The Pension Protection Act added ERISA section 404(c)(5) to offer protection to fiduciaries who select default investments for participants. While that seems like a good idea, in and of itself, it is particularly important because of automatic enrollment ... automatically enrolled plans may experience defaults of 60%, 70% or even 80% of the participants.
As the PPA was being considered, Plan sponsors expressed their concern that automatic enrollment might be problematic if fiduciaries were not given a “safe harbor” for investing participant money where the participant failed to give directions (i.e., a participant “default”). To remove that barrier to the adoption of automatic enrollment—which Congress strongly supports—the PPA directed the Department of Labor to issue a regulation under the new section 404(c)(5) to specify the types of investments that would have, in effect, a fiduciary safe harbor. The DOL promptly issued proposed regulations which identified three types of investments:
- Age-based lifecycle funds (sometimes called target maturity funds);
- Risk-based lifestyle funds and balanced funds; and
- Managed accounts (if the fiduciary manager signs on as an ERISA 3(38) investment manager).
The proposed regulation has proven to be highly controversial. In particular, the stable value industry is aggressively challenging the fact that their product was left out. As a result, the issue has now become highly politicized—on top of the difficult investment and policy considerations.
The PPA mandated that the final regulation be issued by the Department of Labor by mid-February. However, that day has come and gone. At the LABC, a representative of the DOL would only say that the timing of the issuance of the final regulation is slipping. As a result, it is difficult to estimate—or, more accurately, to “guesstimate”—when the final regulation will be issued.
My logical mind tells me that the DOL is under considerable pressure to issue the final regulation because of the statutorily mandated time limit. On the other hand, my intuition tells me that this “hot potato” could take a while to resolve.
However, the timing should not matter to most employers. I say that for two reasons.
The first is that it seems virtually certain that the three alternatives in the proposed regulation will also be in the final regulation. As I see it, the issue is whether there will be additional categories. Based on my experience in working with employers and plan committees over the last few years—and, more recently, after the enactment of the PPA—is that plan sponsors and fiduciaries are moving away from money market accounts and stable value vehicles in any event. The concern that most employers have is that, unless there is some equity component for the default investment (that is, unless some of the money is allocated to stocks), participants have little chance of accumulating benefits at a rate that exceeds both inflation and the impact of taxes on the earnings. Between taxes and inflation, an investment would probably have to compound at 6% or more in order for the principle to grow significantly in terms of purchasing power. As a result, there is a trend among employers in favor of the three categories specified in the proposed regulation.
Secondly, ERISA’s investment principles are based on generally accepted investment theories, including modern portfolio theory. In order to comply with those theories, fiduciaries need to invest participant default money across a broad range of investment options of types that are not highly correlated with one or another. That is, fiduciaries need to invest that money in a way that balances risk and reward in a manner appropriate for long-term investing and that utilizes multiple asset classes. Based on my experience, almost all lifecycle funds, lifestyle funds and managed accounts are built on a foundation of generally accepted investment theories, such as modern portfolio theory and strategic asset allocation. By investing default money in that way, fiduciaries can be comfortable that they are satisfying ERISA’s investment rules under section 404(a) (which contains ERISA’s general fiduciary rules, including the prudent man rule). As a result, the fiduciaries should not be worried about the timing of the issuance of the final 404(c)(5) regulation—because 404(c)(5) provides a defense ... which is not needed by fiduciaries that comply with 404(a). So, while the 404(c)(5) regulation is slipping, there is no reason for plan sponsors and fiduciaries to allow their plans to slip away from prudent participant investing—even in a default situation.
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Any discussion of tax matters contained herein is not intended or written to be used, and cannot be used, for the purpose of avoiding any penalties that may be imposed under Federal tax laws.