Linda Ruiz-Zaiko
Investment Consultant
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.
