Many of ERISA’s investment rules for 401(k) plans are based on the securities laws, rather than fiduciary principles. That is because, by and large, the DoL has incorporated securities law concepts into its guidance, and the difference is meaningful. The securities laws generally rely on disclosure to accomplish their purposes; for example, mutual fund purchasers are provided with prospectuses. While most observers agree that prospectuses provide little of the information that investors in mutual funds really need to make informed decisions, the SEC has determined that, for legal purposes, the disclosures are all that is required. On the other hand, ERISA imposes significant responsibilities on fiduciaries to oversee the operation of their 401(k) plans for the benefit of participants. One regime is based on disclosure, and the other is a form of benevolent paternalism—very different animals indeed!

However, the time for change has come. Let me explain.

The SEC provides guidance for investors who are, for the most part, engaged in, and knowledgeable about, investing in mutual funds. For investors who use the services of an adviser, the SEC guidance provides information for the adviser and investor to review. In reality though, advisers and knowledgeable investors use information and tools that are much more sophisticated and meaningful than government-required disclosures.

On the other hand, the DoL serves two constituencies. The primary concern of the DoL is to protect the interests of participants. Most observers believe that the typical 401(k) participant is not engaged in, or knowledgeable about, investing. Because of that lack of sophistication, 401(k) plans and participants have adopted target-date funds (TDFs) (and other portfolio “solutions” for investing) much faster than individual investors. That is because TDFs are a solution for the lack of investment knowledge of participants, who generally do not have access to individualized one-on-one advice.

As a practical matter, the DoL also has a second constituency—plan sponsors in their roles as fiduciaries. As fiduciaries, plan sponsors must prudently select and monitor the investments that are offered to the participants, including TDFs. So, as a legal matter, while the DoL protects the interests of the participants, as a practical matter, the DoL can better accomplish that objective by educating plan sponsors about their fiduciary responsibilities and about how to fulfill those responsibilities.

Since target-date funds have become the most popular new investment for participants—both by choice and as a default—the starting point for the DoL is to communicate clearly with plan sponsors and fiduciaries about its expectations concerning the selection and monitoring of TDFs.

The DOL clearly is interested in that issue. On June 18, 2009, the DoL and SEC held hearings on TDFs, focusing on the following four questions:

  1. How do TDF managers determine asset allocations and changes to asset allocations (including glide paths) over the course of a TDF’s operation?
  2. How do they select and monitor the underlying investments?
  3. How are the foregoing, and related risks, disclosed to investors (that is, plan fiduciaries and participants)?
  4. What are the approaches or factors used by fiduciaries (and their advisers) for comparing and evaluating TDFs?
    It seems obvious to me that, if the regulatory agencies believe these are the most important questions to ask about TDFs, then they are also important questions for plan sponsors, as fiduciaries, to ask and get answers to.

While a prudent process requires more than the answers to these four questions, they are a good starting point. With the help of an adviser, committee members can prudently evaluate those answers, identify the other issues for evaluation (like costs and the quality of the investments in the TDFs), obtain the appropriate information to evaluate those issues, and reach the outcome of any prudent process: an informed and reasoned decision.

Disclaimer Required by IRS Rules of Practice:

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.

Leave Drinker Biddle to Learn More