Let’s begin with a simple QDIA multiple-choice quiz.
As a plan fiduciary, you are most at risk of legal action if your QDIA:
- Ranks poorly in return comparisons over the last few years
- Has higher than average fees; or
- Doesn’t align with participant demographics
If you chose “C” as the correct answer, then well done! You don’t have to read any further. Unfortunately, many plan sponsors, abetted by their consultants and advisors, still act as if the first two choices are paramount despite Department of Labor (DOL) guidance on this topic. So, if you find yourself thinking that fees or returns are your biggest legal risk, then you owe it to yourself and your participants to read on.
The process of identifying an appropriately qualified default investment alternative (QDIA) for your plan has certainly evolved over the years. We’ve come a long way from the days of money market funds or company stock as the mainstay in defined contribution (DC) plans. Overly conservative or highly concentrated, risky investments aren’t considered appropriate investments for a defaulted DC plan participant.
Modern portfolio theory* and the concept of diversification have rightly led us to a variety of investment strategies that offer more prudent paths to a successful retirement outcome. Chief among these vehicles are target-date funds (TDFs). TDFs are professionally managed, diversified strategies that adjust the asset allocation and risk posture of the portfolio as the participant nears the retirement “target date.” These vehicles are now the dominant QDIA with over $3 trillion** in assets under management across the industry.
All TDFs seek to do one thing: Minimize longevity risk (the risk of outliving one’s wealth). But the risk of running out of money in retirement isn’t an easy problem to solve, even for a single individual. In fact, it’s a complex mathematical/financial problem with no single optimal solution. The degree of difficulty increases further when we try to solve this calculus across all members of a DC plan. Reflecting this reality, there are many valid approaches to target-date design. No one option or approach can lay claim to being the “best.”
Like a Good Suit, a QDIA Should Fit the Individual Plan
A target-date strategy is akin to a suit of clothing. There is no one objectively “best” suit. “Best” or “worst” is defined by how it fits the wearer. In other words, the most appropriate target-date strategy isn’t necessarily the most (or least) expensive or the most daring—it’s the one that best “suits” the plan sponsor’s objectives and the needs of the participant population.
The most appropriate target-date strategy isn’t necessarily the most (or least) expensive or the most daring—it’s the one that best “suits” the plan sponsor’s objectives and the needs of the participant population.
Pushing the “easy button” by selecting the strategy with the highest historical returns or the lowest fees as your plan’s QDIA won’t necessarily prove adherence to the fiduciary’s duty of loyalty and prudence.
The importance of fit was brought to bear in recent litigation alleging mismanagement of TDF selection. U.S. District Court Judge James Selna found, “An important criterion in selecting a TDF for a defined contribution plan is attempting to match a TDF to the participants’ risk profiles and adopting an appropriate philosophy for evaluating the given risk profile.” [1]
You should consider the many readily available plan metrics (or measurements in our suit of clothing analogy) before selecting the appropriate target-date strategy; that is, the one that fits your unique plan the best.
Fully documenting the process by which you analyzed and selected a strategy that aligns with participant demographics provides the highest level of legal protection for your QDIA selection. Suggested data to review include age cohorts, salary levels, account balances, deferral rates and matching programs, employee turnover rate and average tenure, retirement income objectives, availability of other savings (e.g., DB plan) and risk tolerance, among other parameters.
Judge Selna cited a 2023 Fourth Circuit Court of Appeals’ decision in noting that “prudence looks for process, not results.” In that spirit, he concluded that “Considering participant demographics and the plan’s unique circumstances supports a finding of prudence,” ruling in favor of an engineering firm and its retirement plan investment manager.[2]
Fortunately, the DOL has provided an outline for this process. Don’t look that gift horse in the mouth.
SEE ALSO:
• TDFs Continue as Leading Investment Vehicle in DC Retirement Plans
• New Wave of Annuities in TDFs: ‘It’s Complicated’
Richard Weiss is Chief Investment Officer, Multi-Asset Strategies, American Century Investments.
Diversification does not assure a profit, nor does it protect against loss of principal.
The opinions expressed are those of Richard Weiss and are no guarantee of the future performance of any American Century Investments fund. This information is for educational purposes only and is not intended as investment advice.
*The modern portfolio theory (MPT) is a practical method for selecting investments in order to maximize their overall returns within an acceptable level of risk. This mathematical framework is used to build a portfolio of investments that maximize the amount of expected return for the collective given level of risk.
**Sway Research, The State of the Target-Date Market 2024.
[1] Robert Lauderdale et al., v. NFP Retirement, Inc., et al., 8:21-cv-00301-JVS-KES, (C.D. Cal. Feb. 23, 2024).
[2] Benjamin Reetz v. Aon Hewitt Inv. Consulting, Inc. (Reetz II), 74 F.4th 171, 182 (4th Cir. 2023); Robert Lauderdale et al., v. NFP Retirement, Inc., et al., 8:21-cv-00301-JVS-KES, (C.D. Cal. Feb. 23, 2024).