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On February 28, 2013, DOL published its long-awaited target date fund (TDF) ‘tips.’ In this article we review the DOL ‘tip sheet’ and TDF fiduciary issues generally.
The late-2008 financial crisis had a particularly significant impact on some 401(k) plans that offered TDFs. In 2007 the Department of Labor had finalized its qualified default investment alternative (QDIA) regulations, which provided that, where certain conditions are met, plan fiduciaries are relieved from liability for losses resulting from the investment of the participant’s account in a QDIA. Generally, only balanced funds, managed accounts and TDFs qualified as QDIAs.
In 2007 and 2008 many sponsors moved default (and in some cases, non-default) investments out of money market funds and guaranteed investment contracts and into TDFs. Thus, over that period, participants were moved out of principal preservation vehicles and into funds that, in many cases, had significant equity exposure. Then the financial crisis hit, and many TDFs sustained significant losses.
Of particular concern were losses in TDF funds that were, e.g., for participants retiring in 2010. Many assumed that such funds would be conservatively invested, because the participant’s retirement date (2010) was so near. But there are two different points of view on this issue. Some argue that, since the participant may live for another 20 years (or more) after retirement, her account should be allocated, given that long investment horizon, relatively aggressively.
This has come to be known as the ‘to vs. through’ question — generally, whether the TDF glide path should reach its most conservative allocation at retirement (‘to’) or at the end of life expectancy (‘through’). No consensus exists as to the right answer to this question, but there is concern that sponsors and, especially, participants understand which sort of TDF – ‘to’ or ‘through’ — they are getting.
It was in this context — the 2008 TDF losses and the to vs. through controversy — that DOL decided that plan fiduciaries needed a checklist or (as it turned out) ‘tips’ on how to evaluate TDFs and their responsibilities and obligations with respect to them.
These DOL tips are (theoretically at least) not new rules for TDF selection and monitoring. They generally restate ‘old’ rules for fiduciary conduct that are generally applicable to any investment, not just TDFs. They do, however, provide a useful review of the fiduciary issues that TDFs present and DOL’s thinking on those issues.
Here, in DOL’s view, is what plan fiduciaries should do when selecting a TDF:
Establish a process for comparing and selecting TDFs. In general, plan fiduciaries should engage in an objective process to obtain information that will enable them to evaluate the prudence of any investment option made available under the plan.
Establish a process for the periodic review of selected TDFs. At a minimum, the review process should include examining whether there have been any significant changes in the information fiduciaries considered when the option was selected or last reviewed.
Review the fund’s fees and investment expenses.
Understand the fund’s investments – the allocation in different asset classes (stocks, bonds, cash), individual investments, and how these will change over time.
Inquire about whether a custom or non-proprietary target date fund would be a better fit for your plan.
Develop effective employee communications.
Take advantage of available sources of information to evaluate the TDF and recommendations you received regarding the TDF selection.
Document the process. Plan fiduciaries should document the selection and review process, including how they reached decisions about individual investment options.
Much of this is ‘vanilla’ guidance — the restatement of basic principles — but some items are worth attention.
Initial selection. DOL’s emphasis on an ‘objective process’ is important. With respect to ERISA’s fiduciary rules, process is key. Stated simply, the fiduciary needs a clear understanding of what sort of TDF it wants and that the TDF it selects meets those criteria.
Is in-depth consideration of multiple factors – other than age – necessary? Reading between the lines, it would seem that there is no requirement that, e.g., sponsors develop a custom glide path and TDF asset allocation strategy. But they are worth considering. DOL mentions consideration of how well the TDF’s characteristics align with eligible employees’ ages and likely retirement dates and discussing with prospective TDF providers the possible significance of other characteristics of the participant population, such as participation in a DB plan.
Periodic review. Clearly the plan fiduciary should determine, on an ongoing basis, whether the TDF continues to meet the fiduciary’s initial selection criteria. DOL gives these examples: “if a TDF’s investment strategy or management team changes significantly, or if the fund’s manager is not effectively carrying out the fund’s stated investment strategy, then it may be necessary to consider replacing the fund. Similarly, if your plan’s objectives in offering a TDF change, you should consider replacing the fund.”
We would simply emphasize that these are issues for all funds, not just TDFs. Not doing anything about a fund that no longer complies with the investment strategy identified for it is an obvious litigation target.
Fees. We have for some time been concerned about the issue of fees in TDFs. A TDF featured in the 2012 Tussey v. ABB decision — the first ‘big win’ for plaintiffs in the 401(k) fee litigation. TDF fees are, necessarily, less transparent than, e.g., an S&P index fund, because they typically combine other funds.
In this regard, DOL states: “If the TDF invests in other funds, did you consider the fees and expenses for both the TDF and the underlying funds? If the expense ratios of the individual component funds are substantially less than the overall TDF, you should ask what services and expenses make up the difference. Added expenses may be for asset allocation, rebalancing and access to special investments that can smooth returns in uncertain markets, and may be worth it, but it is important to ask.”
We would add that, even where there isn’t an additional layer of fees on top of the fees charged by the underlying funds, analyzing the fees on those underlying funds and comparing them with appropriate benchmarks is, in the current environment, a difficult but necessary duty of the plan fiduciary.
Employee communication. DOL notes that it has proposed regulations providing for additional disclosure with respect to TDFs. Especially after the 2008 financial crisis, making sure that participants understand the TDF’s asset allocation strategy — particularly whether it is a ‘to’ or ‘through’ plan — should be a top sponsor priority.
Documentation. Handled properly, process is the fiduciary’s friend. Having an adequate process that you can document will go a long way in court to support the decisions the fiduciary has made.
Some have expressed concern about elements of the DOL tips. First, some have suggested that the tip that fiduciaries “[i]nquire about whether a custom or non-proprietary target date fund would be a better fit” seems to be steering fiduciaries away from proprietary TDFs. Second, some view the discussion of ‘to’ vs. ‘through’ as loaded in favor of ‘to’ — with ‘through’ funds described as having some post-retirement investment risk, making them only suitable for participants “who don’t expect to withdraw all of their … savings immediately upon retirement, but would rather make periodic withdrawals over the span of their retirement years.”
Finally there is the question of the legal status of these tips. Theoretically they have none — they aren’t rules. They aren’t supposed to be making new law. But there is the possibility that some may view, e.g., the suggestion to inquire about non-proprietary funds as, effectively, a mandate. So may some plaintiffs’ lawyers.
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DOL’s publication of its target date fund ‘tips’ provide a good occasion for sponsor fiduciaries to review their procedures with respect to the selection and review of a target date fund provider.
We will continue to follow TDF fiduciary issues.