Tuesday, March 5, 2013

DOL Provides Guidance on TDFs

In February 2013, the Department of Labor (DOL) issued a paper entitled “Target Date Retirement Funds – Tips for ERISA Plan Fiduciaries.” Clearly, this is a signal from DOL that this is an issue for plan sponsors and their plan committees to watch. But, there are other fiduciaries as well and some have a vested interest in a plan sponsor’s choice of target date funds (TDFs). In this article, we’ll examine the DOL paper and some of its implications, but first we provide some background for those who don’t live in this world on a daily basis.

In 1993, Barclay’s Global Investors introduced the first TDF. While there had been some dabbling in risk-based funds, this was the initial plunge into developing a fund targeted at an individual’s intended retirement date. The evolution of TDFs moved along fairly slowly for the next ten years or so, but in 2006, Congress passed and President Bush signed into law the Pension Protection Act (PPA) starting a veritable explosion in TDF usage in 401(k) and other defined contribution (DC) plans.

The impetus was a provision in PPA establishing the qualified default investment alternative (QDIA), the investment that a plan sponsor uses as a default for moneys in participants’ accounts not otherwise designated for investment. The law and its guidance established that QDIAs should be one of these:
  •  A fund that takes the participant’s age or retirement date into account
  •   An investment service (managed account) that takes the participant’s age or retirement date into account
  • A balanced fund
  • A money market fund, but this can only be used for the first 120 days

According to the 2012 Janus/Plan Sponsor survey, approximately 75% of all defined contribution plans have chosen target date funds as their QDIAs.

Today, there exist a wealth of TDFs of many shapes and sizes. Virtually all of them have in their name a year (multiple of five) that is intended to represent a participant’s expected retirement age. Often, that is where the similarities end. There are “to” funds and “through” funds so named because they are either intended to take a participant to retirement (the participant is expected to take a distribution when he or she retires) or through retirement (the participant is expected to keep his or her money in the plan and draw it down gradually through retirement). There are proprietary funds (those which are essentially a fund of funds run by the asset management institution that manages the TDF) and there are open-architecture (often custom) TDFs composed of those funds that the asset manager thinks are most appropriate for the fund regardless of the manager of the constituent funds. There are TDFs that are composed largely of actively managed funds (these usually have higher underlying expenses) and TDFs that are composed primarily of passively managed funds (usually having lower underlying expenses).

The DOL paper suggests factors that a plan sponsor should consider in its fiduciary decision to choose a family of target date funds, often as the QDIA. Specifically, the paper points out investment strategies, glide paths (this is the move from a more aggressive equity-heavy strategy far from retirement to a more conservative strategy closer to retirement), and investment-related fees.

Plan sponsors should consider this DOL guidance carefully. While there is nothing in the paper that suggests that a plan sponsor must follow the DOL’s suggested steps, one would certainly think that plan sponsors that do so may relatively well shield themselves from costly losses in litigation. No strategy is foolproof, but if I were on a jury or if I were a judge and I heard that a plan sponsor did exactly what the Department of Labor suggested, such evidence would often compel me.

The paper spells out these eight steps:
  • ·         Establish a process to compare and select TDFs
  • ·         Establish a process for periodic review
  • ·         Understand the fund’s investments and how they will change over time
  • ·         Review the fund’s fees and investment expenses
  • ·         Ask about the availability and appropriateness of non-proprietary TDFs
  • ·         Communicate with your employees
  • ·         Use all available sources of information in evaluating and selecting your TDFs
  • ·         Document the process

I am going to add two more items to this list. First, a number of defined contribution recordkeepers are affiliated with or owned by asset management firms. Some of them will only take on a new client if their own proprietary TDFs are used as the plan’s QDIA. It may be acceptable to begin by using these proprietary TDFs as the plan’s QDIA, but when you use recordkeepers of this sort, you will certainly have a contract for services for several years. The contract will offer you financial disincentives to change TDFs to those provided by another vendor. It aligns well with the DOL’s advice to not engage in such a contract. Doing so could put you in a poorly-performing family of funds that you cannot switch out of without incurring significant fees (usually passed on to the participants) or in a very expensive family of funds that are subsidizing hidden fees or both.

Second, the DOL’s final piece of advice (of the eight) is to document the process. Documentation of processes is an excellent idea. It’s especially an excellent idea if you follow your own processes. However, a number of companies (see for example, Tussey v ABB) have lost or settled litigation when they did not follow their own documented processes. Not having a documented process is bad, but documenting what you should and will be doing and then doing something else is probably much worse.

Several points that the DOL makes are particularly noteworthy. Consider, for example, a proprietary family of TDFs composed of high-expense actively-managed proprietary funds. While not all TDFs are set up this way, the following is a possible scenario:
  • ·         Family of TDFs is composed of high-expense, actively-managed proprietary funds
  • ·         The TDFs come with an underlying investment expense
  • ·         Each of the underlying funds in the TDF provide a return net of expenses

In this case, the TDF is essentially double-charging the plan participants. Each of the underlying funds has a significant investment expense and, at the same time, the overall fund comes with an additional investment expense. The DOL paper points out how an account balance of $25,000 compounded at 7% per year for 35 years will accumulate to approximately 40% more than the same account balance compounded for 35 years at 6% per year. Put into more practical terms, for a younger employee, the 40% implicit cost of much higher investment fees may be insurmountable.

Finally, the paper points out the importance of defined benefit (DB) plans in selection of TDFs. While it is true that far fewer employees are covered by DB plans than were 25 years ago, a significant number still are. While the paper doesn’t use these words, it makes clear that plan sponsors that also provide broad-based DB plans might consider those defined benefit amounts as a fixed income investment for participants. In such cases, using a more aggressive TDF is likely appropriate.

The DOL paper is not formal guidance. It’s not part of a regulation on fiduciaries. Following the DOL’s advice in this case is not, per se, required. But, a word to the wise: other such pieces of informal guidance have been considered safe harbors by courts. Plan sponsors and their consultants might wish to consider this publication that way as well.

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