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DOL Set to Endorse Multi-Asset Funds as Default for 401(k) Investors

Safety first has long been the mantra of employers choosing a default investment option for their 401(k) plans—safety of principal, that is. However, times are changing and safety of principal is but one of many goals that employers must balance.

Sometime this fall, the U.S. Department of Labor (DOL) is slated to publish proposed regulations that would effectively endorse multiple-asset-class funds, such as lifecycle funds and balanced funds, as the best investment vehicles for retirement plan participants who don’t choose their own. Specifically, the new regulations would create a fiduciary safe harbor for plan sponsors—employers—who designate such a fund as their plan’s default option. That means employers could not be held liable for the performance of the fund by plan participants who were defaulted into it, as long as the employer had prudently selected and monitored the fund—a responsibility sponsors always have for all investment options they offer.

Until now, most employers have designated either a money market or stable value fund as the default investment option for their 401(k) plans, theorizing that they could minimize their fiduciary risk by not putting their participants’ principal at risk. According to some experts, the proposed DOL regulations scratch that idea.

“In a sense, fiduciaries who had previously used a money market default account are being told that, if they do not put the participants’ money at risk (that is, with some allocation to stocks) then the fiduciaries will be at risk,” well-known ERISA attorney Fred Reish of Reish Luftman Reicher & Cohen wrote in a recent client newsletter. “Correspondingly, if fiduciaries put the participants at risk in a proper way (for example, through a multi-asset-class vehicle) then the fiduciaries will not be a risk.”

The choice of a default fund has become more important as increasing numbers of employers have chosen to automatically enroll eligible employees in their 401(k) plans rather than wait for employees to join voluntarily. This makes it more likely that the default process will actually come into play. According to the Annual 401(k) Benchmarking Survey conducted by the Human Capital practice of Deloitte Consulting LLP, 23 percent of plan sponsors had embraced automatic enrollment by year-end 2005, up from 14 percent in 2004.

The DOL has not been shy about letting the retirement plan industry know that it was planning to address this issue. “With the move toward automatic enrollment, the choice of a default fund becomes critically important because many employees will be placed in the fund and are likely to leave their assets in the default,” said Ann Combs, Assistant Secretary of the DOL’s Employee Benefits Security Administration in January during a speech before the Northern Indiana ASPPA Benefits Council. “A money market fund is not a good long-term investment for a retirement plan. We are considering allowing employers to use more appropriate investment alternatives, such as lifecycle or target-age funds, balanced funds, or professionally managed accounts as defaults.”

Lifecycle funds, which feature a gradually changing asset allocation mix targeted to the investor’s planned retirement date, are expected to be especially popular once the new regulations take effect. Even without the DOL’s backing, they’ve been springing up in retirement savings and 529 plans. Last year, the Deloitte survey found, 44 percent of 401(k) plan sponsors offered the funds, up from 28 percent the prior year.

Reish expects that once employers understand the value of a fiduciary safe harbor, they will make multiple-asset-class funds the default investment option for almost all 401(k) plans. In fact, he told clients in his firm’s July newsletter that employers may even manage their plans, over time, to encourage participants to let themselves be defaulted into those funds. For example, when changing plan administration providers, they might say that unless participants choose new investments prior to the conversion, they will be defaulted into the default choice. Or they might redesign enrollment forms to show that if participants do not choose their own investments, they will be placed into the default vehicle. For all participants who allow this to happen, employers would enjoy a fiduciary safe harbor that does not currently exist even for participant-directed investments unless the plan meets the roughly two dozen requirements spelled out in Section 404(c) of the Employee Retirement Income Security Act.

Once the proposed regulations are published, the DOL will solicit and review comments from the public, a process that can take at least six months. Reish estimates that final regulations could be published in mid-2007 and take effect then or on January 1, 2008.

Most retirement plan experts expect the new rules to have some impact on the stable value industry, and indeed, it’s hard to construe government endorsement of a competing investment option as a plus. But with more than 20 percent of 401(k) assets currently allocated to stable value investments, and with the product’s unique investment proposition—bond-like returns with the stability of a money market fund—many experts also believe that stable value will continue to play an important role in the 401(k) marketplace. For more discussion of the impact the new rules might have on the stable value industry, see “Proposed Default Fund Rules Leave Room for Stable Value” elsewhere in this issue of Stable Times.

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