Default Investments – Target Date Funds

Marcia Wagner, Esq. Tess J. Ferrera, Esq.The Wagner Law Group Schiff Hardin, LLP99 Summer Street, 13th Floor 901 K Street, N.W., 700Boston, MA 02110 Washington, D.C. 2001marcia@wagnerlawgroup.com tferrera@schiffhardin.com617.357.5200 202.778.6435

Target-Date Funds -- BackgroundTarget-Date Funds -- BackgroundPopularity exploded after Pension Protection

Act (“PPA”) of 2006.◦PPA added ERISA § 404(c)(5)

Encouraged employers to include automatic enrollment as a feature of their plan.

Created Qualified Default Investment Alternatives (“QDIA”) to provide plan fiduciaries a safe harbor default investment option in the event the default option experienced loses.

Provides investment solution to participants that did not manage their account.

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Background on Target Date FundsTypically, formed as open-end investment

companies registered under the Inv. Co. Act.Defining characteristic – “glide path” which

determines the overall asset mix of the fund.Performance issues in 2008 raise concerns,

especially for near-term TDFs.◦ Based on SEC analysis, the average loss for TDFs

with a 2010 target date was -25%.◦ Individual TDF losses as high as -41%.

Target-Date Funds -- BackgroundTarget-Date Funds -- Background

What was learned when the market crashed in 2008?

Some TDFs designed for 2010 retirement date lost a lot of value.

Many participants were unaware of the risks associated with TDFs and that large losses possible so close to retirement.

TDFs with same target date exhibited wide variation.

Target-Date Funds -- BackgroundTarget-Date Funds -- Background

Did the 2008 losses demonstrate that plan fiduciaries breached their duty of prudence and/or loyalty to participants?

Target-Date Funds – Fiduciary RulesTarget-Date Funds – Fiduciary Rules

Overview of Fiduciary Obligations:

◦ERISA § 404 – Prudence, Loyalty, Diversification and Adherence to Plan documents

◦ERISA § 406 – Prohibited Transactions

Target-Date Funds – Fiduciary RulesTarget-Date Funds – Fiduciary RulesPension Protection Act of 2007 added a new Section

404(c)(5) to ERISA.◦ Safe Harbor for default investments when participant

fails to make investment selection. Automatic Enrollment. General failure to make election. Historically, defaults were very conservative

vehicles.◦ Applies anytime participant fails to make selection,

not only in the automatic enrollment context.

Target-Date Funds – Fiduciary RulesTarget-Date Funds – Fiduciary RulesA plan fiduciary that complies with the

regulations will not be liable for any loss resulting from the investment.

Not intended to be the exclusive method by which a fiduciary can discharge his or her obligations absent an affirmative participant election.

Target-Date Funds – Fiduciary RulesTarget-Date Funds – Fiduciary RulesTo comply with the regulations, a

fiduciary must:◦ Invest the assets in a Qualified Default

Investment Alternative (“QDIA”);◦Participants and beneficiaries must have been

given the opportunity to direct investments, but failed to do so; and

◦Comply with notice requirements.

Target-Date Funds – Fiduciary RulesTarget-Date Funds – Fiduciary Rules

First notice must be provided at least 30 days in advance of eligibility, or the date of any first investment in a QDIA; or

On or before the date of plan eligibility, provided that the participant has the opportunity to make a permissible withdrawal under IRC Section 414(w); and

Second notice – within a reasonable period of time at least 30 days in advance of each subsequent plan year.

Target-Date Funds – Fiduciary RulesTarget-Date Funds – Fiduciary RulesA fiduciary provides to a participant

materials relating to the QDIA, i.e., ◦Account statements◦Prospectuses◦Voting rules◦List of assets comprising the portfolio

Target-Date Funds – Fiduciary RulesTarget-Date Funds – Fiduciary RulesParticipants must be given the opportunity to

transfer their assets, in whole or in part, out of the QDIA at least as frequently as any other participant that affirmatively made an investment decision, but in no event less frequently than every three months.

Target-Date Funds – Fiduciary RulesTarget-Date Funds – Fiduciary RulesDuring the first 90-days, a participant that

withdraws or transfers their account from the QDIA shall not be subject to any restrictions, fees or expenses, including surrender charges, liquidation or exchange fees or other similar charges.

Normal operating expenses are permissible, i.e., investment management fees, legal and accounting, distribution fees, 12b-1 fees, etc.

Target-Date Funds – Fiduciary RulesTarget-Date Funds – Fiduciary RulesThe notices must be written in a manner calculated to

be reasonably understood and contain the following:◦ The circumstances under which assets may be

invested in the QDIA and a statement notifying of the right to withdraw or change the percentage of the election;

◦ An explanation that participants have the right to direct their accounts;

Target-Date Funds – Fiduciary RulesTarget-Date Funds – Fiduciary Rules

◦A description of the investment characteristics of the QDIA, including investment objectives, risk and return, and related fees and expenses; and

◦An explanation that participants have the right to redirect their investments and information about how they go about making changes.

Target-Date Funds – Fiduciary RulesTarget-Date Funds – Fiduciary Rules

If a fiduciary complied with the regulations, was the fiduciary protected by the safe harbor 404(c)(5) regulations when the market crashed in 2008?

Target-Date Funds – Fiduciary RulesTarget-Date Funds – Fiduciary RulesUnder the 404(c) regulations, DOL takes

the position that those regulations do not protect the fiduciary for the fiduciary selection of the investment menu in the 401(k) line-up.

Same is likely true in the QDIA context under 404(c)(5).

Target-Date Funds – Fiduciary Target-Date Funds – Fiduciary ChallengesChallengesProblems for a fiduciary in the selection

of the a TDF:◦TDFs are relatively new and lack

long-term track records – difficult to find benchmarks.

◦Variance in glide paths make it difficult to find the right benchmark.

◦Variance in underlying asset classes cause a similar problem

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Government Reaction to TDF 2008 Performance

DOL and SEC at Senate Special Committee on Aging hearing on TDFs (Oct. 28, 2009).◦ Investor Bulletin jointly released by DOL and SEC.◦ DOL’s fiduciary checklist on TDFs is pending.

SEC proposal for TDF advertising materials.◦ If name has target date, “tag line” disclosure needed.◦ Advertising must include glide path information.

On Nov. 30, 2010, DOL proposed rules on TDF disclosures for participants, amending:◦ Participant-level fee disclosure reg’s that were

finalized on Oct. 20, 2010. DOL TDF regulations not yet final.

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DOL’s Proposed Changes to QDIA Reg’s

DOL proposes change to QDIA notice for TDFs.◦ Explanation and illustration of TDF’s glide path.◦ Relevance of target date (e.g., 2030) in TDF name.◦ Disclaimer that TDF may lose money after retirement.

DOL also proposes general changes to QDIA notice (even if not a TDF).

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DOL’s Changes to Participant-Level Fee Disclosure Reg’s

Background (recap)◦ New rules will require disclosure of plan-related fees

and annual comparative chart for plan’s investments.

DOL proposes change to annual comparative chart for TDFs (even if not a QDIA).◦ Must include appendix with additional TDF info. ◦ Same info as required for QDIA notice.

Informal follow-up guidance from DOL◦ TDF prospectus is unlikely to satisfy QDIA notice and

annual comparative chart requirements, as proposed.

◦ DOL will not provide “model” target date disclosures.

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Congressional Proposal for TDFs

Senator Kohl announced his intent to introduce new legislation (Dec. 2009).◦ Concerns over high fees, low performance or

excessive risk in many TDFs.◦ Would impose ERISA fiduciary status on TDF

managers when TDF used as QDIA in 401(k) plans.

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Avatar Advisory OpinonConflicts arise when a “fund of funds” invests

in affiliated underlying funds.◦ Conflicts are permitted because fund managers are

carved out from ERISA’s fiduciary requirements.Are fund managers ever subject to ERISA?

◦ Firm requested clarification on scope of carve-out.◦ In Adv. Op. 2009-04A (Avatar Associates), DOL

declined to rule that the TDF managers are fiduciaries.

Implications of DOL guidance◦ Plan sponsors are alone in their fiduciary obligation.◦ Must ensure TDFs (and underlying funds) are

appropriate plan investments.

Target-Date Funds – Fiduciary RulesTarget-Date Funds – Fiduciary RulesFiduciary selection process:

◦Consider retaining an expert if plan sponsor lacks internal expertise to assist with selection.

◦Define investment goals and objectives before choosing a TDF.

◦Understand participant population.

Target-Date Funds – Fiduciary RulesTarget-Date Funds – Fiduciary RulesIssues to evaluate:

◦Actively managed vs. passive management◦Underlying investments – how risky – look

under the hood. ◦Glide paths◦Fees

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Default Investments – TDFs Practical Implications

Provide meaningful TDF disclosures to participants as a “best practice” right now.◦ Provide key information about TDF’s glide path, landing

point and potential volatility.

Also facilitate sponsor’s prudent review of the plan’s TDF series.◦ Assist in the fiduciary review of the “fund of funds”

structure, glide path, underlying funds and risk.◦ Special review of TDFs for participants in or nearing

retirement (e.g., 2015 TDF).