risk tolerances.

Along these lines, DOL recently published a notice with tips for plan fiduciaries who are selecting TDFs.39 The notice provided the following steps that fiduciaries should take in selecting TDFs:


  • Establish a process for comparing and selecting TDFs.

  • Have a process for the periodic review of the TDFs.

  • Understand the allocation of the TDFs' investments in different asset classes and how the allocation will change over time.

  • Review the TDF's fees and investment expenses.

  • Inquire whether a custom or nonproprietary TDF would be a better fit for the plan.

  • Develop effective employee communications.

  • Take advantage of available sources of information to evaluate the TDF and recommendations received regarding its selection.

  • Document the process.


In making this assessment, plan fiduciaries may wish to seek advice from independent fiduciary service providers, to the extent that such advice is necessary to obtain a full understanding of these attributes. In addition, such a service provider can be solicited to provide expert advice as to whether the mutual fund platform provider is charging reasonable fees in connection with the TDF and whether there are any conflict of interests issues inherent with the TDF that should be more thoroughly vetted. However, it should be remembered that, unless the fiduciary authority in this regard is delegated to an “investment manager” under ERISA, the fiduciaries may nonetheless remain responsible as co-fiduciaries and thus should still obtain a sufficient understanding of the products they are offering in their plan.

Bernard T. King (btking@bklawyers.com) is the senior partner at Blitman & King in Syracuse, N.Y. He serves as counsel to a diverse base of employee benefit plans, including large and small multiemployer plans, public plans, and the benefit plans of professional athletes. Michael R. Daum (mrdaum@bklawyers.com) is an associate for the firm. He advises employee benefits plans on a variety of issues, including plan drafting, regulatory compliance, and planinvestments.

©2014 The Bureau of National Affairs, Inc. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of The Bureau of National Affairs, Inc.

Disclaimer
This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.

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