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How QDIAs Have Changed the Fiduciary Role of 401k Plan Sponsors

How QDIAs Have Changed the Fiduciary Role of 401k Plan Sponsors
March 12
00:02 2019

Target date funds are the fastest growing segment on the 401k investment menu. In the more than ten years since they’ve become a default staple in 401k plans, target date funds have certainly changed the retirement prospects for employees. How have these investment vehicles changed the roles, responsibilities, and even the fiduciary liability of the plan sponsor?

While they’ve been around much longer, the real boost to target date funds came from a major piece of retirement plan legislation in the middle of the first decade of the new millennium. “The Pension Protection Act (PPA) of 2006 included a ‘safe harbor’ provision for employers that designate a Qualified Default Investment Alternative (QDIA) as the default investment within their qualified plan,” says Matthew Zokai, Senior Advisor Retirement Services at 1st Global in the Dallas/Fort Worth Area. “In this law, plan Sponsors are essentially granted fiduciary defense as long as they select a QDIA compliant default investment option. Target Date funds are one of three approved QDIA options (Target Date, Balanced Fund or Managed Account)”

The PPA immediately became a game changer for retirement savers. “Sadly, before the QDIA safe harbor was established,” says Joshua Escalante Troesh, President of Purposeful Strategic Partners in Alta Loma, California, “the default option was a money market fund because it was the only option which didn’t create a major liability for the plan sponsor; and the money market fund then was the most popular investment. This left employees with retirement funds which were insufficient to fund their retirement, because the returns often didn’t even keep up with inflation. The QDIA has allowed plan sponsors to provide employees with a default option which more closely resembles a portfolio which is appropriate to the employee.”

While the 2006 PPA permitted the plan sponsor to select from three different QDIA option, the target date fund – or “TDF” – quickly became the most popular choice. “Many Plan Sponsors now use Target Date funds as the QDIA within their plan,” says Zokai. “A QDIA acts as the default investment if a participant fails to make an affirmative investment election. Many providers will default a participant into the designated QDIA based on their birthday in the recordkeeping system. This not only provides the plan sponsor relief from fiduciary liability but also ensures the participant has a long-term retirement saving strategy regardless of their engagement.”

The TDF also became popular with plan participants because it made choices easier and more obvious. “Most people lack the education and thus confidence to make specific investment decisions,” says Michael Tanney, Managing Director of New York City based Wanderlust Wealth Management. “Therefore, a target date fund removes the need to be afraid and take the simpler glide path to their retirement age, trusting the underlying investment manager to allocate properly along their professional journey.”

Not only was the decision easier, but there was greater comfort in that decision. “Target date funds take the guesswork out of investing by offering participants a professionally managed solution that addresses asset allocation and diversification while automatically adjusting to a more conservative allocation over time,” says Zokai. “All a participant must know in order to invest in a target date fund is their birthday. Ease of use and understanding are the driving forces behind the popularity of these funds.”

Many retirement savers would prefer to think about things other than retirement. They’re attracted to a “set-it-and-forget-it” option that, until the 2006 PPA, plan sponsors simply couldn’t offer without taking on undue fiduciary liability. “Target date funds address a problem that has long plagued 401k plan sponsors: How to identify appropriate investment options for the participants who take a ‘hands off’ approach to investing,” says Robin Solomon, an attorney in the Benefits and Compensation practice of Ivins, Phillips & Barker, in Washington DC. “With a target date fund, the participant’s account is allocated between asset classes (such as equities and fixed income) based on the participant’s projected retirement date. As a result, the account of a younger participant would be invested heavily in equities – which offer more growth – while the account of an older participant would be split between equities and fixed income options, which present less risk. This asset allocation adjusts automatically over time as the participant approaches retirement age.”

The real power behind the QDIA lay in its allowance for plan sponsors to adopt the “opt-out” default policy of automatically enrolling employees into the retirement plan. “Sponsors now have more confidence to implement auto enrollment knowing participants have professionally allocated investments,” says Rick Skelly, Client Executive Service at Marsh McLennan Agency in San Diego, California. “In addition, they have protection under ERISA (QDIA) rules against market losses if participant communication requirements are met. TDF funds’ popularity is centered on the ability for participants to have a well-diversified professionally managed option without having to become an investment expert. Whether participants select the fund or are defaulted as a result of auto enrollment, it has simplified the investment decision piece of the entire enrollment process.”

TDFs offered the kind of sound-bite simplicity the average employee could sink his teeth into. “Target date funds have become incredibly popular with 401k plan participants because the funds offer a good investment return, with an asset allocation calibrated based on the participant’s age,” says Solomon.

Troesh adds, “The target date fund has become so popular simply because a 401k participant doesn’t have to do anything to invest in it; the relevant target date is pre-selected as the default option. Concern over making the wrong choice, confusion about what the investment options mean, need to focus on their career, and business with life outside of work all contribute to participants leaving the default option and simply moving on with life.”

It’s hard to argue with the attraction to target date funds – for both the plan sponsor as well as the plan participant. “TDFs have become popular for several reasons,” says John C. Hughes, an ERISA/benefits attorney at Hawley Troxell in Boise, Idaho. “For both plan sponsors and plan participants, they are popular due in large part to their simplicity. It is easy for plan sponsors to add it to their investment option menus without having to attempt to customize a broad and balanced spectrum of individual funds. It also is easier for participants to choose a TDF instead of seeking professional advice, using an online tool, or deciding themselves how to appropriately diversify their investment selections. It is an attractive set it and forget it proposition.”

That simplicity may appear to make life easier for the 401k plan sponsor – maybe too simple. Tanney says, “I think of that song by Carrie Underwood ‘Jesus take the wheel.’ That’s what the plan sponsors are allowed to do with target date and thus lessen their need for oversight.”

On the face of it, given the added protections built into the 2006 PPA, placing a TDF onto the investment menu does offer advantages to the plan sponsor. “When selecting a default fund, plan fiduciaries struggle to balance the need for capital preservation with the desire for asset growth,” says Solomon. “Target date funds offer a middle ground between conservative investments (e.g., money market and stable value funds) and growth investments (e.g., equities). The selection of a target date fund as the default investment may reduce the risk that plan fiduciaries would be charged with breaching their fiduciary duties by selecting a default fund that is either too conservative or too aggressive.”

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While TDFs do reduce the fiduciary risk, they don’t eliminate it. “Target date funds decrease employer fiduciary liability by removing responsibility for the investment outcomes of the fund, assuming the funds are appropriately selected, and the many rules are consistently followed,” says Troesh. “What surprises many employers I talk to, however, is that they still have fiduciary liability for selecting and managing an appropriate advisor, controlling fees, providing proper disclosure, and following many other rules.”

Indeed, choosing an appropriate target date fund provider presents the same level of fiduciary liability as that of selecting any other investment option. “It is still critical that plan sponsors understand the TDFs they choose to offer,” says Hughes. “I suspect that often does not happen because the concept is so easy and comforting on a basic level.

The good news for 401k plan sponsors is the 2006 PPA has created a path for reducing fiduciary liability. “TDF funds qualify for the QDIA protection for default investments,” says Skelly. “This means participants can’t sue sponsors for market losses associated with being defaulted to these funds. The sponsor must meet certain communication requirements each year to qualify for this protection. But overall this lowers a significant risk they have as plan fiduciaries.”

In the end, though, the more things change (with the 2006 PPA), the more they remain the same. “The selection of a default investment fund in a 401k plan is a fiduciary decision,” says Solomon. “Target date funds may decrease the risk of liability for plan fiduciaries because they offer an attractive ‘Goldilocks’ option for the plan’s default investment fund.”

Perhaps there’s a greater good here. “The real game changer with the QDIA isn’t the reduced liability,” says Troesh, “it’s the fact employers can now provide a real retirement for more of their employees.”

Christopher Carosa is a keynote speaker, journalist, and the author of  401(k) Fiduciary SolutionsHey! What’s My Number? How to Improve the Odds You Will Retire in Comfort, From Cradle to Retirement: The Child IRA, and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on TwitterFacebook, and LinkedIn.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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