While many fund trustees, fiduciaries and investment managers spend inordinate amounts of time pouring over investment returns, diversification strategies and risk matrices to find the optimal rate of return for their defined contribution plans (401(k) and profit sharing plans), participants in these plans struggle to make investment decisions. When faced with the opportunity to self-direct their 401(k) or profit sharing plan contributions, they hesitate. In fact, many participants experience such a huge sense of inertia that they abdicate their right to elect investments of their plan balances to the plan sponsor. Such inaction then places an additional fiduciary duty on plan trustees and committees to protect the retirement balances of these participants from a significant risk of loss.
Before the Pension Protection Act (PPA) in 2006, lack of participant involvement commonly meant that plan sponsors “parked” participant account balances in default investments until they felt comfortable making their own choices. These default investments, while they were in low-risk categories, garnered lower rates of return that often did not even keep up with inflation. Consequently, retirees’ account balances were inadequate to support them in their golden years. As part of the PPA, the Department of Labor (DOL) addressed this problem with regulations under section 404(c)(5) of the Employee Retirement Income Security Act (ERISA), creating the qualified default investment alternative (QDIA). The QDIA now enables fiduciaries to implement more aggressive investments when participants fail to make their own investment elections without violating their fiduciary obligations.
But don’t assume that the DOL gave plan trustees and committees total freedom when choosing QDIAs as part of their plan’s investment menu. Quite the contrary is true due to the narrowly defined guidelines and options specified in ERISA’s Section 405(a) regulations. Among other restrictions, only three investment options are allowable for long-term QDIAs: target-date funds (TDFs), managed accounts and balanced funds. Each has its advantages and disadvantages with different costs, reporting issues and levels of customization for participant groups. However, the main goal for trustees and committees when choosing a QDIA should be diversification to minimize the risk of large losses to participants’ accounts.
To reinforce their due diligence in making QDIA choices, many plan trustees request unofficial approval letters from qualified legal counsel to ensure that a QDIA meets the parameters defined in the ERISA regulations and fits the description of either a TDF, a balanced fund or an appropriately individually managed account. They get guidance on their process in communicating their QDIA option to participants and beneficiaries. Formal review from legal counsel may provide trustees with proof that they did their fiduciary “homework” in choosing a QDIA while remaining compliant with current regulations and making decisions for the exclusive purpose of providing benefits for participants and beneficiaries.
Ultimately, when choosing a QDIA option, plan sponsors must consider several questions to determine which selection best fits their plan participants:
- What is the aggregate age of our workforce or participant group?
- What is the average age of retirement for our workforce?
- Is there a general risk tolerance that applies to our workforce?
- Is our QDIA selection designed to outpace inflation?
- Does our QDIA selection consistently insulate participant accounts from risk of large losses with a diversification strategy?
By navigating these questions, focusing on guidelines set out by section 404(c)(5) of ERISA and consulting legal counsel to ensure that the criteria for QDIA status are met, trustees will have fewer allegations from participants that their retirement balances were defaulted or “parked” in inappropriate investment vehicles.