Module 7
(a) What are generally accepted investment theories, and (b) how do they relate to fiduciary investment selection when designing a 401(k) plan?
(a) Generally accepted investment theories are fundamental principles associated with appropriate and rational investing. Among these principles would be modern portfolio theory and strategic asset allocation. Modern portfolio theory is a theory instructing risk-averse investors on a method to construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward. According to the theory, it is possible to construct an effcient frontier of optimal portfolios offering the maximum possible expected return for a given level of risk. This theory was pioneered by Harry Markowitz in his paper "Portfolio Selection," published in 1952 by the Journal of Finance. There are four basic steps involved in portfolio construction: (1) security valuation, (2) asset allocation, (3) portfolio optimization and (4) performance measurement. Strategic asset allocation is a portfolio strategy that involves periodically rebalancing the portfolio in order to maintain a long-term goal for asset allocation. When the portfolio is originally constructed, a base policy mix is established based on expected returns. Because the value of assets can change given market conditions, the portfolio constantly needs to be readjusted to meet the policy. A plan sponsor must examine investments using an overall portfolio approach and adequately diversify such a portfolio. (b) Fiduciaries are called upon to consider generally accepted investment theories, including modern portfolio theory, and prevailing practices being used within the investment industry when they select plan investments in the design of a 401(k) plan. A plan sponsor must examine investments using an overall portfolio approach that will allow plan participants to adequately diversify their portfolios. The number and types of investments must be adequate to allow participants to use those investments to properly balance risk and reward according to their needs. Many experts believe that at least six or seven specific types of investments are needed for that purpose. Regardless of the exact number or type, though, this illustrates that fiduciaries need to understand these concepts to prudently fulfill their responsibilities.
(a) How did PPA extend the reasoning first introduced by the Securities and Exchange Commission (SEC), and (b) what are the alternatives open to plan sponsors seeking to allow retirement plan providers to provide investment advice to their participants?
(a) In 2005, SEC published its "Staff Report Concerning Examinations of Select Pension Consultants." This document provided certain conditions under which an investment advisor providing advice to retirement plan participants could avoid prohibited transactions. PPA extended the reasoning of this document by providing an actual exemption from the prohibited transaction rules for fiduciary investment advisors operating under an eligible investment advice arrangement. Under these arrangements, investment advisors may offer personally tailored investment advice by charging a flat fee that does not vary depending on the participant's investment option. A plan sponsor that prudently selects and monitors an investment advice provider will not be liable for the advice furnished by such provider to the plan's participants and beneficiaries. An eligible investment advice arrangement also permits the use of computer models to deliver unbiased investment advice. Computer models must be certified by an independent investment expert and must meet specified audit requirements. (b) As a result of the clarifications made by PPA, plan sponsors can prudently select and monitor investment advice providers and allow them to provide personally tailored investment advice to plan participants. By doing so, plan sponsors will be exempt from liability associated with the advice provided by an investment advisor operating under an eligible investment advice arrangement. Retirement plan service providers can serve as investment advisors. Advice can be provided as long as a flat fee is charged that does not vary depending on the participant's investment option. Computer models may also be utilized to provide this investment advice if certified by an independent investment expert.
Describe some of the emerging issues of relevance to 401(k) plans in the following areas.
(a) Innovative investment products: As innovation occurs in the creation and delivery of investment products, there is an incentive for financial service companies to distribute these products to retirement plans generally and to 401(k) plans in particular. The retirement plan market is highly attractive because of its enormity and the recurring contributions that are made within this market sector. Plan sponsors are faced with the ongoing challenge of adapting their 401(k) plans to the evolving capital markets and must determine whether innovative financial products should be included as plan offerings. A good case study of this process can be seen in attempts to promote the offering of exchange-traded funds (ETFs) through 401(k) plans. Although this innovative financial product has experienced dramatic growth in other market sectors and offers some unique advantages, it also has certain drawbacks and challenges with regard to efforts to make the product available as a 401(k) plan investment choice. One of the key challenges associated with ETFs involves valuation and recordkeeping issues, since ETFs settle in three days when traded, in contrast with traditional mutual funds, which offer a net asset value at the end of each day. Although the challenges are not insurmountable, and various approaches have been developed presently to offer ETFs through 401(k) plans, these approaches involve additional administration, and plan sponsors must weigh the advantages, disadvantages and additional costs in making innovative investment products available to their employee investor population. (b) Behavioral finance investments: Having realized that many individual investors are ill-equipped for self-managing their investments, many plan sponsors are increasingly looking to the relatively new field of behavioral finance to construct their plans with built-in protections that will minimize the damage participants can inflict on themselves when managing their accounts. Essentially, plan sponsors attempt to construct plan choices in such a way that inertia and inactivity on the part of plan participants will work to their advantage rather than to their detriment. This concept is readily apparent in the public policy approach now being endorsed by the government in the realm of automatic enrollment. Rather than waiting for plan participants to enroll and make investment choices, plan participants are automatically enrolled unless they make a positive election to opt out of plan participation. Additionally, plan sponsors are exempted from fiduciary liability if they place participant funds into certain designated investment portfolios that have historically provided positive investment results over time horizons that are seen as appropriate given the expected working lives of plan participants, using age to determine asset allocation. As the field of behavioral finance illumines human proclivities to make irrational investment decisions, plan sponsors will look to products and services that will serve to eliminate or bypass these proclivities. (c) Distribution planning: Given the relatively short history of the 401(k) plan, it is not surprising that the initial efforts of financial service companies were directed at asset accumulation and at procuring both the initial business and ongoing contributions of individual employees and the matching contributions of plan sponsors. Although the competition to retain existing business and capture assets from other sponsors when 401(k) plans switch providers will continue to be important, an industrywide effort to better serve participants during the asset distribution phase of their retirement is garnering enhanced attention. Several factors account for the increased attention to plan distribution issues. Among these factors are the maturing of the 401(k) market, the need to service the greater demand for distribution that is associated with the Baby Boomer demographic cohort that is retiring, the lessened presence of workers possessing a defined benefit component as part of their retirement programs and the natural move to distribution that occurs as assets accumulate in 401(k) plans over time. Additionally, changes in the law allowing for increased portability and transferability between various types of retirement plans and various vendors has heightened the need for providers to deliver these services or see assets move to competing providers whose plans and products provide these features. (d) Fee transparency: Fee transparency involves the ability of plan sponsors and plan participants to easily and accurately identify the fees that are being charged against their plans. Given the complex nature of 401(k) plan administration and the variety of services needed to properly administer these accounts, it is not surprising that a variety of fees are associated with 401(k) administration. Many of these fees have historically been diffcult to decipher, and many plan participants and plan sponsors were relatively unaware of what was being charged and how these expenses were being assessed against their accounts and plans. In recent times, class action lawsuits have been initiated claiming excessive fees that directly serve to reduce the eventual payouts available to plan participants. At the same time that lawsuits have been initiated, DOL and legislators are raising this issue as a matter of public policy. Since the issue of fees directly impacts participant benefits, vigilance over fees and the determination of their reasonableness is a fiduciary issue for plan sponsors. One can expect that this issue will continue to grow in importance and that increased scrutiny will be paid to the level of fees, fee transparency and the methods to determine and monitor these charges.
List and briefly describe the distinct operational functions involved in 401(k) plan management.
(a) Plan compliance: ERISA and the Internal Revenue Code (IRC) delineate a number of specific requirements 401(k) plans must comply with to receive and retain a tax-qualified status. Additionally, the plan must comply with various Internal Revenue Service (IRS) and Department of Labor (DOL) regulations, which are issued from time to time, as well as any legislative changes. A plan sponsor is responsible for ensuring that the plan conforms to these legal requirements, and the sponsor must conduct certain ongoing administrative functions, such as actual deferral percentage (ADP) testing, to maintain tax qualification. Some sponsors will conduct these ongoing functions themselves using their internal human resources (HR) staff while other plan sponsors will utilize the services of one or more external vendors to furnish the services needed to comply with legal requirements. (b) Plan communication: Closely aligned with plan compliance, and at its most elementary level a requirement for plan qualification, is the plan communication function. In order for a plan to have tax-qualified status, certain minimum plan communication and disclosure functions must occur. Since communication to plan participants is such a critical function to ensure that participants utilize the plan to its fullest potential, many plan sponsors will actually surpass the minimum requirements of the law when designing their communication program. The communication approach often includes a variety of different media such as Internet, printed brochures, articles in employer publications, videos and live instructor-led seminars. Elements of the communication approach may be handled through the recordkeeper or a separate vendor who specializes in communication or financial education. (c) Investment management services: Because of the very nature of defined contribution plans generally, and 401(k) plans as a subcategory of defined contribution plans, investment management services are an inherent and critical component of plan operational functions. Most plans use mutual fund choices and allow individual participants to select which funds their monies will be contributed to. Plan participants also have the ability to move monies between mutual fund offerings once those monies are deposited into the plan. Creation of these fund products and the ongoing asset management function associated with investing demands professional expertise. Most often plan sponsors contract with various providers to supply these specialized services. (d) Recordkeeping services: Recordkeeping involves tracking incoming plan contributions and the allocation of these funds among the specific individual accounts maintained on behalf of each plan participant. For each participant there can be several subaccounts such as salary deferral, matching contribution, discretionary employer contribution; qualified nonelective contribution (QNEC) or qualified matching contribution (QMAC), Roth 401(k) contribution and rollover contribution, as well as earnings for each of these subaccounts. Since most plan sponsors allow the individual plan participant to designate how plan contributions are invested, the recordkeeper must update all participant account balances and record all participant and plan sponsor transactions. Other transactions can occur depending upon the various features of a 401(k) plan. For instance, plan loans and the allowance for hardship withdrawals will generate transactions within individual accounts. Dispersals will occur for both loans and hardship withdrawals, while loans will also result in interest charges and the repayment of loans. All of these transactions must be meticulously and accurately accounted for by the recordkeeper. (e) Directed trustee services: The directed trustee, oftentimes a bank or a trust company, is the entity that executes the buying and selling of plan assets on behalf of plan participants. Essentially the directed trustee executes all orders that would be initiated by either a plan participant or an agent of the plan sponsor, depending on the operational characteristics of the plan. The directed trustee is responsible for processing investment orders in a timely and accurate manner. The directed trustee generally serves a trustee function holding the plan assets in aggregate but does not keep track of the asset holdings at the individual level by participant unless the directed trustee is also providing recordkeeping services.
Describe (a) how the fiduciary context in which plan sponsors operate influences 401(k) plan design and (b) the fiduciary standard to which plan sponsors must adhere.
(a) The fiduciary context in which plan sponsors operate influences the design and operational decisions that all plan sponsors must make. (b) Under the law, the plan sponsor is responsible for the operation of a retirement plan and is liable for breaches of fiduciary duty. The duties of fiduciaries are described in Section 404(a)(1) of the Employee Retirement Income Security Act (ERISA). Section 404(a)(1) requires that "a fiduciary shall discharge his (or her) duties with respect to a plan solely in the interest of the participants and beneficiaries and (1.) for the exclusive purpose of: (A.) providing benefits to participants and their beneficiaries; and (B.) defraying the reasonable expenses of administering the plan; (2.) with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims. . . ."
Does offering a larger number of fund options within a 401(k) plan encourage greater participation by plan participants?
At one time many plan sponsors believed that offering a larger number of funds would encourage greater participation in 401(k) programs by plan participants. However, subsequent research has indicated that a greater array of funds does not result in greater plan participation. In one research study it was found that for every ten funds added to a plan's menu, the probability that an employee will take part in a retirement savings plan drops by 2%. Further, variety might not enhance asset allocation strategies. The boost in funds apparently made employees more riskaverse, leading the participants to increase their contributions to money market and bond funds by five percentage points and lower their allocations to stock funds by seven to nine percentage points.
Compare and contrast the unbundled and bundled approaches to plan management, explaining the positive and negative aspects of both approaches.
Both the unbundled and bundled approaches have their strengths and weaknesses. When opting for the unbundled approach, a lead or primary vendor generally would provide one or two of the five necessary services described in Learning Objective 2.1 and would serve to coordinate and oversee the direction of the other services by subcontracting with specialized vendors. Traditionally the primary unbundled vendors have tended to specialize in recordkeeping, compliance with ERISA and IRC requirements and consulting services. A primary vendor of this type would stress its ability to coordinate the entire plan management process and would emphasize the importance of flexibility in plan design and unlimited investment selection. Flexibility in plan design and unlimited investment selection are advantageous hallmarks of the unbundled approach. Contrasting the unbundled providers with the bundled providers illustrates certain key differences. The bundled providers supply all five component functions described in Learning Objective 2.1. Traditionally the firms offering the bundled approach have been banks, mutual funds and insurance companies. These firms tend to emphasize their own investment offerings and related services as their core competency or area of expertise. These investment products and services generally serve as the primary source for generating profit to the bundled provider. These firms clear trades internally, so they do not necessitate the retention of an outsidedirected trustee, which becomes critical in pricing and servicing the plan. Sometimes bundled providers require plans to place a certain amount of funds or assets in their proprietary funds to ensure a certain level of profitability in servicing the plan.
What guidance has DOL provided to plan sponsors regarding the proper methodology to use in analyzing investment options for 401(k) plans?
DOL has not issued formal guidance explaining how a plan sponsor should evaluate a provider of services and/or specific investment options for a participant-directed 401(k) plan. However, DOL has indicated that "plan fiduciaries must conduct an objective, thorough and analytical search. . . . Furthermore, the DOL has indicated that in conducting such an analysis, a fiduciary must evaluate a number of factors and reliance solely on ratings provided by insurance rating agencies would not be suffcient to meet this requirement." Similarly one could conclude that a plan utilizing mutual funds could not fulfill this requirement by solely relying on the services of a mutual fund rating service.
Generally describe the three ways in which plan sponsors can comply with nondiscrimination testing requirements.
Generally 401(k) plan sponsors can comply with nondiscrimination testing requirements in one of three ways. The three ways are: (1) Engaging in the normal means of testing involving the examination of each participant's deferrals (2) Utilizing the safe harbor plan designs first made available in 1999, where the employer uses either formulaic plan matches or nonelective contributions (3) Implementing formulaic employer matching or nonelective contributions in conjunction with an automatic enrollment feature.
Explain the different approaches to procuring recordkeeping services under the unbundled approach to 401(k) plan management.
In any type of unbundled approach, the relationship to the recordkeeper is a critical element of the arrangement. The plan sponsor can retain the recordkeeping service provider directly. Alternatively, a plan sponsor can retain a recordkeeping service provider through an investment advisor or broker. Sometimes a recordkeeping service provider acts as the back offce recordkeeping administrator for its client or partner. The client or partner may be a mutual fund company, broker/dealer, bank or insurance company. In such a case, the back offce recordkeeping administrator would have no direct contact with the plan sponsor but would resolve participant issues at the direction of the primary vendor serving as the relationship manager with the plan sponsor. All of the direct contact would occur through the relationship manager. Another arrangement involves use of a third-party administrator (TPA) model. Under this arrangement, a plan sponsor retains a recordkeeper through an investment advisor or broker. Under this approach, one service provider (usually insurance firms and some mutual fund companies) performs the day-to-day recordkeeeping administration, and a second provider such as a TPA performs all compliance work, including testing, vesting determinations, required government filings and potentially the calculation of all distributions and loans. This model tends to be prevalent in the small plan marketplace.
Discuss the two different approaches a plan sponsor can take in fulfilling its operational functions when sponsoring a 401(k) plan.
In order to operate a 401(k) plan, a plan sponsor must oversee a minimum of at least five distinct operational functions. Rather than having the plan sponsor manage these distinct operational functions internally, many plan sponsors rely on the services of outside vendors. Managing the operations of a retirement plan can be a complex endeavor requiring the expertise of specialized vendors. The selection of these outside vendors is important, since the plan sponsor is ultimately responsible under the law for the fiduciary responsibilities associated with plan sponsorship. If a plan sponsor decides to contract with external vendors for these services, the operational functions may be purchased separately, using what is known as an unbundled approach, or these operational functions may be purchased together from a single provider, using what is known as the bundled approach.
Describe some of the foundational features in designing a successful 401(k) plan.
In terms of elements of design, certain key decisions are foundational features in designing a successful 401(k) plan. Among these are the level of employer matching contributions, the number and type of investment options, offering the option of Roth 401(k) deferral contributions, whether to adopt a safe harbor plan design, whether and how automatic enrollment will occur, how the plan will provide for adequate investment diversification and the means by which investment education and investment advice may be provided to plan participants
Is a directed trustee responsible for investment decision making? Explain.
No, a directed trustee is not responsible for any investment decision making but rather receives direction in such capacity. The directed trustee is responsible for processing investment orders in a timely and accurate manner. In contrast, a discretionary trustee, such as a bank or a trust company, would bear full fiduciary responsibility for plan investments. Because of the potential for substantial liability arising from such responsibility, there are very few discretionary trustees.
In what ways did the Pension Protection Act of 2006 (PPA) clarify issues for plan sponsors, making it easier to offer automatic enrollment features for 401(k) plans?
PPA contained a number of features that made it easier for plan sponsors to offer automatic enrollment features for their 401(k) plans. PPA directed the Employee Benefit Security Administration (EBSA) of DOL to issue guidance clarifying acceptable default investment options that would exempt employers from certain fiduciary obligations. The act also specifically preempted state wage-withholding laws when these rules conflicted with retirement plan automatic enrollment provisions. PPA also permits the distribution of employee contributions if an appropriate election is made within 90 days of the first payroll deduction.
As a result of PPA, when must publicly traded companies allow participants in their defined contribution plans to diversify from plan investments being held in publicly traded employer securities?
PPA required that, beginning after 2006, defined contribution plans of publicly traded companies holding publicly traded employer securities allow participants to diversify account balances that are invested in employer securities. Generally participants may immediately diversify investments resulting from elective deferrals and employee after-tax contributions. Participants who have completed three years of service must be permitted to diversify the investment of any employer contributions. To comply with these requirements, plans must offer at least three diversified investment options other than employer securities, and plans must permit diversification elections to be made at least quarterly.
Discuss how plan design decisions are often linked with operational issues when configuring a 401(k) plan.
The actual plan design decisions often are inextricably entwined with the operational model selected for administering the plan. Therefore a plan sponsor should contemplate elements of plan design and elements of ongoing operation and administration when configuring a 401(k) plan or other defined contribution savings vehicle.
Describe some of the decision elements facing plan sponsors in the initial design and ongoing administration of a 401(k) plan
There are several decision elements in the initial design and ongoing administration of a 401(k) plan. Among these decision elements are the ways in which the plan sponsor will design the plan, handle continuing administrative tasks (such as loans and hardship withdrawals), communicate plan offerings and features, fulfill fiduciary responsibilities, control costs associated with managing the plan and implement technology to assist in streamlining plan operations.
When comparing various services of 401(k) providers, what categories can be used to segregate and distinguish between various types of fees charged?
When comparing various services of 401(k) providers, different categories can be used to segregate and distinguish between various types of fees charged. One approach is to determine the base on which fees are computed. Asset-based fees are computed as an annual percentage charge on the total assets of the plan. Censusbased fees are imposed on a per capita participant basis, and itemized fees specify a fixed charge for a specific service. These different approaches can have very different outcomes over time as a plan evolves. For instance, suppose one is comparing two proposals where one vendor charges asset-based fees and another vendor charges census-based fees. If the organization is not growing and the plan is relatively new, but the business is highly profitable with growing account balances, asset-based fees may appear modest initially but can become much more expensive as plan balances grow. Ongoing monitoring of these fee implications over time is very important. From a practitioner's viewpoint, it may be helpful to categorize fees on the basis of whether they occur on a one-time basis or will be recurring on a continuing basis. It is also helpful to examine these fees in connection with various operational functions that may occur on a one-time or recurring basis. (This basic framework was developed by EBSA in its landmark study "Study of 401(k) Plan Fees and Expenses," April 13, 1998.) The classification used in the EBSA study segregated fees into the following major categories: (a) Setup and conversion fees: These are certain one-time costs arising in the establishment of a 401(k) plan at inception or upon the conversion from one servicing arrangement to another. (b) Recurring and administrative costs: These fees cover trustee services, recordkeeping, compliance, distribution of account proceeds to departing participants, loan processing and withdrawals. (c) Communications expenses: Communication expenses typically include meetings with employees, printed and video materials describing the plan features and encouraging participation, basic election materials, and newsletters. Other expenses related to communications apply to operation of a call center, participant asset allocation software and Internet services. (d) Investment management fees: These fees compensate the provider, who recommends the allocation of funds flowing into a particular 401(k) plan investment option from the overall universe of financial instruments available for that particular fund. The investment management fee pays for the research that supports these buy-sell decisions. Additionally, these fees compensate the mutual fund manager for the pro-rata operating expenses of the fund attributable to each 401(k) plan that buys shares. (e) Distribution fees: Many 401(k) providers use various methods to distribute and sell their plans. Distribution fees compensate the distribution network participants for their labors in marketing the 401(k) plans. Retail mutual funds pay sales commissions to those distributing their funds and disclose the nature and level of these sales commissions in their prospectuses. (Student note: Distribution fees as used in this context relate to marketing and selling expenses. Students should not confuse distribution as used here with the word's use relating to disbursements or withdrawals of funds from the plan.) (f) Mortality and expense risk fees: Insurance products, such as group and individual annuities, bear costs that are unique to these products and that reflect the insurance risk of each product. These risks include the mortality and expense guarantees inherent in the annuity contracts. The mortality and expense fees pay these costs.
When determining whether a 401(k) plan is meeting its objectives, what elements of plan design are the most critical?
When determining whether a plan is meeting its objectives, it is important to concentrate analysis on the core elements of design that are most likely to determine plan success and impact whether participants utilize the plan to its full advantage. Two of the most important attributes of plan design involve whether an employer will provide an employer contribution and, if provided, the level of the employer contribution. Another important plan feature involves the menu of investment options offered through the plan. In these three critical areas an employer has total discretion
Identify the employee matching formula generally considered to be the industry standard by a majority of employers.
While there are many variations in matching formulas, an employer pay-in of 50% up to the first 6% of salary that the employee contributes is increasingly considered to be the industry standard by a majority of employers. In terms of a suggestion for plan design, matches stretched out across as big a percentage of pay as possible encourage workers to allot higher percentages of their paychecks to their 401(k)s. For instance, 50% on the first 6% of pay is better than a full match on the first 3%.
