Bridgebay Financial, Inc.
The Pension Protection Act (PPA) of 2006, created qualified default investment alternatives (QDIA) and expanded the 404(c) "safe harbor" protections for defined contribution (DC) plan sponsors. QDIA's include target date funds, target risk funds, balanced accounts, managed accounts and grandfathered stable value funds.
The financial crisis that still lingers today, has prompted plan sponsors, recordkeepers and participants to reassess the risk-reward profiles of their retirement investments.
The sweeping changes of the Pension Protection Act of 2006 prompted plan sponsors to quickly implement improvements. Yet the continuing onslaught of legislative, regulatory and disclosure measures suggest that it may be time to rethink their DC plan design, educational programs and investment offerings. The introduction of Roth 401(k), Roth 403(b) and conversion rules have increased participant choices but complicated the education programs.
Recordkeeping innovations have enabled plan sponsors to add funds at a furious pace. Yet a plan with a large number of funds may be as sub-optimal as one with too few choices. Many plans may have an unintended gap in their investment menus. Conversely, the plan sponsor may want to proactively minimize overlaps and redundant funds in asset categories.
The rapid asset growth of QDIAs and financial crisis have prompted significant changes to these ever-evolving investment strategies. Many investment managers have added asset classes to their allocations in an attempt to reduce correlation between assets and dampen volatility.
Target Date and Target Risk Funds
By far the most widely adopted QDIA by plan sponsors, target date funds continue to attract the majority of plan assets. The use of target date funds in DC plans has surged and are most popular with new hires and younger participants according to the Profit Sharing/401(k) Council of America.
Many plan sponsors have replaced balanced funds that have a fixed asset allocation and may not be suitable for all participants with target date funds whose asset allocations vary by age and change over time.
Many plan sponsors, relied on their recordkeeper's proprietary target date fund recommendation without vetting the extent to which the underlying funds and asset classes deviated from their core menu of funds. The financial crisis uncovered the performance differences among target date funds and the impact of high allocations to equities and volatile asset classes. Different glide paths produced drastically different results, prompting plan sponsors to reconsider their target date funds, underlying asset classes and allocation assumptions.
In response to the financial crisis, many target date managers have changed their investment strategies and underlying assets. Some changes were implemented to increase diversification, mitigate downside risks and add uncorrelated assets. The most common changes include the introduction of inflation hedges, including TIPS (Treasury inflation-protected securities), REITs (real estate investment trusts), natural resource and commodity linked instruments, derivatives, currency swaps, emerging markets and high-yield bonds.
These changes have been marketed as being consistent with the previous asset allocation, yet they constitute a significant shift that should be evaluated and understood by the plan sponsor. Recently, the DOL pronounced that target date fund investment managers are not fiduciaries to the plan, yet they are permitted to make decisions that impact participant returns without consulting plan fiduciaries.