Is the DOL safe harbor lulling fiduciaries to sleep?
One of the most transformative regulations for DC plans was the Pension Protection Act (“PPA”) of 2006. PPA defined a qualified default investment alternative (“QDIA”) and made the practice of defaulting participant contributions absent an affirmative investment election into a QDIA a fiduciary “safe harbor.” Since PPA, the QDIA has been the single biggest winner of plan assets, capturing significant dollars within target-date funds (TDFs). As illustrated in the following exhibit, DC assets in TDFs have grown from 17 percent to 28 percent1 over the past five years. This increase is primarily due to contributions into TDFs growing from 31 percent to 49 percent,2 resulting in a decrease in the average number of funds held by participants from 3.1 to 2.7.3
Going forward, we believe the importance of QDIAs will continue to grow. In fact, some are projecting that TDFs will capture more than 70 percent of participant contributions over the next five years.4 We are concerned, however, that the QDIA safe harbor might be lulling fiduciaries into a false sense of security.
Two questions fiduciaries may ask:
- What is wrong with a diversified, multi-asset investment solution that automatically reduces risk as participants approach their anticipated retirement dates?
- Are pre-packaged target-date funds the best solution?
To address the first question, we propose that nothing is fundamentally wrong with TDFs. Our concern is the negative impact this trend may have on fiduciaries’ ability to control fees. The reality is that every new dollar a pre-packaged TDF gains results in a relative decrease in the assets held in a DC plan’s core investment lineup. The extent of this change is illustrated in the following exhibit. Between the years 2012 and 2016, DC assets within the core investment lineup decreased by 11 percent while contributions to TDFs increased by 18 percent5 during that time period. The long-term impact of this trend will dramatically impair fiduciaries’ ability to control and lower investment fees for the funds offered in their DC plans’ core investment lineups.
Alternatively, by using a DC plan’s core investment lineup of funds as the building blocks for its TDFs, plan sponsors can leverage this trend to reduce the investment fees of both their TDFs and their core investment lineup. Furthermore, a custom TDF solution may allow fiduciaries to use less correlated, diversifying investment strategies that would not typically be offered within the core lineup, including risk parity, factor-based equity, and private real estate.
Unbundling the target-date fund solution
Ten years ago, fiduciaries saw the value in “unbundling” their administrative record keeping relationships to regain control over the investment selection process and how administrative service fees were assessed. A similar trend is starting to emerge for QDIAs. Fiduciaries are examining the benefits of offering a custom solution that provides greater control over how their TDFs are constructed.
Fiduciaries have been hearing about custom DC solutions for years, so many might be wondering, “Why is this opportunity different?” For one thing, technology has improved over the past decade, making custom TDF solutions more economical. In addition, the significant increase in QDIA assets has given sponsors greater leverage in developing a custom TDF solution that will benefit all their plans’ participants.
We observe that a custom TDF solution can be unbundled into the following four components:
- Asset allocation. This includes the asset classes to be incorporated in the TDF as well as putting them together in a glide path designed to meet the plan’s unique demographics and the plan sponsor’s objectives.
- Investment manager. The entities responsible for investing the custom TDF’s assets according to a specific mandate.
- Trustee/custodian. The entity responsible for packaging the custom TDF solution by striking a daily NAV (net asset value) for each fund.
- Record-keeper. The company responsible for providing participants the daily NAV, along with education and communication materials regarding the custom TDF solution.
Where a record-keeper has already been engaged, a fiduciary has only three components to evaluate for its custom TDF solution. Based upon our experience, fiduciaries typically leverage an investment consultant to design the asset allocation and select the investment managers. In addition to reducing fees, fiduciaries are able to simplify the ongoing monitoring process by using the existing core lineup of funds within the custom TDF solution. But the trustee/custodian is the factor that often stalls a custom TDF solution from moving forward. This is primarily due to trustee services being offered through a record keeping relationship where fees are bundled into an investment’s expense ratio or a plan’s administrative record keeping fees (“bundled trustee”).
Our experience has shown that most bundled trustees have the capabilities to support a custom TDF solution and are willing to expand their service offering for an additional fee. This is analogous to when sponsors unbundle their recordkeeping fees. Whether a sponsor chooses to use its existing bundled trustee or engages an independent trustee/ custodian, these fees simply become another negotiable administrative cost.
A special note for 403(b) plans: Retirement plans established for certain tax-exempt organizations under Section 403(b) of the Internal Revenue Code are not eligible to invest in collective investment trusts. As a result, a trustee/custodian is prohibited from striking a net asset value (NAV) for a custom TDF solution. However, 403(b) plan fiduciaries may be able to leverage their record-keeper’s model portfolio service to create a custom TDF solution. As described earlier, this solution utilizes a plan’s core investment lineup for the QDIA. The difference is that participants see their allocation to each underlying fund, as opposed to a single custom TDF solution. Implementing a custom asset allocation in this way removes the complexity of a trustee/custodian. It also provides the 403(b) plan fiduciary with a mechanism to control the fees of its QDIA and core investment lineup. We are even seeing this method as a way to offer an in-plan retirement income solution. Under this approach, participants have more flexibility when selecting distribution options, because they can direct which holdings will be used to fund their retirement checks.
Fiduciaries have been hearing about custom DC solutions for years, so many might be wondering, ‘Why is this opportunity different?’ For one thing, technology has improved over the past decade, making custom TDF solutions more economical.
Why does all of this matter?
As fiduciaries become better educated about QDIAs and custom TDF solutions, they are beginning to incorporate investment practices that have traditionally been limited to other asset pools (e.g., public and corporate DB plans, endowments, and insurance programs). For example, we are seeing fiduciaries incorporate the following into their custom TDF solutions:
- Changing the shape of a QDIA’s glide path to accommodate a structured defined benefit series of lifetime income payments.
- Using alternative investments commonly found in endowments and pension plans (e.g., risk parity, private real estate, and bank loans) to improve risk-adjusted performance.
- Embracing guaranteed fixed annuities to provide participants with an opportunity to generate sustainable retirement income.
We believe the more fiduciaries understand that they are already monitoring many of the key components of a custom TDF solution, the less daunting the idea of implementing a custom TDF solution becomes.
1 Vanguard: 2017 How America Saves
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