What’s a Target Date Fund (“TDF”)?

Target date funds (“TDFs”) are premixed portfolios that automatically become more conservative as an investor’s “target” retirement date approaches. The mix of equities to fixed income gradually shifts to lower risk fixed income investments as the retirement age gets closer. This is referred to as a TDF’s “glide path.”

We like TDFs. They are a useful tool to address a huge problem with 401(k) and 403(b) plans — too many employees don’t know or care how to make wise investment choices. With a TDF, all a participant needs to do is pick a “target retirement date” (the target retirement date is usually designed to be the date the participant attains age 65) and the fund’s manager handles it from there. A well constructed TDF provides participants a simple way to save for retirement without having to fret over asset allocation decisions, mutual fund selection, or rebalancing.

TDFs received a boost when the U.S. Department of Labor (“DOL”) approved TDFs as one of three “qualified default investment alternatives” (“QDIAs”). When participants are given an opportunity to direct their own investments, but fail to do so, plan fiduciaries are generally protected if the participants’ contributions are invested in a QDIA. The plan fiduciaries will not be responsible for losses resulting from the investment of the participants’ contributions in the QDIA.

We also recognize there’s no perfect solution and TDFs may not be appropriate for every investor/participant. For example, TDFs do not generally take into account the risk tolerance, income needs and life spans of individual participants. Also, the TDFs offered by different providers differ greatly from one another in terms of risk and diversification; as a result, they are difficult to benchmark and evaluate.

The TDF Controversy

The current controversy surrounding TDFs primarily involves the “2010 funds” (i.e., a fund that would be selected by an employee expecting to retire in 2010). Various providers’ TDFs for participants who are close to their retirement age differ dramatically in their asset mix and “glide path” (i.e., the rate at which the TDF’s asset mix changes from equities to fixed income over time).

Last year, the 2010 funds lost 23.3% on average. This blindsided many participants investing in these funds who were expecting to retire next year or even earlier. The 2010 TDF with the best return lost just 3.6% in 2008 and the worst performing 2010 TDF lost 41.3%. This difference is largely attributable to the amount of equity exposure in different providers’ TDFs at the target retirement age (the equity exposure ranges from as low as 14% to as high as 65%). Participants in TDFs with a higher percentage of equities at the target retirement age incurred the highest losses.

A TDF’s equity allocation at the target retirement age is disclosed in its prospectus (and perhaps in other materials provided to the participants). However, many (if not most) participants don’t review the prospectus (or any other information provided to them) and may have mistakenly concluded that a TDF with the looming retirement date would be heavily weighted towards fixed income investments such as bonds, money market funds, etc.

While there is a wide disparity in the equity allocation for the various 2010 TDFs, there is no consensus of opinion as to which allocation is better or more appropriate. Some TDF managers take a conservative glide path, downshifting to a relatively low percentage of equities (e.g., 30%) promptly at retirement age. Other TDF managers view the TDF as the lifetime strategy, and given current life expectancies, do not shift to a maintenance allocation the date a participant reaches age 65. A TDF with a conservative allocation at age 65 may provide more stability around the participant’s retirement date, but it may not generate the growth needed to address one of a participant’s most significant risks – the risk of outliving his or her retirement funds.

The DOL’s position is that the selection of an investment option made available under a retirement plan, including a QDIA, is a fiduciary act subject to challenge as a fiduciary breach. Given the current controversy and the second guessing caused by the market turmoil, a participant might challenge the fiduciaries’ selection and retention of a particular TDF as inappropriate based upon the TDF’s equity allocation at its target retirement age.

Action Steps to Protect Plan Fiduciaries

To mitigate the potential fiduciary liability and demonstrate that the fiduciaries engaged in a prudent process, plan fiduciaries should work with their advisors and analyze the TDF offering’s asset allocation glide path, choice of investments, and overall fees. The process will enable the fiduciaries to assess the TDF’s equity allocation at various stages in relation to retirement age and make a determination that the TDF’s glide path is appropriate. As noted, there is no right or wrong answer. The important thing is to demonstrate that the plan fiduciaries engaged in a reasoned decision-making process (i.e., procedural prudence) in selecting and/or retaining the TDF.

The results of the TDF analysis should be documented in the plan fiduciaries’ minutes or other records.

Communication/Education Helps

Following the analysis of a plan’s TDF offering, the plan fiduciaries should consider participant communications. While an equity allocation of 50%, 55%, or 65% at a fund’s target retirement date maybe “reasonable”, not all participants who invest in the TDF will desire this level of risk. As such, we recommend that plan fiduciaries work with their TDF vendors to ensure that the risks associated with the TDFs are adequately communicated.

TDFs present other educational challenges. Many participants do not understand what they are or how to properly use them. A TDF is designed to be an “all or nothing” investment option; TDF holders have a tendency to over diversify (either by combining TDFs with different retirement dates or by combining TDFs with other mutual funds).

Some participants also mistakenly select TDFs based upon the year they expect to leave their employer instead of the year they intend to retire; some participants also mistakenly believe TDFs offer pension-like income guarantees.

We are continuing to assess interest in a seminar on retirement plan fiduciary governance and best practices. If you would be interested in attending a seminar on this topic, please let us know by replying to this email. Please also indicate if you would be interested in a webinar.

As described in the attached article, the court ruled that plan fiduciaries were not subject to liability under ERISA for paying allegedly excessive fees to a mutual fund or maintaining underperforming investment options where they were able to demonstrate that their decisions were based upon a prudent process (also referred to as “procedural prudence”) and they were able to document the process. The ruling is part of an “excessive fee” lawsuit filed against Bechtel Corporation and its plan fiduciaries.

It’s worth noting that retirement plan fiduciaries who fail to act “prudently” are personally liable to make good on any losses sustained by a plan, including lost earnings.

Court Case Provides Important Guideposts for Plan Fiduciaries

The following factors were of special significance to the court in finding that the plan fiduciaries demonstrated procedural prudence (i.e., prudent fiduciary process):

1. The fiduciaries met regularly to discuss the plan’s investments;

Fiduciary Partners Comment: We recommend that plan fiduciaries meet at least twice a year (and preferably quarterly) to review a retirement plan’s investments.

2. The fiduciaries relied on the advice of disinterested outside consultants;

Fiduciary Partners Comment: Some plan sponsors mistakenly assume that it’s sufficient to rely upon the investment research, analysis, recommendations, etc. provided by a retirement plan’s investment provider (e.g., mutual fund family, insurance company, etc.). This case confirms that such reliance is not prudent fiduciary practice, likely due to the investment provider’s inherent conflict of interest. In the eyes of the
courts and the Department of Labor, the involvement of independent consultants goes a long way in demonstrating prudent fiduciary process.

3. The fiduciaries employed a benefit structure that was customary for the type of plan being maintained;

4. The fiduciaries regularly reviewed the performance of the investment options and considered alternatives; and

5. The fiduciaries offered fund options that, as a whole, were competitive with the industry standard.

Fiduciary Partners Comment: Plan fiduciaries should periodically benchmark a plan and its investments; we recommend the involvement of an independent third party consultant with expertise in retirement plan cost management.
Of at least equal importance in this case was the plan fiduciaries’ ability to document the important components of their process.

Although some of the funds may have underperformed, the court emphasized that “the test of prudence is one of conduct and not performance…” The courts and the Department of Labor have often said that fiduciaries are not judged by the results they obtain – they do not guarantee results – but their performance is measured by the steps they have taken to get there. In other words, the process followed in reaching a decision.

We believe, and the guideposts provided by the court confirm, that prudent fiduciary process is a readily attainable goal. This not only protects the plan fiduciaries, but also results in a better retirement plan for employees.

Roger J. Rovell, J.D., LL.M., President
Fiduciary Partners Retirement Group

The information contained in this document (including any attachments) is not intended by Investech Retirement Plan Services to be used, and it cannot be used, for the sole purpose of avoiding penalties under the Internal Revenue Code that may be imposed on the taxpayer.

In our view, an employer may be reluctant to reduce an existing match upon implementing automatic enrollment. There may be concerns that the reduction in the match may be viewed as a “take away” by employees. Also, some plan sponsors like the idea of rewarding employees for participating in a savings program. Also, in many cases, the match is viewed as an effective benefit for recruiting and retaining employees.

Even though auto enrollment will increase overall participation in retirement plans that provide only a non-contingent/nonelective contribution, there may be additional pressure for employees to opt-out of automatic enrollment. The concern seems to be that employees might feel adequately funded as a result of receiving the employer’s contribution and consequently believe there is no need to contribute their own pay to the plan. This reaction is known as “income effect.”

Depending on the demographics of the employee base, employers may decide to add a few (and just a few) specialized choices to their core offerings. Companies should not offer too many eclectic or trendy choices, because they often fail to perform well in retirement plans, which can have time horizons as long as 40 years. Specialty funds, such as real estate investment trust (REIT) funds, can be especially problematic for employees who are unsophisticated investors and who may place a significant percentage of their total plan account balance in the REIT or other specialty fund.

Even though a lifecycle fund, such as a target retirement date fund, can simplify an employee’s investment decisions, participant education is still necessary. For example, while some plan participants may want to allocate some of their investment dollars to a target retirement date fund and spread the rest around, the blended nature of a target retirement date fund may cause an employee to end up overexposed to certain parts of the market. Employers should therefore encourage participants to either put all of their 401(k) dollars into a lifecycle fund or avoid the category entirely. In other words, this should be an all-or-nothing proposition.
Some employees will also mistakenly choose multiple target retirement date funds such as a 2020 fund, a 2030 fund, and a 2040 fund, in the mistaken belief that doing so is similar to choosing a mix of stock and bond funds and will thus yield better diversification. This is another indicator that education is necessary.

Roger J. Rovell
President

The lawsuits allege that the defendants breached their fiduciary duties of loyalty and care under the Employee Retirement Income Security Act (ERISA) by subjecting the plan participants to excessive fees and expenses, which reduced the participants’ account balances, and by failing to inform plan participants of the fees. It is alleged that the excessive fees were incurred because the plan fiduciaries failed to, among other things, identify all the direct and indirect fees paid to service providers, evaluate the fees against services received, and monitor the amount of the fees.

The defendant plan sponsors in these lawsuits are very large employers; however, the legal theories in the cases could apply to most 401(k) plans. The lawsuits are hitting closer to home than most PEOs would like. Litigation firms representing plaintiffs are currently soliciting claims from participants via postings on their Web sites, including participants in a retirement plan arrangement maintained by a large PEO.

The allegations in the lawsuits are very broad and may not consider all the factors that affect plan expenses. The plan fiduciaries being sued may have acted in accordance with ERISA’s fiduciary requirements and the plan participants may have been well served. Filing a complaint is not the same as surviving a defense in a lawsuit or surviving an appeal. Even so, this wave of 401(k) fee litigation is significant and should serve as a wake-up call to PEOs regarding the importance of ERISA fiduciary best practices.

The lawsuits may be seen as a predictable outgrowth of the increased public and regulatory interest in 401(k) plan fees and expenses over the past decade. The U.S. Department of Labor (DOL) has long been concerned with the effect of fees that are deducted from a participant’s account balance. A DOL publication for participants provides as follows: “Assume that you are an employee with 35 years until retirement and a current 401(k) account balance of $25,000. If returns on investment in your account over the next 35 years average 7 percent and fees and expenses reduce your average returns by .5 percent, your account balance will grow to $227,000 at retirement, even if there are no further contributions to your
account. If fees and expenses are 1.5 percent, however, your account balance will grow to only $163,000. The 1 percent difference in fees and expenses will reduce your account balance at retirement by 28 percent.”

Even at the time of this writing, Congress is holding hearings on 401(k) fees and expenses.

This article will review relevant ERISA fiduciary responsibilities, common fee structures used by 401(k) plans, including PEO-sponsored multiple employer plans (MEPs), and provide recommendations for PEOs to protect themselves from alleged breaches of fiduciary duty.

401(k) Fee Structures

Some view the lawsuits as an attack on the asset-based fee structures employed by many 401(k) plans, such as the revenue sharing arrangements between plans, mutual funds, insurance companies, and plan service providers. Lawsuits have also been filed against investment vendors (i.e., insurance and mutual funds companies) challenging their 401(k) fee structures.

“Revenue sharing” is a broad term used to describe indirect payments (i.e., not paid directly by the plan) to plan service providers by third parties such as mutual funds and insurance companies. In many cases, revenue sharing payments made to service providers are derived from expenses embedded in the plan’s investment options. Other types of “revenue sharing” include finder’s fees paid to brokers and other service providers by some mutual fund companies for the placement of
money in their investments. Finder’s fees can be an attractive revenue sharing vehicle for service providers because the fund family, not the plan, pays them. Unfortunately, plans sometimes unknowingly permit finder’s fees to be retained by a broker or other service provider who has failed to disclose the fee. Plan fiduciaries should be aware of any finder’s fees and should take the position that such fees belong to the plan.

The vast majority of plan sponsors do not know the actual cost of running their 401(k) plans. However, a fiduciary is obligated to understand and analyze plan fees and expenses. Understanding total plan expenses is not sufficient; the fiduciary must also understand the fees paid to service providers and evaluate the services provided to the plan. The fees and expenses include direct payments and the hidden, or indirect “revenue sharing” payments, such as finder’s fees, fees paid from mutual fund expense ratios (e.g., 12b-1 fees and sub-transfer agency fees), and float income. A fiduciary who fails to understand 401(k) fees and expenses, as well as the actual compensation received by the parties servicing the plan, is open to allegations of a breach of fiduciary duty.

Many plan sponsors, including PEO sponsors of MEPs, have shifted most, if not all, plan costs to their 401(k) plans. In the case of PEO MEPs, cost shifting to a plan is generally accomplished by all or a combination of the following fee arrangements:

Asset charge

This is an asset-based fee paid from participants’ accounts to compensate the third party administrator (TPA), record keeper, broker, consultant, etc. The fee is usually expressed in basis points, with each basis point representing a fraction of a percent. For example, an 80 basis point asset charge would be expressed as .80 percent. One hundred basis points would be a 1 percent annual charge on participants’ accounts. In some PEO MEPs, the asset charge varies by adopting employer, depending upon the amount of plan assets attributable to the adopting employer. In other cases, the asset charge does not vary by adopter and is based upon total plan assets. In some PEO MEPs, there is no asset charge. When this occurs, the fees for servicing the plan are generally derived from the fund expenses (described below.)

Fund expenses

The fund expenses, also expressed as basis points, are asset-based fees embedded within the mutual fund options offered under the plan. These fees include so-called “12b-1” fees and sub-transfer agency fees. A fund’s expenses or fees are referred to as the fund’s “expense ratio.” It stands to reason that expense ratios will vary for different mutual funds (e.g., an actively managed fund will be costlier to operate than an index fund). However, mutual funds frequently offer multiple share classes of the same fund with different expense ratios. A mutual fund may offer a “retail” class of shares that has an expense ratio of 125 basis points (i.e., 1.25 percent in annual fees), with 40 basis points paid to the fund’s investment manager and 85 basis points paid as “revenue sharing” to the plan’s broker, TPA, record keeper, and/or other service providers. The exact same mutual fund may offer an “institutional” class of shares with 40 basis
points paid to the investment manager, with no revenue sharing paid to service providers.

Per participant fees

This fixed fee is generally deducted from each participant’s account balance through the year and is used to pay administrative costs. This fee generally ranges from $20 to $45 per year per participant. Some PEO MEP sponsors and adopting
worksite employers mistakenly view a PEO MEP as “free” when all plan costs are paid to service providers indirectly as a percentage of fund returns rather than as a direct separate charge to the plan sponsor or participants. In any case, with plan costs borne by participants, some might assert that plan fiduciaries should be even more vigilant with regard to understanding plan fees and determining whether such fees are “reasonable.”

What is a Reasonable Fee?

Plan fiduciaries have a duty to pay only “reasonable” fees and there is no defined standard for what constitutes a “reasonable” fee. It should be stated that the least expensive alternative might not be what is best for a retirement plan. The DOL has stated that service quality is a factor that should be taken into account in determining whether plan fees are reasonable.

Single-employer plan fees can usually be benchmarked against plans with similar characteristics to determine if the fees are reasonable. However, determining the appropriate benchmark for PEO MEPs is more difficult. For starters, there are only a small number of service providers in the PEO MEP marketplace. Further, should a PEO MEP be benchmarked only against other PEO MEPs, or should a PEO MEP also be benchmarked against similarly sized single-employer plans? While the latter comparison may not seem fair given the complexity of a PEO MEP, a plaintiff in a lawsuit might assert that this comparison is appropriate.

Another possible benchmark might compare MEP costs incurred by each adopting worksite employer to the 401(k) costs an adopter might obtain in the open marketplace. This comparison would vary depending upon several factors, such as the work-site employer’s size, plan assets, etc.

What Can PEO MEP Sponsors Do to Protect Themselves?

PEO MEP sponsors should consider the following steps, which represent prudent fiduciary “best practices,” to protect themselves from potential lawsuits:

• Avoid transactions with vendors who refuse to disclose the amount and sources of all fees and compensation received in connection with the plan.
• Determine annually how much the PEO, the MEP, and the participants are paying in fees and expenses. Service providers should provide annually in writing a complete breakdown in exact dollar terms of the fees and expenses (including any “hidden” fees, such as finder’s fees and float income) that are being charged.
• For each investment option, obtain information on fees and any revenue sharing arrangements. Determine the availability of other mutual funds or share classes within a mutual fund with lower revenue sharing arrangements (i.e., lower expense ratios) prior to selecting an investment option.
• Review fee arrangements and investment alternatives regularly. According to the DOL, a fee arrangement that is best for a new plan with a smaller asset pool may not be the best arrangement for the same plan a few years later when asset values have grown, either through increased participation, merger with other plans, or market upturn. A fiduciary should be able to identify an opportunity to negotiate a better fee structure.
• Be aware that with asset-based fees, fees can grow as the size of the asset pool grows, regardless of whether any additional services are provided; as a result, asset-based fees should be closely monitored.
• Consider hiring an independent (i.e., not tied to or receiving fees from the investment vendor, TPA, etc.) consulting firm to analyze and compare the amount of fees and expenses paid by the plan and its participants to other plans having similar attributes.
• Provide participants with clear information regarding total plan fees. The lawsuits allege that participants must be provided detailed information regarding revenue sharing; however, this is an open issue. The DOL may require detailed disclosure in the future.
• Document the process that plan fiduciaries followed to analyze/monitor fees and ensure that the fees are reasonable.
• Identify all fiduciaries, allocate fiduciary authority to the appropriate persons, and establish a committee to oversee the plan.
• Implement, follow, and periodically review the plan’s investment policy statement.

Conclusion

With the increased scrutiny of 401(k) fees by lawmakers, regulators, the press, and plan participants, along with the new wave of 401(k) fee litigation, PEO plan sponsors should pay serious attention to fiduciary best practices. This would include a detailed understanding of all plan fees and expenses and thorough documentation of the process used to monitor fees and expenses. Plan sponsors who engage in this “prudent process” are far less likely to be deemed in breach of their fiduciary duties under ERISA.

REPRODUCED WITH PERMISSION OF THE NATIONAL ASSOCIATION OF PROFESSIONAL EMPLOYER ORGANIZATIONS
PEO INSIDER | MAY 2007