Default Investments

In the PPA, Congress endorsed (and well it should have) automatic enrollment 401(k) plans by adopting legislation to make it easier for employers to sponsor such plans.

One issue addressed by the PPA was the appropriate default investment option, since some if not many employees automatically enrolled in such plans will not designate an investment choice. Will a plan fiduciary have liability simply because of the type of default investment option to which salary deferrals are mapped in the absence of participant direction? In particular, will the plan qualify under ERISA section 404(c) as a self-directed plan?)

The PPA directed the Department of Labor to issue rules on permissible default investment options when an employee does not direct how assets are to be invested. The DOL issued proposed regulations in September.

Under the proposed regulations, a plan may use one of three alternative types of funds as the default investment for automatic enrollment plans. The default options are essentially the following: (1) a life-cycle or retirement-date type funds; (2) balanced funds; or (3) individually managed accounts in which assets are allocated on a life-cycle model. The regulations do not permit the use of money-market or stable value funds because the Department of Labor does not believe such funds will generate sufficient returns to provide adequate retirement savings.

I am sympathetic to the Department’s position about money-market and stable value funds, but I wonder whether there should be a window period, perhaps three to six months, where a plan could temporarily park a participant’s initial contributions to a plan in a money-market or stable value fund. (After the window period funds would be mapped to one of the qualified default investment vehicles currently identified in the proposed regulations.)

Use of a “safe” fund for a window period might temper the inclinations of some employees to opt out of participation in response to an early loss of principal. It might also make it more likely that some employees will actually consider how they want their money invested rather than simply having the plan direct contributions to a qualified default fund. (I am assuming that some employees who might accept the default investment chosen by the employer would think about where they wanted their money invested if it would otherwise sit for a few months in a money-market fund. Of course, one could argue that employees might be better off in the plan’s qualified default investment than they would if they make their own investment decisions.)

In any event, employers often know their workforces better than the Department of Labor does and if an employer thinks that a money-market fund is appropriate for its workforce for a relatively brief period of time, the Department should probably respect the employer’s insight.

There would be another advantage to permitting the employer to use a money-market default fund for a brief period of time. Under the proposed regulations, a participant must be given notice, 30 days before initial investment of funds, about the plan’s investment options. Presumably this is in the regulation because it ensures that every employee has either selected an investment option or impliedly consented to the plan’s default investment fund before they have contributed to the plan. If there is loss to principal, the employee will have expressly or impliedly consented to the investment fund in which the loss occurred.

But some observers think that employees do not like to see their paycheck decline after a month of employment and that seeing such a decline may cause some to opt of plan participation (to get their paycheck up to where it was the first month of employment). So how do we square this concern with the Department’s concern that participants might suffer a loss before having time to select an investment option? By mapping the contributions to a risk-free fund until the employee has time to choose another investment option. And if the employee does not exercise that right within the specified window period, then the employee’s account gets automatically mapped to a permissible default fund. (And if the employee decides to opt out, the employee can get their contributions returned without loss of principal.)

Before posting this, I spoke with Marc Iwry, who tells me that he and some others submitted comments to the Department of Labor along these lines. Their comments, in my view, deserve careful consideration. Given this blog, its no surprise that this is my view!

Comments

[Carl Johnson]

At least implicit in the DOL's proposed default investment regulations (and more or less explicit in the preamble) is that a DC plan is a "retirement plan" (providing for "retirement savings"). Clearly, a "retirement" purpose is not dictated for DC plans by either the qualification rules of the Code (except in the case of the relatively rare money purchase pension plan) or ERISA. What bothers me is this. The prudence rules of Section 404(a)(1)(B) of ERISA require that prudence be determined in the context of "an enterprise of a like character and with like aims." My argument is that the DOL should have linked the appropriate safe-harbor default fund to the character and aims of the particular DC plan.

That in turn would require that employers focus on the real purpose of the plan (an independently valuable exercise), and to reflect that purpose in both the stated objectives of the plan and in the plan's operative provisions (a very rare occurrence). An employer with a relative high turnover rate might reasonably design a plan with characteristics recognizing that in most cases the participants accounts will not last long in the plan. In that case, a short-term investment may well be the most appropriate default fund.

This linked approach would also seem to be encouraged, if not mandated, by the language of new Section 404(c)(5) requiring "guidance" with respect to "default invesments that include a mix of asset classes consistent with capital preservation or long-term capital appreciation , or a blend of both." "A mix of asset classes consistent with capital preservation" and the statutory direction that "guidance" be provided as to the "appropriateness" of the alternative [under the circumstances (character and aims)?] seem to support, in the context of the other alternatives, a "safe fund" option.

I would also note that if Congress had wanted to provide a safe-harbor only for "retirement-oriented" investment options, they could have said so easily. Moreover, my reading of excerpts (admittedly incomplete) from the Committee reports on new Section 404(c)(5) fails to find any reference to "retirement" purposes.

Of course, the DOL's regulations are only a safe-harbor. An employer can go it alone under general fiduciary responsibility principles, and possibly bolster its position by designating the default fund in the terms of the Plan document (settlor function), subject to the difficulties arising from the consistency-with-ERISA Title I requirement of Section 404(a)(1)(D). However, most employers are not likely to take that sort of risk, so the regulations will play a key role in default fund selection.