A Primer On Qualified Default Investment Alternative Consulting

By Herbert A. Whitehouse. Mr. Whitehouse is Chief Fiduciary Officer at The Bogdahn Group of Orlando, FL. He can be reached at 407.246.7221 or herbw AT bogdahnconsulting.com.

It used to be that a participant's failure to make a decision to participate in an individual account plan, whether involving a failure to decide whether to contribute to the plan, how much to contribute, or where to invest contributions, was simply treated as not having made a decision to participate.

In 2006, however, a new section was added to the Employee Retirement Income Security Act of 1974 (ERISA) by § 624 (a) of the Pension Protection Act (PPA). This new ERISA section does not require that a plan accept monies from participants without an accompanying investment direction from the participant. However, § 404(c)(5)(A) provides that a participant in an individual account plan will still be treated as exercising control over the assets in his or her account if: (1) the participant does not submit an investment election; (2) the plan meets all the notice requirements in § 404(c)(5)(B); and (3) the plan invests the participant's account in accordance with default investment regulations issued by the Secretary of Labor.

The PPA requires the DOL to promulgate regulations providing guidance on the appropriateness of default investments that include a mix of asset classes consistent with (i) capital preservation, or (ii) long-term capital appreciation, or (iii) a blend of both capital preservation and long-term capital appreciation. Clearly, this new ERISA section permits default investment portfolios that are primarily composed of very conservative investments, including stable value or GIC type assets.

What has made the proposed regulations controversial, however, is that they appear to contradict the spirit of ERISA by excluding default investments if they are exclusively composed of stable value or GIC investments. This is controversial because the most prudent short term investment is almost always a very low risk and low volatility investment. Imagine, for example, the spouse of a participant in a plan with a company stock fund. The company is real - a Bogdahn Consulting client - and the company is being acquired this summer.

An important question for the plan fiduciary, and for our consulting, is whether the cash purchase price should be moved to one of the three types of "qualified" default alternatives for a participant who does not make his or her own elections. The fiduciaries of this plan very prudently considered what would happen if they defaulted the retirement savings of the recent widow of a participant who did not make an election to direct the investment of the cash purchase price.

The widow may have not made this election precisely because of the confusion and disruption of her husband's death, even though the husband had intended to move the monies into the stable value fund in preparation for his immediate retirement. The fiduciary decision was to keep the monies in a stable value investment until the end of the year. This period of time would allow the fiduciaries to contact every participant who did not make an election, and ensure that the failure to make an election was a conscious and deliberate choice. What is significant about the fiduciary analysis here, and about our consulting, was that it was clear that it would be contrary to the best interests of participants to adopt a default that conformed to the Department of Labor proposed regulations.

Some Perspective on the Regulations Themselves

To be fair, the proposed regulations do expressly state, consistent with the Department of Labor's long standing position, that it is the fiduciary who determines what default investment is prudent for defaulting participants.

Not adopting a "qualified" option is not being imprudent. In fact, as the illustration above suggests, a prudent fiduciary may have to use a default other than, or in some combination with, the "qualified" alternatives in order to act in the best interest of participants. The real problem with the proposed regulations is that a fiduciary who is guided by these regulations (should they become final) but who also wants to act in the best of interest of participants, will fear, because of the way that the regulations were drafted, the loss of the very liability protection that Congress intended to provide this fiduciary.

Given that every fiduciary always has an obligation to consider what investment options are best for defaulting participants, will a fiduciary be relieved of liability for choosing a "qualified" default investment alternative (QDIA) that is not in the best interest of defaulting participants. No. Only very casual fiduciaries (or consultants) who misunderstand the role of these regulations will take the position that a qualified default is per se prudent when a diligent and skilled fiduciary, familiar with such matters, would have determined for this particular plan that the alternative was not in the best interest of defaulting participants.

Still, with the Pension Protection Act's addition of §404(c)(5) to ERISA, more plan sponsor's are considering something called automatic enrollment. And where a plan does have an automatic enrollment feature, the plan fiduciary will wish to use default investments that allow for preemption of state wage withholding laws under ERISA § 514 (e). In general, however, the fiduciary who attempts to gain a fiduciary liability reduction by using a "qualified" default without first determining that the investment alternative is best for defaulting participants will increase rather than decrease his or her fiduciary liability risk.

For example, consider the evaluation of the Board of Trustees at one of our clients in the Midwest. The question was whether a managed account would be an appropriate default option. The common sense evaluation was, of course, that the value provided to participants from managed accounts comes from the information provided by the participant on risk tolerances, outside assets, time horizons, etc. The Board of Trustees made the very appropriate observation that having defaulting participants pay for this managed account service would not make much sense. They did not expect the very participants who did not even make an investment election to also go online and provide all this other information.

Now where the cost of the managed account default is charged to the plan as a whole, the decision to use a managed account as a default may be justified under ERISA fiduciary standards. In fact, The Bogdahn Group advises a nationally know company that does just that, using an Ibbotson advice and managed account approach.

Of course, today we don't know what investments options will be qualified, except through the haze of controversial proposed regulations. Moreover, even if the three options in the proposed regulations were to be the only options that remain as "qualified", there is almost an infinite range of actual approaches for implementing each option. The appropriate skew toward capital preservation or long term appreciation is each age-based target fund asset allocation or in a managed account is never going to be - or never should be -- specified in any DOL regulations.

Similarly, the skill of the investment manager implementing the option, and the cost of investment management must also be considered by a diligent and prudent fiduciary. A fiduciary whose investment consulting firm suggests that choosing an alternative in the final QDIA regulations will provide the fiduciary with a "Get Out of ERISA Jail Free" card on its many default decisions is being too simplistic about the role of these regulations.

First of all, except for its value in preempting state wage withholding laws that give employees control over their paychecks, ERISA §404(c)(5) is not intended to encourage or favor fiduciary decision making over participant decision making. In fact, this new ERISA section only matters to plans that actually "walk the walk" of giving participants control over investment decisions. §404(c)(5) only helps to confirm the common sense position that the defaulting participant can be considered to have control when he or she has full opportunity, and notice, prior to the any default to actually make investment decisions, and complete freedom to change the default decision at any time.

Secondly, this new ERISA section does not determine the range of prudent default investment options. For example, plans that offer a single balanced investment portfolio for all employees will not be concerned with choosing among qualified default alternatives because these plans do not give participants investment control. But this does not make the balanced portfolio imprudent. Even where participants do have investment control, there is no requirement that a fiduciary make contributions when a participant chooses not to direct the investment of those contributions. It is very common for plan fiduciaries to require participants to make elections as to the amount of the contribution that they wish to make and where they wish to invest those contributions before these monies go into the plan.

Furthermore, even if ERISA §404(c)(5) were to tell a fiduciary the prudent asset allocation (including the percentage to be invested in stable value or other low risk investments) under qualified age-based target funds, this new ERISA section does not suggest that a higher percentage stable value, annuity, or guaranteed investment is not a prudent choice for all or certain groups of defaulting participants. Moreover, despite talk to the contrary by certain DOL staff, even where a fiduciary decides on a "qualified" default investment, it is simply absurd to conclude that the fiduciary could act in accordance with his or duties under ERISA by deciding on a particular "qualified" investment alternative while also concluding that the "qualified" alternative selected was not in the best interest of participants.

A fiduciary has an obligation to consider what default arrangement, if any, is best for participants, regardless of whether that arrangement is classified as a "qualified" default option. ERISA §404(c)(5) has a much narrower scope than some consultants attribute to it. The purpose of this new ERISA section is so that participant failures to make an investment decision can now be treated as a decision on where to invest for purposes of the kind of protection that fiduciaries seek from Section 404(c) in carrying out the investment directions of plan participants.

Settlor Question

The guidance provided by final QDIA regulations will be important to any fiduciary of a plan that auto-enrolls participants; viz., automatically makes contributions for, and/or requiring contributions from, eligible employees. Fiduciaries need to recognize, however, that automatic enrollment itself is not a fiduciary decision. It is primarily a business decision with very significant cost implications. However strong the fiduciary's vision of full participation and adequate retirement benefits for all participants, this vision is one that lies outside of the sphere of fiduciary decision making.

Automatic enrollment and automatic escalation of employee contributions may increase retirement security, but there is usually a significant cost for these actions. Moreover, recent research shows that a voluntary approach will tend to direct employer matching monies at more productive employees.

Employees who are more optimistic about their long term future at a company tend to participate, and at levels that maximize the company match. And since these employees also tend to be more productive, the company that does not impose automatic enrollment and escalating contributions not only spends less on the plan, but the money that it does spend is directed toward more productive employees.

Stable Value Funds and the General Obligations of a Fiduciary

Any fiduciary needs to be cautious about accepting the advice of a consultant that recommends defaults based on the proposed regulations without working with the fiduciary to understand what kind of investment approach best serves the needs of the participants. The best consultant will work to provide context and perspective for plan fiduciaries, and to organize the knowledge and insights of plan fiduciaries. And a good consultant will understand the roles that ERISA and its implementing regulations.

But fiduciary advice that comes from the perspective that the QDIA regulations constrain what is best for participants misses the core of valuable QDIA consulting. This seems to be especially true of fiduciary investment advice that does not consider the important role of stable value and equivalent low risk investments. Stable value or equivalent investments, at least in the short term, will often be the most prudent option for a participant. And even where a 100% stable value asset might not be the best investment for the next thirty years, the initial impact weighting of any default investment is always in the first month or year and not on the 360th month or 30th year. Lawyers, or consultants who play lawyers on television, will often be the least valuable consultant for a field that is centered on fiduciary judgment, and on the fiduciary's knowledge of his or plan and participants.

Investment consulting advice that does not consider the role of stable value and other low volatility investment approaches simply because those particular assets are not included a regulatory legal list will not help a fiduciary to make prudent decisions in this area. A prudent fiduciary will engage in a deliberate evaluation process that considers both:

a) the appropriate type of short term and long term default; and

b) the specific design, asset allocation, cost, and management of any default option.

The essence of prudence here means examining the cost of alternative default investment options relative to the benefits that these options provide. Fiduciaries and fiduciary consultants also need to begin working with plan record keepers to create model portfolio default approaches that may start out with a 90 -- 100% stable value allocation; but move toward a more balanced allocation over time.

Target Funds

Target funds have the advantage of simplicity. Perhaps that is why they have been described as both "simple minded" (Sortino) and "too simple" (Bodie). Target funds drive asset allocation off a single variable -- the age of the participant. Significant finance theory (Samuelson and Merton) suggests that a diligent fiduciary will have a skeptical view toward the idea that asset allocations driven by age alone serve the interests of most plan participants.

Most fiduciaries need the assistance of a sophisticated consultant to either evaluate or design age-based target funds.

Managed Account Target Funds

There is an odd aspect to how the proposed regulations treat a managed account default alternative. The regulations reasonably contemplate that defaulting participants will not provide the information that is normally provided in a managed account. Because of this, the definition of a managed account in the regulations is essentially that of a target fund - one in which the asset allocation is exclusively based on age -- except that the "managed account target fund" is restricted to the investments that are otherwise available as investment options in the plan. In other words, if the proposed regulations stay as is, managed accounts that are not built using the plan's investment options can not be a "qualified" default option.

Balanced Funds

Balanced funds may provide a very good fit with the risk based asset allocation education and investment advice that is now being provided by many plans. However, the proposed regulations provide that a balanced fund must be appropriate for the participants in the plan as a whole. This will may not be an appropriate fiduciary standard.

If most participants are not defaulting, and if the characteristics of non-defaulting participants are significantly different for the characteristics of defaulting participants, the standard of the proposed regulations may result in the application of a default that is generally appropriate for participants who are not defaulting, and generally inappropriate for the participants who do default.

Conclusion

Fiduciaries will benefit the most from using fiduciary consultants that can put this new QDIA opportunity into the context of what is best for participants. This answer will not be a one size fits all approach. In fact, a significant part of the QDIA answer for any particular plan should come from the fit that the default approach has with the plan's overall approach for helping participants to optimize portfolios for meeting their individual objectives.

A plan that provides model portfolios and has investment education and advice services focused on how to use those models will probably want a default approach that fits into this overall picture. In this situation, a balanced model portfolio might be used as the default. As mentioned earlier, a plan that used investment advice and managed accounts to help participants with the task of getting into the right optimized portfolio may use a default that is consistent with this overall approach. The same overall approach may make sense for a plan that uses age-based target funds, or a customized modification to this concept such as that provided by ProManage.

There is a strain of investment and fiduciary consulting out there that likes the implied skew of the proposed regulations away from asset mixes directed as preservation of principle and toward asset mixes that tilt toward capital appreciation. Some of these consultants even believe that the QDIA regulations are an important tool for changing the overall portfolio approach of all fiduciaries in all plans. But this view has the tail wagging the dog. The QDIA regulations should not drive the overall approach that a fiduciary uses to assist participants in connecting optimized portfolios with their individual objectives and risk tolerance. Instead, that overall approach, one that fiduciaries will have approached differently in different plans, is an important consideration in determining the appropriate approach to default investments.

In any case, neither ERISA nor the DOL regulations should be interpreted as providing a legal list of prudent investments. There is nothing in ERISA or even the proposed DOL QDIA regulations that should be seen as constraining the obligation of a fiduciary consider, design, or adopt default alternatives that address both the short and long term interests of a plan's defaulting participants.

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