The Pension Protection Act (PPA) added a new section 404(c)(5) to ERISA. That section provides a fiduciary defense for default investments for participants in 401(k) plans and ERISA 403(b) plans. However, not every type of investment qualifies for the new fiduciary protection.
Before getting into the substance of this article, I need to clarify two things:
- 404(c)(5) fiduciary protection is, technically speaking, a defense; however, it is being referred to as a fiduciary safe harbor because of the protection it gives fiduciaries.
- A “default” investment is one where a participant is given the opportunity, but does not direct the investment of his account. Therefore, the fiduciaries, i.e., the plan sponsor or the committee, must invest the money for the participant—either as they decide or as directed by the plan.
The PPA directed the U.S. Department of Labor (DOL) to issue a regulation defining the types of default investments that qualify for the fiduciary safe harbor by February 17th-a few months ago. The DOL issued a proposed regulation last year, but that proposal turned out to be highly controversial and the final regulation has been delayed ... perhaps until July or August.
Notwithstanding that delay, we have a high degree of confidence that certain investments will qualify for the fiduciary safe harbor. (By the way, those investments will be called qualified default investment alternatives, or QDIAs.) Because of our confidence that the three categories of investments specified in the proposed regulation will be included in the final regulation, we recommend that plan sponsors add at least one of those three types of investments to their plans at this time and that they consider one of them for the plan’s default investment. Those three categories are:
- Age-based funds, which are commonly named after the anticipated year of retirement, like 2020 funds, 2025 funds, and so on.
- Risk-based lifestyle funds, including balanced funds.
- Managed accounts, where an investment manager agrees to act as a fiduciary to manage participant accounts.
There are two other categories of investments which are in “contention” to be included in the final regulation. Those are:
- Asset allocation models (without the requirement that they be managed by a fiduciary); and
- Stable value vehicles.
My educated guess is that the former-the asset allocation models-will be included, but that the latter—stable value-will only be allowed in a limited way, if at all. The stable value option will likely be limited or excluded because the legislative and regulatory history of ERISA says that the law’s investment principles are based on generally accepted investment theories, such as modern portfolio theory, which requires a mixture of asset classes to balance risk and return. In addition, there is a concern among investment advisers that, without some exposure to equities, participants will have little, if any, chance of achieving their retirement goals.
Of course, those are just my best guesses. In truth, the matter is uncertain.
The outcome of the fight to be included on the list is one of great importance. Most likely, the types of investments described in the final regulation will become popularly viewed as pre-approved investments—something equivalent to a governmental seal of approval. If that perception prevails, those investments are destined to capture a disproportionate share of 401(k) money. That is the case because, among other things, automatic enrolment is rapidly becoming popular and, in automatic plans, 50% to 80% of the participants may default into QDIAs.
Even though there is a delay in the issuance of the final regulation, there is no need for plan sponsors to wait. We are confident that the three non-controversial categories—age-based funds, risk-based funds, and managed accounts—are virtually certain to be included in the “pre-approved” category.