Chapter 18
Adequate Investment—The Asset Allocation Challenge
The second 401(k) adequacy challenge is: once we have gotten the participant to save an adequate amount, how do we get him to invest it efficiently, that is, invest it in a way that produces a reasonable (or even, optimal) return? In this regard, there are two major issues: asset allocation and fees. In this chapter we deal with the first issue, asset allocation.
As with the first adequacy challenge (adequate savings), the problem with respect to asset allocation is how to produce optimum outcomes—the appropriate asset allocation—under a system (the 401(k) plan) that prioritizes participant choice.
There are different views about the nuances of asset allocation, but there is broad consensus that asset allocation is a critical determinant of retirement savings outcomes and that, in that regard, participants with longer investment horizons should have a greater exposure to equities.27 The Department of Labor based its 2007 Qualified Default Investment Alternative (QDIA) regulation (about which more follows) on this principle, explaining:
Historically, over long time horizons, diversified portfolios that include equities have tended to deliver higher returns than those consisting only of lower risk debt instruments. It therefore is widely believed to be advantageous to invest retirement savings in diversified portfolios that include equity.
Thus, with respect to investment, we are faced with this typical 401(k) problem: We have generally granted participants autonomy with respect to their investment choice, within the framework of the plan’s fund menu. But we, or at least the experts we have come to trust, believe that in fact participants with longer time horizons should invest significantly in equities.
Nevertheless, there will be, for instance, some younger participants (with long investment time horizons) who are risk averse and will tend to (from the expert’s point of view) mis-allocate their retirement savings investments, allocating “too much” of their portfolio to “safer” fixed income and capital preservation investments and not enough to equities. The question then becomes, how can we encourage participants to follow the general rule and, in this example, allocate more assets to equities?
As we’ll see, this effort—to get participants to adopt an appropriate asset allocation strategy—played out in a similar way to the effort to get participants to save enough.
Participant Education
The first tool adopted by sponsors to persuade participants to adopt appropriate asset allocation strategies was, again, talk. Sponsors produced another set of ad campaigns, informing participants about how to invest plan contributions. Tools were developed—e.g., the retirement savings estimators that are now ubiquitous on the web—that estimated long-run savings results under different asset allocation scenarios.
The Department of Labor facilitated these efforts by producing guidance to the effect that, if certain requirements were met, this sort of investment “education” would not constitute fiduciary advice.
All of this no doubt had some effect. But the effective use of these education tools generally required some effort on the participant’s part, and the data showed that a limited number of participants actually used them and even fewer followed through on whatever suggestions they outputted.
Many viewed the problem as one of inertia: it wasn’t that participants didn’t want someone or something (e.g., a computer program) to guide their investments or even decide their investments for them. It was that they did not want to, or did not have the time to, “educate” themselves to make that decision for themselves.
And so, as with adequate savings, sponsors turned to defaults as a solution.
In this case, the process of adopting defaults as a solution to the asset allocation challenge began with a very specific sponsor problem—what to do about participants who did not elect any investment for their 401(k) savings.
Default Investments
At the risk of being excessively repetitive, the fundamental principle of 401(k) plans is participant control, including participant control of investment decisions. With respect to investment decisions, this feature of 401(k) plans does not just empower participants, it also provides plan fiduciaries with certain protections. As we discuss in more detail below, under ERISA section 404(c), if the participant is allowed to choose investments, then (provided certain conditions are met) plan fiduciaries are not responsible for the negative consequences of the participant’s investment choices.
In this regard, there has always been a problem: ERISA section 404(c) protections are generally not available where the participant, for some reason, makes no affirmative election. This issue was less significant when a participant was, in the first place, required to affirmatively enroll in a 401(k) plan to make any contributions at all to it. When enrollment forms were filled out the employee could be strongly encouraged (or even given no choice other than) to indicate how contributions should be invested.
The default investment problem became much more acute with the widespread adoption of automatic enrollment policies. Under automatic enrollment, the employee was typically defaulted into the plan and contributions were taken out of salary without any effort on the employee’s part, including without any obligation to make an affirmative investment election.
2007 QDIA Rules
Until DOL adopted its Qualified Default Investment Alternative (QDIA) regulation in 2007, most plans defaulted contributions by these non-electing participants into an ultra-conservative capital preservation vehicle, either a money market fund or a guaranteed investment contract (GIC). While this policy did not reflect ERISA principles—which, as we’ve discussed, base investment prudence on “modern portfolio theory”—it did reflect a (risk averse) intuition by plan fiduciaries (and, more to the point, the attorneys advising them) that as long as no money was lost, the participant was less likely to bring a lawsuit.
The QDIA rule effectively reversed this policy. That rule generally implemented the principle quoted above, that “over long time horizons, diversified portfolios that include equities have tended to deliver higher returns than those consisting only of lower risk debt instruments.” And, in doing so, it created the framework not just for default investments but also, especially through the widespread adoption of target date funds (discussed below) as the preferred QDIA, for asset allocation policy for the majority of participants who do not want to pick their own investments.
DOL’s QDIA Regulation
DOL’s QDIA regulation provided a “safe harbor” for default investments. Where certain conditions are met, plan fiduciaries are relieved from liability for losses resulting from the investment of the participant’s account in a QDIA.
The regulation provided (generally) for three types of QDIAs: target date funds, which vary asset mix based on the age of the participant; balanced funds, which vary asset mix based on the age of the participant group as a whole; and investment management services, where an investment manager allocates the assets of a participant’s individual account (based on age, target retirement date or life expectancy).
The QDIA regulation provided a solution to the problem we identified above—that ERISA section 404(c) protection is not available where the participant does not (affirmatively) elect an investment—by letting sponsor fiduciaries off the hook where one of the three QDIA defaults is used. As a result, sponsors rapidly adopted safe harbor QDIAs.
And, while as noted there are three different types of QDIAs, the vast majority of sponsors adopted target date funds as the preferred QDIA solution.
Target Date Fund Basics
In its regulation, DOL defines a QDIA target date fund as “an investment fund product or model portfolio that applies generally accepted investment theories, is diversified so as to minimize the risk of large losses and that is designed to provide varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed income exposures based on the participant’s age, target retirement date (such as normal retirement age under the plan) or life expectancy.” [Emphasis added.]
A typical (and very simple) target date fund might, at the top level, have a stock and a bond portfolio and a “suite” of, for example, 10 sub-funds, each sub-fund with a stock/bond investment allocation corresponding to the 5-year window in which the participant is expected to retire, e.g., a 2020 fund for those near retirement, a 2025 fund, etc. ending with a 2065 fund for those who do not expect to retire for another 45 years. Each of these funds would have a different asset mix, that is, a different allocation between stocks and bonds depending on each age cohort’s investment horizon. For instance, participants in the 2020 fund (with a relatively short investment horizon) might be invested 60% in stocks and 40% in bonds, and participants in the 2065 fund (with a much longer investment horizon) might be invested 90% in stocks and 10% in bonds.
As the participant ages, the fund also automatically “ages.” For instance, after 10 years (in 2028), the investment horizon of the 2065 fund will have shortened, and that fund might be invested 80% in stocks and 20% in bonds. The arc of this change, from more aggressive to more conservative investments over time as the participant ages and the investment horizon shortens, is called the target date fund’s “glide path.”
Figure 18.1 shows an example of a target date fund glide path.
There is debate (about which many reasonable people and different providers and investment experts differ) over whether the participant should reach the most conservative investment allocation at the date of retirement or (estimated) life expectancy. The illustration in Figure 18.1 demonstrates that latter approach. The asset allocation is 60/40 (60% stocks/40% bonds) at the participant’s target retirement date, in effect treating the participant’s investment horizon as extending out to the period of (post-retirement) life expectancy. The participant does not reach the most conservative asset allocation (30% stocks/70% bonds) until 25 years after retirement.
QDIA/Target Date Funds as the Preferred Asset Allocation
Over time, QDIA target date funds became a solution not just for participants who did not elect an investment allocation, but also for participants who made what would conventionally be viewed as a “sub-optimal” asset allocation election or who were simply uncomfortable or dissatisfied with their own elections.
Thus, in effect, target date funds became the preferred or recommended asset allocation strategy for most participants. In the spirit of libertarian paternalism, participants who wanted to customize investment, e.g., participants with big account balances or significant investment knowledge, could always affirmatively opt for a different asset allocation.
Indeed, some sponsors have, in effect, required participants to revisit their asset allocation decisions through “reenrollment”—periodically defaulting participants back to the target date fund unless the participant affirmatively elects a different asset allocation.
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Thus, we see that the solution to the 401(k) asset allocation adequacy challenge took a path similar to the one taken with respect to the 401(k) savings adequacy challenge—beginning with talk (investment education) and ending with defaults. Most view defaulting participants routinely into an asset allocation appropriate to their age as effective.
The other 401(k) investment challenge—really a complex of issues focused on the construction of the 401(k) fund menu, the selection and monitoring of funds and the fees paid for investment and other services typically billed to participants’ accounts, and the application of ERISA fiduciary rules to these decisions—is more complicated and more intractable.
In the following chapters we are going to begin with a discussion of the regulatory framework—ERISA’s fiduciary rules. Then we will revisit the issue of how 401(k) plans are structured, this time with a focus on who does what and how they get paid.
We will then survey ERISA litigation in three key areas: (1) the fees paid to plan investment and administrative services providers; (2) the prudence of fiduciary fund menu choices; and (3) the special case of litigation with respect to participant investments in company stock.
We will then consider, at length, fiduciary best practices in these areas.