Table of Contents
This report was produced by the Advisory Council on Employee Welfare and Pension Benefit Plans, which was created by ERISA to provide advice to the Secretary of Labor. The contents of the Council’s report do not represent the position of the Department of Labor.
The 2008 ERISA Advisory Council formed a working group on Hard To Value Assets and Target Date Funds (hereinafter referred to as the “Working Group”) to study issues involving two topics concerning: first, plan assets invested in Hard To Value Assets, or alternative investments, and second, plan assets which allow participants to invest in Target Date Funds.
The Working Group studied fiduciary issues surrounding the selection, monitoring, and valuation, as well as the accounting and reporting requirements for Hard To Value Assets. The goal of the Council was to address fiduciary issues and to help guide fiduciary conduct with respect to ERISA responsibilities associated with Hard To Value Assets ("HVAs").
Regarding Target Date Funds, the Working Group studied numerous issues in retirement savings investments. The desired result of the Working Group was to address and resolve questions and concerns regarding the implementation of Target Date Funds (“TDFs”) as prudent retirement investments. The Working Group studied the role TDFs play in the current marketplace, especially now that they are permitted as qualified default investment alternatives included in the DOL’s regulations. This Working Group made inquiries into the challenges, risks, and issues to fiduciaries and participants who invest in TDFs.
Testimony to the Working Group was provided on July 15, 2008, and September 11, 2008, by 24 witnesses, representing plan sponsors/employers, investment managers, trustees, lawyers/consultants, custodians, the accounting industry, and the federal government.
After much discussion and debate concerning the issues presented and whether the Council believed the Department needed to address concerns relative to Hard to Value Assets and Target Date Funds, the Council submits the following recommendations to the Secretary of Labor for consideration:
Recommendation 1: The Department of Labor should issue guidance which addresses the complex nature and distinct characteristics of Hard to Value Assets. This guidance should define Hard To Value assets and describe the ERISA obligations when selecting, valuing, accounting for, monitoring and disclosing/reporting these assets. The Department should coordinate its issuance of the guidance on Hard To Value Assets utilizing resources such as recent accounting pronouncements by the SEC on fair value rules, the General Accounting Office report, the AICPA, the Department of the Treasury Blueprint for a Modernized Financial Regulatory Structure from March 2008 ("The Paulson Report"), and the 2006 ERISA Advisory Council’s Report on Prudent Investment Process.
Recommendation 2: The Department should reinforce ERISA requirements relative to plan investments in Target Date Funds.
Recommendation 3: The Department should develop participant education materials and illustrations to enhance awareness of the value and the risks associated with Target Date Funds.
Stephen McCaffrey, Working Group Chair
David Evangelista, Working Group Vice-Chair
William Scogland, Ex Officio
Patricia Brambley, Ex Officio
Mary Nell Billings
The Working Group undertook a study of two specific fiduciary issues, the first, relative to Hard To Value Investments, also known as Alternative Investments, and the second, relative to Target Date Funds, which in certain instances may include Hard To Value Assets thus causing possible valuation issues. The first half of this report addresses the scope of the Working Group relative to Hard To Value Assets, and the latter half addresses the scope issues associated with Target Date Funds. The balance of the report will address the questions for witnesses, the list of witnesses, the consensus consideration of the Council, and a Summary of Testimony from the witnesses relative to the respective fiduciary and participant concerns and issues relative to and associated with Hard To Value Assets and Target Date Funds.
The Working Group first sought to analyze the DOL's current guidance concerning a fiduciary’s process for selection, monitoring, accounting and reporting for, and valuation of Hard To Value Assets or Alternative Investments. A concern in this area, as more fully set forth below, was the recent letter from the Department of Labor Boston field office concerning valuation of alternative investments, which caused confusion to fiduciaries and their professional advisors.
The Working Group also studied and made inquiry into the role Target Date Funds play in the current marketplace, especially now that they are among the qualified default investment alternatives included in the DOL’s regulations. The Working Group made inquiries into the challenges, risks, and issues to fiduciaries and participants who invest in TDFs.
Scope and Objective of Working Group
The Scope of this Working Group is to identify the concerns, potential associated risks, and the roles of fiduciaries, trustees, plan administrators, custodians, investment managers, accountants/auditors and participants, when Employee Benefit Plans (“EBPs”) invest in Hard To Value Assets (“HVAs”).
Questions for Potential Witnesses
Should valuation issues play a role in the selection of plan investments, and in achieving proper asset allocation and diversification? What, if any, modifications to plan investment policies and guidelines should plans consider when utilizing HVAs? As fiduciaries, what do you deem to be or what do you expect to be HVAs?
Who can the fiduciary rely upon when ascertaining the value of HVAs when the fiduciary is incapable of valuing, in order to fulfill their fiduciary responsibility to plan participants:
- Investment Manager(s)?
- Plan Administrator?
- Independent valuation expert/Appraisers?
What valuation policies and procedures should a fiduciary adopt when holding HVAs? How much reliance should be placed upon custodian or investment manager supplied values (vs. possible reporting ‘lags” or “self-provided” valuations by investment managers)?
What is the Accountant/Auditor’s obligation to determine the proper reporting/valuation of HVAs relative to FAS 157 and FAS 158 implementation?
If a plan holds HVAs, does the limited scope audit still effectively protect plans, fiduciaries and participants, and satisfy DOL regulations? Are HVAs widening the disjunct between investment information being certified and the information required to be reported on Form 5500 (i.e., “fair value)?
If a plan holds HVAs, do certifications still meet the reporting requirements as originally intended under ERISA and regulations promulgated or adopted there under? What effects do “carve-outs” and disclaimers by certifying entities, due to investments in HVAs, have on plan audits?
What disclosures and education measures are required or suggested for Participants and Fiduciaries with respect to plans which invest in HVAs?
The Working Group solicited testimony of witnesses from a broad cross section of the employee benefit community. Both through their written presentations and their testimony, the witnesses addressed the issues raised and provided a considerable source of developmental information for consideration by the Working Group. In addition, the Working Group considered written testimony from certain parties who were unable to present oral testimony. The scope of the inquiry for the Working Group and the attendant questions were given to all witnesses in advance of testimony. The witnesses were told that the questions were merely a starting point to generate thought and discussion of the scope of the Working Group. The questions were not intended to limit the parameters of testimony. The witnesses did not answer every question and in many instances, there was not enough information presented to form a consensus as to every inquiry by the Working Group.
The witnesses and the dates of their testimony relative to Hard to Value Assets were as follows:
July 15, 2008
Robert Doyle, Employee Benefits Security Administration ("EBSA")
Scott Albert, EBSA
Marilee Pierotti Lau, KPMG LLP, for the American Institute of Certified Public Accountants ("AICPA")
Peggy Bradley, The Northern Trust Company
September 11, 2008
Virginia Smith, EBSA
Randall Crawford, Lee Munder Capital Group
John Taylor, National Venture Capital Association
David Larsen, Duff & Phelps
Walter Zebrowski, Regulatory Compliance Association
Susan Mangiero, Pension Governance, LLC
John Connolly, State Street Corporation, on behalf of American Banking Association ("ABA")
Mary Mohr and Rich Radachi, Retirement Industry Trust Association
Consensus of Council Recommendations
ERISA establishes comprehensive standards governing fiduciary conduct in connection with employee benefit plans. According to Robert J. Doyle, Director of Regulations and Interpretations for the Employee Benefits Security Administration (EBSA), U.S. Department of Labor (DOL), the cornerstone of these standards is ERISA Section 404(a) that requires fiduciaries to carry out their duties prudently and solely in the interest of the plan’s participants and beneficiaries. These fiduciary standards necessarily govern all aspects of plan management, including investment determinations and an ongoing responsibility to monitor and value investments on behalf of the plan. Without knowledge as to these investments, a fiduciary cannot prudently determine an appropriate level of plan benefits. In setting forth the standard of care required of plan fiduciaries, ERISA Section 404(a)(1)(B) specifically requires that fiduciaries must discharge their duty “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 like character and like aims.”
According to Mr. Doyle, investments in “Hard To Value” assets are subject to these fiduciary responsibility requirements in the same manner as any other plan investment. Therefore, concerning “Hard To Value” assets, Mr. Doyle stated that a fiduciary’s analysis, as part of a prudent due diligence process, would include, but not be limited to, how the investment fits in the plan’s investment portfolio; the role of the investment in the plan’s portfolio; and the plan’s exposure to losses, for example, is the investment subject to extreme price fluctuations and a high degree of leverage?
In the past, the DOL has issued guidance to plan fiduciaries concerning the discharge of their duties under Section 404(a)(1)(B) in connection with investment decisions – 29 CFR Section 2550.404(a)-1. This provision generally states that a fiduciary must give appropriate consideration to the role of the investment in the plan’s portfolio, as well as, as above stated, how the investment will impact the portfolio relative to the funding objectives of the plan.
In considering witness testimony and their discussions, the Council was generally of the view that DOL has not provided any specific guidance, particularly in the present economic climate, as to the unique nature of Hard To Value assets.
While indeed, administrators of employee benefit plans (with 100 or more participants) are required to file an Annual Report – Form 5500 Series – with the DOL under Sections 101 and 103 of ERISA, and Schedule H of the Form 5500 defines the “current value” as the basis for reporting the plan’s assets, as set forth in Section 3(26) of ERISA, it is left to a plan fiduciary to make a good faith determination of the fair or current value of assets where there is no readily ascertainable value. Thus, under ERISA, the plan and it fiduciaries are responsible for the valuation of alternative investments as presented in the financial statements. The Council discussions revealed confusion revolving around which plan fiduciary has the actual responsibility for the good faith determination to satisfy form 5500 requirements.
Mr. Doyle noted that plans are required to engage an independent qualified public accountant/auditor to audit plan financial statements and stated that this engagement requires the accountant to opine that the plan’s financial statements are presented fairly in conformity with generally accepted accounting principles. The Council in its discussion expanded on Mr. Doyle’s statement, finding that the accountant (auditor) should also opine that the plan's financial statements present fairly the net assets available for benefits of the plan.
An audit includes assessing management’s processes for valuing plan assets, and in a full scope audit requires testing the valuations used for compliance with generally accepted accounting principles (GAAP), but does not require the auditor to make their own good faith determination of fair values. The auditor's opinion would only be rendered if plan management has made a good faith and proper determination of the value of plan assets in the financial statements following generally accepted accounting principles (GAAP), including the values of any Hard To Value assets held by the plan. Mr. Doyle also noted that in a limited scope audit the DOL permits the auditor to rely upon the certification of values by the custodian. When the auditor conducts the audit, all valuation procedures are evaluated by the auditor as part of the audit of the plan's financial statements. As a result, although plan fiduciaries may be able to outsource the process of valuation and the auditor reviews such process whether done by the fiduciary or an external party, there is confusion as to who bears the ultimate fiduciary responsibility if the valuation is incorrect
It also appears from the testimony that new FASB Statement No. 157 requires extensive financial statement disclosures about the valuation of plan assets. In many instances, for example, with respect to equities and fixed income investments, the value of such assets is readily ascertainable and that does not place the fiduciary in a position of having to consider further procedures to determine their value.
The difficulty arises with a further requirement that fiduciaries have an adequate understanding of the characteristics of investments in the valuation process in order to determine whether certain valuations are reasonable. To the extent discussed, there appears to be no disagreement among the Council members with respect to investments that have an ascertainable value. However, valuing alternative investments can present unique challenges. Often alternative investments are investments for which there is not a readily determinable fair value or a market. For example, as noted in the Plan Advisory on Valuing and Reporting Plan Investments issued by the AICPA, alternative investments are not generally listed on national exchanges or over-the-counter markets, nor are quoted market prices available from sources such as financial publications, the exchanges, or the National Association of Securities Dealers’ Automated Quotations System. To complicate the matter, according to the AIPCA Study, these alternative investment/hedge fund managers generally provide limited information to third parties, and the assets themselves can range from marketable securities to complex and/or illiquid investments, and such assets may not be disclosed by the alternative investment/hedge fund managers.
Another complicating factor is to ensure that the financial statements that support valuations of such assets are timely. As noted in the AICPA Study, if a plan is invested in a limited partnership with audited financial statements as of the date that is three months prior to the plan’s year-end statement, a fiduciary may need to determine how the value of that limited partnership may have changed over the three-month period between the date of the partnership’s financial statements and the date of the plan’s financial statement. This places an additional burden on the plan fiduciary to understand the nature, strategy, and assumptions used in valuing alternative assets. To a plan fiduciary, or his professional advisor, generally used to obtaining investment reports supported by values based on national exchanges, all these issues constitute uncharted territory. For these reasons, a position taken by a plan fiduciary that it can rely upon an outside auditing firm to support an asset valuation is drawn into question. In addition, plan fiduciaries need to be aware of lag periods, even where a Hard to Value Asset, such as a limited partnership, has the same year-end as the Plan, but the final audited year-end audited valuations are not provided to the Plan's investment custodian or fiduciaries until many months after the year end of the Plan. In addition, both the plan fiduciaries and the plan auditor need to review the alternative investment's audit reports and qualification of its auditor to ascertain whether this provided information is satisfactory to support the plan's valuation of the investment.
Virginia Smith, Director of Enforcement for the EBSA, in her background commentary, referenced the testimony of Mr. Doyle, who had told the Council that plan fiduciaries who hold “hard-to-value” assets had the same responsibility to properly value these assets as any other asset. Ms. Smith noted that the proper valuation of assets is essential to ensure that benefits to be used in retirement are properly planned.
Ms. Smith then extensively detailed the DOL’s voluntary fiduciary correction program and the fact that there are currently several active regional enforcement projects that involve “hard-to-value” assets, and that the review about a Plan's asset valuation process is part of the standard enforcement review procedure. While Ms. Smith stated that it is to the benefit of plan fiduciaries to understand the breath and width of their fiduciary responsibility in this area, she deferred to others at EBSA when asked whether it would be appropriate for the DOL to issue guidance or a checklist that plan fiduciaries could consult as to items they should reference when considering the question of valuing “hard-to-value” assets.
The potential of addressing enforcement compliance is not limited to the investigatory front.
Scott C. Albert, Chief, Division of Reporting Compliance of EBSA’s Office of the Chief Accountant, reported on the work his division performs on reviewing Form 5500 Annual Reports that plans file with the DOL. He emphasized that EBSA is examining what plan administrators are doing regarding properly valued alternative investments, and it is his view that alternative investments such as hedge funds and private equity arrangements are characterized as “hard-to-value” and the DOL wishes to determine whether such investments, as audited, contain a suitable basis for their valuation. Mr. Albert underscored that plan fiduciaries remain responsible for knowing the fair market value of an investment asset. Mr. Albert also noted that his office has started reviewing the valuation practices and documentation of administrators whose plans hold alternative investments.
In the context of “limited scope audits,” Mr. Albert cautioned administrators that such audits cannot be relied upon for assurance that alternative investments have been properly valued. Instead, it is Mr. Albert’s view that administrators should carefully review whether a limited scope audit is appropriate, given the investment portfolio. Marilee Pierotti Lau of KPMG, LLP, representing the AICPA, also points out that:
"We have seen a number of certifications that are changing to say 'are complete and accurate based upon the best available books and records of our institution' as opposed to just 'complete and accurate'. So there's been a change over the past several years in order to indicate exactly what they are certifying to."
Ms. Lau also testified that there are now cases where the plan invests assets without readily determinable values and where the trustee or custodian may have been hired only to provide custodial services. The values in the trust report typically will pass through the values provided by the fund company or limited partnership for commingled funds or by a boutique vendor or broker for nonmarketable securities. In those cases, the reported values are based on the best information available to the trustee and custodian at the time of the report, which may or may not be fair value.
On a regional basis, the EBSA’s Boston Regional Office on July 1, 2008 (the “Boston letter”), recently issued a letter which stated in relevant part:
“It is incumbent upon the Plan Administrator to establish a process to evaluate the fair market value of any “hard-to-value assets” held by the plan. Such a process will include a complete understanding of the underlying investments and the fund’s investment strategy. In addition, the Plan Administrator must have a thorough knowledge of the general partner’s valuation methodology to assure it comports with the fund’s written valuation provisions and reflects fair market value. A process which merely uses the general partner’s established value for all funds without additional analysis may not insure that the alternative investments are valued at fair market value.”
The letter goes on to threaten legal action, absent compliance with certain requirements set forth in the letter.
It appears to be the view of the DOL from testimony given that there is sufficient guidance in this area, including its enforcement manuals, such that plan sponsors and fiduciaries are on notice of their obligations. Yet, the complexity of this situation, in the view of the Council, requires more. In the past, citing one example, DOL has provided plan fiduciaries with guidance concerning the discharge of their duties in connection with investment decisions by issuing regulations 29 CFR Section 2550.404(a)-1. The Council believes that in the area of valuing assets, fiduciaries need to know their level of investment responsibility and how to attain compliance with those responsibilities. As John Taylor of the National Venture Capital Association testified, it is important to have a process to establish, monitor, report and review (asset) valuation, which is transparent and prudent. Specifically, relative to venture capital, he stated that a fiduciary as a limited partner can rely on the valuations provided by the general partner and believes that the plan fiduciary must ensure that a formal process is in place to obtain fair market value of “hard-to-value” assets. He concluded stating that the plan fiduciary needs to consider the cost benefit analysis for implementing such a valuation process vs. the expected increased yield from investing in the Hard to Value Asset.
The Investors Committee of the President’s Working Group on Financial Markets has recently issued a report on Principles and Best Practices for Hedge Fund Investors. This document provides guidance with respect to valuation policy, the governance of the valuation process, valuation methodology, as well as assessment of fees and expenses incident to the valuation process.
Plan sponsors and their fiduciaries are now placed in a dilemma. It has been widely advertised that failure to properly value assets will place them in breach of their fiduciary duties, yet in view of the Council, there has not been sufficient guidance issued to assist them in understanding the scope of those responsibilities. For example, is an independent fiduciary needed to value alternative investments, and what should be required of hedge fund and other managers in providing valuation specifics? The Council believes that the unanswered questions warrant the preparation of appropriate guidance – whether as noted by way of checklist or a best practices communication to assist plan sponsors and their fiduciaries in meeting their obligations.
A letter filed with the Council by the Managed Funds Association ("MFA") supports the proposition that the DOL issue guidance in this area and coordinate its efforts with other regulatory agencies. The MFA disagrees in its letter with the proposition that plan fiduciaries must have full portfolio level transparency to meet their valuation obligations with respect to plan investments and alternative investments. They believe that plan sponsors and their fiduciaries should not be precluded from generally relying on valuations reported by managers or general partners in alternative investments. The Council believes that such a position may cause confusion if fiduciaries without DOL guidance believe they can shed their fiduciary responsibilities merely by hiring professionals, such as accountants, custodians or valuation professionals, to value these assets without providing the requisite level of full transparency for form 5500 reports.
The letter from the MFA makes the point that the Boston letter has caused uncertainty in the industry, which may have a chilling effect on pension plan investments in alternative vehicles to the detriment of those plans realizing the benefits of diversification, risk management, and returns from their investments in this area. Therefore, since most parties agree that it is appropriate for plan sponsors and their fiduciaries to consider alternative investments under the appropriate circumstances, an additional advantage of guidance by the DOL will allow these individuals to understand that such investments are acceptable based on the ground rules that can be provided by the DOL.
The Council believes that any guidance to be issued can and should be done in coordination with other governmental agencies and financial bodies who have issued recent pronouncements in this area, including but not limited, to the General Accounting Office report, the SEC hearing on fair value, FASB 157 and the AICPA pamphlet on valuation of alternative investments. The accounting community could be particularly helpful in providing plan sponsors and their fiduciaries with information as to areas where in valuing assets as part of auditing a financial statement, the accountant sees the potential difficulties or the need for further valuation processes often beyond their expertise. The DOL could suggest to the Securities and Exchange Commission that it issue further guidance to hedge fund or private placement managers in the area of transparency and the requirement to provide valuation reports on a periodic basis, so that they may be up-to-date when a plan sponsor is required to prepare an audited financial statement.
The ERISA Advisory Council in November 2006 recommended that the DOL “should publish guidance which expresses the unique features of hedge funds and matters for consideration and their adoption for use by qualified plans as a matter of procedural prudence.” The 2006 Working Group on a Prudent Investment Process found hedge funds to be an acceptable form of plan investment, but certain aspects of hedge funds should be brought to the front of the line “in educating Trustees, fiduciaries, and plan sponsors.” The Council’s report stated that fiduciaries should “concern themselves with certain due diligence” in inclusion of hedge fund investments. The report went on to provide a definition of the term “hedge fund” and categorized the various investment styles of hedge funds. In summarizing its comment, the report stated the following:
“…it is most important for the plan fiduciaries to have a rudimentary understanding of the hedge fund alternative investment vehicle under consideration and its operation. In addition to a fiduciary understanding of investment styles and liquidity issues – conflicts of interest and prohibitive transaction rules must constantly be scrutinized when a hedge fund investment is considered and undertaken…”
The GAO has called upon the DOL to provide guidance for investments by defined benefit pension plans in hedge funds and private equity, so that plan fiduciaries understand the challenges and risks of these asset classes. The report by the GAO recommended that the guidance include a description of the steps funds should include to address the challenges and risks of alternative investments while meeting their fiduciary obligations under ERISA.
In a July 16, 2008 letter response to the GAO’s draft report, which is included in the final GAO report, Bradford P. Campbell, Assistant Secretary of DOL’s Employee Benefits Security Administration, underscored:
“…a plan fiduciary must gather sufficient information to understand the nature of the investment, make a determination as to its prudence, and periodically monitor the investment to evaluate whether it remains a prudent plan investment.”
Mr. Campbell then concluded his letter by stating:
“Nonetheless, we will consider the feasibility of developing the type of specific guidelines regarding investments in hedge funds and private equity funds as recommended in the draft report.”
Mr. Campbell also noted in his letter that providing additional guidance could be difficult because “there is no statutory definition” of hedge funds or private equity funds, and investment objectives and strategies may vary greatly among these funds. In response, the GAO stated that “the lack of uniformity among hedge funds and private equity funds is itself an important issue to convey to fiduciaries, and highlights the need for an extensive due diligence process preceding any investment.”
Since the issuance of 2006 Council report, other entities have weighed in, e.g. the President’s Working Group on Financial Markets. In the report of its Investors Committee, which provides a discussion of best practices for hedge fund investors, this Committee extensively sets forth due diligence requirements to consider prior to investing in hedge funds. More expansive than the 2006 Council report, it notes that fiduciaries should review the history of investment managers, the firm and its professionals, its past and current portfolio, the investment philosophy, its decision processing for implementing the investment strategy, its organizational culture, and its internal economic incentive. The Investors Guide also assesses legal, tax and accounting considerations, among other items, that should be considered by fiduciaries in considering such an investment.
The Council is of the view that utilizing the prior 2006 report, as well as other source material, including the President’s Working Group report on Financial Markets for Hedge Fund Investments, would be relevant in consideration by the DOL in expanding the 2006 Council recommendation related to hedge funds to include all alternative investments.
Finally, the Council believes that DOL should develop definitions and types of alternative investment vehicle terms to assist plan sponsors, fiduciaries, and service providers in their evaluation of matters that the DOL considers as critical in disclosing alternative investments for Form 5500 reporting of the financial disclosures. It is the view of the Council that such undertaking should take into account definitions, terminology, and so forth. We note that the 2006 Report on Prudent Investment Process contains a definition of a hedge fund. Also, the Investors Committee’s Report defines hedge funds as a pooled investment account that:
“…generally meets the following criteria: (i) it is not marketed to the general public (i.e., it is privately-offered), (ii) it is limited to high net worth individuals and institutions, (iii) it is not registered as an investment company under relevant laws (e.g., U.S. Investment Company Act of 1940, as amended), (iv) its assets are managed by a professional investment management firm that shares in the gains of the investment vehicle based on investment performance of the vehicle, and (v) it has periodic but restricted or limited investor redemption rights.”
The issue of developing and providing definitions of the various types of alternative investment vehicles has been considered by the ERISA Advisory Council in another venue. Specifically, as part of the report of the Council on Revenue Sharing in 2007, the need for a better definition of Revenue Sharing was recommended.
In concluding our remarks on Hard to Value Assets, the Council understands that over-regulating or making an issue more complex than necessary will add cost to any plan sponsor’s operations and may also cause confusion. However, the Working Group believes that there is ample confusion in this area already as to responsibilities of the plan sponsor and its fiduciaries, and therefore, guidance issued by the DOL as to as to a plan fiduciary’s responsibility to evaluate alternative investments as an investment vehicle and the fiduciary’s responsibility for valuing such investment assets would go far to simplify what a plan sponsor and its fiduciary need to know about these subjects.
Scope and Objective of Working Group
The Working Group was next asked to address the issues surrounding the introduction of a relatively new investment vehicle for 401(k) Plans, known as Target Date Funds ("TDFs") . TDFs are being introduced because of the decline in the number of employers that are offering traditional defined benefit retirement plans Participants are recognizing that they are responsible for amassing their own retirement income during their working years, yet they do not know how to invest, are not saving enough, suffer from inertia and fail to realize that those investments they do have, are not diversified. TDFs can help participants allocate their plan assets, a task done for them in a DB plan model. Additionally, fiduciaries and investment providers recognize that participants may not have the financial literacy to address their retirement needs. TDFs are a new means to assist participants (i) to address these issues, (ii) automate their investment allocations and (iii) hopefully achieve, the desired result of greater retirement account balances. Additionally, because TDFs receive favorable statutory protection if they satisfy the QDIA regulations promulgated pursuant to the Pension Protection Act, fiduciaries are now willing to consider the offering of these funds in their plans. The Working Group studied the role that TDFs will play in the current marketplace, especially now that they are among the qualified default investment alternatives included in the DOL’s regulations. This Working Group made inquiry into the challenges, risks, and issues to fiduciaries and participants who invest in TDFs. Specifically, this Working Group analyzed the different types of TDFs, the criteria for adopting TDFs, and the proper methodology for monitoring the success of TDFs. The desired results of the Working Group were to determine when and under what circumstances TDFs are a prudent retirement investment, and who can benefit from including TDFs in his or her portfolio. Because TDFs are a relatively new retirement investment tool, the goal of the TDF study is to provide information and recommendations to plan fiduciaries who may be responsible for selecting and monitoring a TDF as a prudent investment alternative in a defined contribution plan lineup.
Questions for Potential Witnesses
What should be the plan’s desired purpose in using TDFs?
What retirement and participant assumptions should be employed by the fiduciary/investment counselor when selecting and monitoring TDFs?
What investment strategy, investment allocation, risks and costs must be considered when selecting funds to be included in a plan? How have these changed since the creation of TDF and what is anticipated in the future over the life of TDFs?
How does a fiduciary/investment counselor evaluate and monitor TDFs when there is no standardized benchmarking methodology or performance metrics? What are current benchmarking methodologies for TDFs given their short term existence?
What criteria should be used in adopting a proprietary TDF or non proprietary TDF when creating a TDF specifically for a plan?
What investment education and communication is required for participants with respect to plans to enable them to invest in TDFs or to assess whether they should actively manage their own investment?
What are the different types of TDF?
If the TDF is found to fail any criteria established by the plan sponsor’s investment committee, what options does a fiduciary have?
What criteria would cause a TDF to require closer monitoring or even removal of the fund from the investment lineup offered to the participant?
The scope of the inquiry for the Working Group and the attendant questions were given to all witnesses in advance of testimony. The witnesses were told that the questions were merely a starting point to generate thought and discussion of the scope of the Working Group. The questions were not intended to limit the parameters of testimony.
The Working Group solicited testimony of witnesses from a broad cross-section of the retirement investment industry. The witnesses did not answer every question and in many instances, there was not enough information presented to form a consensus as to every inquiry by the Working Group.
The witnesses and the dates of their testimony relative to Target Date Funds were as follows:
July 15, 2008
Robert Doyle, EBSA
Troy Saharic, Mercer Investment Consulting
Michael Sasso, David Hudak and Greg McCarthy, Portfolio Evaluations, Inc.
September 11, 2008
Seth Masters, Alliance Bernstein Defined Contribution Investments
John Ameriks, Vanguard
Robert Brokamp, The Motley Fool
Carmela Elco, Resources for Retirement
Wes Schantz, The Corporate Consulting Group
Anne Lester, JPMorgan Asset Management
Peter Bobick, Charles Schwab Investment Management
Consensus of Council Recommendations
When evaluating topics to be addressed by this years Council, it was recognized that financial illiteracy in the area of retirement benefits is prevalent among many plan participants and plan participants need help in making proper investment choices in their 401(k). In fact, last year’s Council specifically reported on the need for education of participants to assist them in making the proper investment choices for their retirement funds. Specifically, the 2007 Council made a recommendation that the “Department of Labor initiate, engage and facilitate …materials and resources that employers, plan sponsors and fiduciaries can draw upon to increase financial literacy of employees and plan participants.” This recommendation was made because of the Council’s finding that employees do not believe that they have the requisite knowledge to make investment decisions and have little knowledge of financial concepts and financial instruments, in general. The 2007 Council also found that this combination of the lack of knowledge and employees’ lack of attention and engagement could result in people close to retirement failing to change their behavior even when necessary to plan for retirement In addition, because many employees may not have the knowledge necessary to make correct investment choices, they may choose not to invest or may make imprudent choices when selecting the funds for their 401(k) account.
Plan providers and investment professionals, recognizing the need to simplify investment choice for plan participants, believe they have created a solution through an investment vehicle known as Target Date Funds (“TDF”). The Council took testimony which addressed the fact that TDFs provide the instant diversification, growth potential and regular portfolio realignment that every investor needs and the TDFs do it for participants in a relatively inexpensive, efficient manner. One witness testified that TDFs are the ideal means for delivering a comprehensive investment solution for participants who will allow TDFs to evolve automatically as time unfolds. The plan providers also support TDFs because these funds could receive favorable treatment pursuant to the Pension Protection Act of 2006 (“PPA”).
The PPA amended ERISA section 404(c) to provide relief for fiduciaries that invest participant assets in certain types of default investment alternatives in the absence of participant investment direction. Since the adoption of the “qualified default investment alternatives” (“QDIAs”) regulations, the use of TDFs by plan sponsors has grown dramatically. It is estimated that in the near future “between fifty and sixty percent” of all plan assets held in individual account plans will be invested in TDFs. While TDFs have been around since the 1950s, if not earlier, there has been a recent resurgence in interest in this approach. The Council heard testimony that defined contribution plans are the future of the U.S. retirement system, and TDFs will represent the bulk of new funds in those plans. It was suggested that TDFs are “the next best choice” for those individuals who may not be qualified to select their own investments. However, with the onset of these new funds come issues There is a belief in the benefits community that the regulators have not given sufficient information to the plan fiduciaries to enable them to satisfy their fiduciary requirements under ERISA § 404. Some witnesses expressed concern that plan fiduciaries may be unaware of the unique aspects of evaluating TDFs. when selecting and monitoring TDFs as an investment option for their the plan.
Given these issues, the Council endeavored to review the role that TDFs could play in the current marketplace, especially because TDFs, if they satisfy the requirements established in the DOL regulations issued last year, can be treated as a QDIA. The Council received testimony providing that there is, however, little information that plan fiduciaries have in the course of satisfying their fiduciary requirements under ERISA § 404 when selecting and monitoring TDFs as an investment option under the plan. Not unlike the DOL position as was discussed in the HVA section, Mr. Doyle explained that investments in “target date funds” are subject to the fiduciary responsibility in the same manner as are any other plan investments. The Council, in the HVA section above, cited Mr. Doyle’s testimony relating to ERISA and the fiduciary standards, and re-emphasizes it here because of the importance of these standards as applied in the TDF context. His testimony provided that the cornerstone of these ERISA Section 404(a) standards require fiduciaries to carry out their duties prudently and solely in the interest of the plan’s participants and beneficiaries. These fiduciary standards necessarily govern all aspects of plan management, including investment determinations and an ongoing responsibility to monitor and value investments on behalf of the plan. Without knowledge as to these investments, a fiduciary cannot prudently determine an appropriate level of plan benefits. In setting forth the standard of care required of plan fiduciaries, ERISA Section 404(a)(1)(B) specifically requires that fiduciaries must discharge their duty “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 like character and like aims.”
Specifically addressing TDFs, Mr. Doyle defined “target date” funds as funds that automatically reset the asset mix (stocks, bonds and cash equivalents) in the portfolios, generally by investing in other funds, to a time frame appropriate for the investor, typically the date of retirement or death. While “target date” funds are among the qualified default investment alternatives under the DOL regulation, nevertheless, the plan sponsors and their fiduciaries remain responsible to make prudent selections of “target date” funds for inclusion in their plans. Mr. Doyle cautioned that fiduciaries have an ongoing obligation to monitor the plan’s investments to ensure that they continue to be appropriate for the plan and its participants and beneficiaries.
Given this perspective the Council then identified the legal foundation, both statutory and administrative, regarding TDFs as ERISA investments. In the past, the DOL issued guidance to plan fiduciaries concerning the discharge of their duties under Section 404(a)(1)(B) in connection with investment decisions – 29 CFR Section 2550.404(a)-1. This provision generally states that a fiduciary must give appropriate consideration to the role of the investment in the plan’s portfolio, as well as, as above stated, how the investment will impact the portfolio relative to the funding objectives of the plan.
ERISA generally require plan fiduciaries to act prudently and solely in the interest of the plan’s participants and beneficiaries. The Council understands that a special exception to this general rule is provided under ERISA section 404(c) for individual account plans that allow participants the ability to exercise control over assets in their own account. For these plans, the plan fiduciaries are relieved of liability for any losses that result from the participant’s exercise of control over the assets in his or her account.
While fiduciaries may be relieved of liability under ERISA section 404(c) for losses resulting from participant direction, the Council understands that the Department of Labor takes that position that plan fiduciaries of a 404(c) plan continue to retain responsibility for prudently selecting and monitoring the designated investment options from which participants may choose. The Council also understands that under ERISA, the DOL historically took the position that a participant must affirmatively exercise investment control in order for the fiduciaries to claim 404(c) protection.
As described above, the enactment of the PPA supplied the potential protection for fiduciaries that invest participant assets in a QDIA, when participants fail to give direction to the fiduciaries as to how their account investments should be invested. Under the new law, the Council understands that a participant in an individual account plan is treated as exercising control over those assets which are, in the absence of an investment election by the participant, invested by the plan in accordance with DOL regulations. The Council further understands that when the PPA was enacted it required DOL regulations to provide guidance on the appropriateness of designating defaults that include a mix of asset classes consistent with capital preservation or long-term capital appreciation, or a blend of both.
In response, the DOL published final regulations in October of 2007 providing rules for “qualified default investment alternatives” (“QDIAs”). In addition to meeting several other requirements under the QDIA regulations, the Council’s understanding is that in order for fiduciaries to be relieved of responsibility for investment losses, the QDIA must qualify generally as one of three types of investment products, portfolios, or services:
- A “life-cycle” or “targeted-retirement-date” fund or account;
- A “balanced fund”; or
- A “managed account”.
The Council further recognizes that while the QDIA regulations provide relief when participants are defaulted into a QDIA, the DOL maintains its view that fiduciaries are not relieved of the responsibility to prudently select and monitor any QDIA under the plan.
Lastly, on April 29, 2008, the Department of Labor issued Field Assistance Bulletin 2008-03 (“FAB 2008-03”) to clarify certain aspects of the QDIA regulations. Under FAB 2008-03, Q&A 2-3, the Department clarified that a fiduciary may obtain relief under the QDIA regulations for assets invested in default investment prior to the issuance of the QDIA regulations, whether or not the participant or beneficiary had previously affirmatively elected the default investment.
In light of this legal foundation provided by ERISA and the regulations, the Council then attempted to ascertain whether fiduciaries had sufficient guidance and understanding to implement TDFs in their plans’ investment lineups. The consensus of the Council is that fiduciaries would be well served if the DOL reinforced ERISA requirements relative to plan investments in Target Date Funds. The Council believes that this specific education should address the fiduciaries obligations relative to selection, communication and implementation and monitoring of TDFs as well as the identification for participants of the value and the potential risks associated with TDFs. The Council then reviewed each of these obligations.
One witness expressed his concern regarding selection by stating while the reasoning behind TDFs has an elegant simplicity, actually choosing and then monitoring specific TDFs is more complicated. One common theme among witnesses was the importance of analyzing a Fund’s glidepath. Mr. Doyle expressed his opinion that plan fiduciaries when evaluating TDFs must analyze the “glide path,” the rate at which the fund shifts its investment portfolio to reduce market risks, taking into account the plan’s demographics; the ability of the investment to alter the “glide path” on a post-investment basis and the extent to which notice will be provided to the investor; the portfolio of the funds in which the participants will be invested; the historical returns, recognizing that target date funds are relatively new types of investments and comparisons may be difficult; and the fees attendant to the investment.
The witnesses acknowledged that TDFs are subject to these fiduciary responsibility requirements in the same manner as any other plan investment, as expressed by the DOL. The Council found that the witnesses were in general agreement that the unique characteristics of TDFs make it difficult to apply the traditional evaluation criteria to TDFs that are used for standard or core options. As Anne Lester –JPMorgan Chase testified, this is because a TDF is an investment solution rather than an investment product. The TDF and its glidepath has been designed by a manager and selected by the plan fiduciary to maximize the probability of generating a specific outcome. A fiduciary when analyzing such investment solutions must (i) identify the primary objective of the TDF, allowing the fiduciary to choose the strategic glidepath which fits it specific needs and (ii) evaluate the ability of various types of providers or implementation models (i.e., open architecture, active vs. passive, the specific asset class and type of investments employed and the various risks associated with each TDF fund) to deliver that primary objective while considering the target returns, risks and costs which may be borne by a participant.
Once the specific TDF is selected by the fiduciary, a critical component of participant acceptance of the fund is the ease of implementation. As several witnesses testified, it is important to consider participant behavior, so that the TDF can produce changes in participant portfolios with more suitable risk levels and diversification, which enhances the prospects that participants will achieve financial security. The general consensus of the witnesses was that by making participants aware of TDFs and how they work, participants who acknowledge that they lack the time, skill or inclination to manage a portfolio, may be more inclined to invest in TDFs. Hopefully, this inclination will yield the result that they will experience better rates of risk adjusted returns with greater wealth accumulation, helping such participants to have more income during their retirement.
Seth Masters of Alliance Bernstein identified another critical implementation topic that the Council concurred in, that of the need for clarification from the DOL relative to possible re-enrollment strategies. Mr. Masters addressed the final QDIA guidelines and FAB 2008-03, which describe circumstances where fiduciaries are protected when moving or “mapping” participant assets into QDIAs in instances when participants fail to make affirmative investment elections. He emphasized that the guidelines are an excellent start, but felt that such guidelines could be expanded to allow more general mapping and default protection because the current guidelines fail to address the other mapping circumstances.
Mr. Bobick of Charles Schwab offered a different perspective concerning mapping. His experience suggests it is becoming more common to map to TDF solutions based on age. However, he testified that the Plan sponsor should continue to be very hesitant to do wholesale mapping. Unlike other witnesses, he does not generally advocate re-enrollment because it is cumbersome and costly.
The Council agrees that mapping and other re-enrollment techniques should be addressed through DOL guidance, including mapping techniques relative to Company stock and stable value investments. For example, Mr. Masters identified a technique being utilized by fiduciaries whereby participants who fail to re-enroll after given an opportunity are “mapped” or defaulted entirely into the QDIA. He expressed his belief that fiduciaries are protected by this implementation, yet more explicit clarification regarding re-enrollment or mapping is warranted.
The Council discussed the re-enrollment or mapping procedure and agreed that there is confusion among participants, fiduciaries and their advisers as to what is permissible. In addition, the Council discussed that participants should receive more education with regards to the possible ramifications and costs associated with mapping when they fail to elect the investments in their accounts. This education may help participants to be more engaged and knowledgeable in investment selection.
The Council received significant levels of testimony about benchmarking and monitoring techniques. Witnesses from PEI, testified about the problem with benchmarking only against a TDF’s stated benchmark. They stated that the problem with this methodology is that (1)such a benchmark does not give a perspective against peers, since it is only measured against the benchmarks selected by the fund company, (2) sponsors must examine the underlying benchmark to see if it actually represents the asset allocation of the TDF, and (3) given the limited performance history of most TDFs, it is difficult to get a perspective based on a benchmark selected by the fund company. The Council received additional testimony relative to problems with (i) benchmarks that attempt to benchmark by maturity year, which could be flawed because various providers TDFs’ asset allocations could be significantly different and (ii) benchmarks measured in terms of risk and return characteristics (e.g., aggressive, moderate or conservative) which may yield inaccurate results because individuals interpret those terms differently. Combining these benchmarking techniques – reviewing peer comparisons, reviewing available indexes, and creating a tailored index – will go a long way toward solving the benchmarking problem. But it might be impossible to resolve the problem because so many TDFs are new. Given this testimony, the Council recognizes that at the present time there is no established monitoring model or technique that takes into consideration all the different aspects of the TDFs; yet there is consensus among its members that monitoring and benchmarking of TDF is critical as a fiduciary evaluates any ERISA investment. The Council recognizes Mr. Doyle’s caution that fiduciaries have an ongoing obligation to monitor the plan’s investments to ensure that they continue to be appropriate for the plan and its participants and beneficiaries. The Council believes that the DOL should continue to educate fiduciaries on their duty to consider all possible benchmarks and evaluation techniques presently in the market and to guide fiduciaries that they must stay informed if better monitoring solutions are created for TDFs.
The Council considered witness testimony, the fiduciary responsibility rules under ERISA standards, the newness of TDFs as investment vehicles, and the potential for significant investments by unknowledgeable or defaulted future participants. The Council concluded that DOL should provide more specific guidance as to the complex nature of TDFs and the methodology necessary for plan fiduciaries who are responsible for selecting and monitoring TDFs as a prudent investment alternative in a defined contribution plan lineup. The Council also thought that additional education material and illustrations would be beneficial for plan participants to make them aware of the value and risks relative to TDFs.
Hard to Value Assets Witnesses
Robert J. Doyle and Scott Albert, U.S. Department of Labor, EBSA
Robert J. Doyle, Director of Regulations and Interpretations for the U.S. Department of Labor’s Employee Benefits Security Administration, testified that the valuation of “hard-to-value” assets and “target date funds” are critical for retirement plans. According to Mr. Doyle, “investments in hard-to-value assets and target date funds are subject to the fiduciary responsibility rules in the same manner as any other plan investments.”
Concerning “hard-to-value” assets, a fiduciary’s analysis, as part of a prudent due diligence process, would include, but not be limited to, how the investment fits in the plan’s investment policy; the role of the investment in the plan’s portfolio; and the plan’s potential exposure for losses, for example, is the investment subject to extreme price fluctuations and a high degree of leveraging. The analysis should further include a review of the methodology for valuing the investment changes in the value of the investment; and if investing in a pooled fund, whether the managers are qualified to manage the asset, and whether the managers of the fund are ERISA fiduciaries. This is an issue which generally turns on whether the fund/investment is determined to be holding “plan assets” within the meaning of ERISA.
According to Mr. Doyle, “the most comprehensive discussion of these principles” in the context of hard-to-value type assets appears in a March 21, 1966 letter from the DOL Assistant Secretary for Pension and Welfare Benefit to the Comptroller of the Currency dealing with investments and derivatives. Mr. Doyle added that the fiduciary’s specific analysis will vary depending on the type of plan, that is, the role of an investment might be different depending on whether it is an asset of a defined benefit plan, or an investment option under a defined contribution plan.
Citing appropriate authority, ERISA Section 404(a)(1)(B) and 29 CFR, Section 2550.404.a-1, in substance, a fiduciary should undertake “appropriate consideration” to the role of the investment in the plan’s portfolio, taking into account the risk of loss and the opportunity for gain or other return associated with the investment. Plan sponsors and their fiduciaries also need to consider how the investment will affect diversification, liquidity, and the projected returns relative to the funding objectives of the plan.
Mr. Doyle defined “target date” funds as funds that automatically reset the asset mix (stocks, bonds and cash equivalents) in the portfolios, generally by investing in other funds, to a time frame appropriate for the investor, typically the date of retirement or death. While “target date” funds are among the qualified default investment alternatives under the DOL regulation, nevertheless, the plan sponsors and their fiduciaries remain responsible to make prudent selections of “target date” funds for inclusion in their plans. Mr. Doyle believes that plan fiduciaries should be analyzing the “glide path,” the rate at which the fund shifts its investment portfolio to reduce market risks, taking into account the plan’s demographics; the ability of the investment to alter the “glide path” on a post-investment basis and the extent to which notice will be provided to the investor; the portfolio of the funds in which the participants will be invested; the historical returns, recognizing that target date funds are relatively new types of investments and comparisons may be difficult; and the fees attendant to the investment. Mr. Doyle cautioned that fiduciaries have an ongoing obligation to monitor the plan’s investments to ensure that they continue to be appropriate for the plan and its participants and beneficiaries.
As to the annual reporting requirement, administrators of employee benefit plans (with 100 or more participants) are normally required to file an annual report – Form 5500 Series - with the DOL under Sections 101 and 103 of ERISA. Schedule H of the Form 5500 defines the “current value” basis for reporting the plan’s assets, as set forth in Section 3(26) of ERISA.
Mr. Doyle addressed assets for which there is no readily ascertainable value, and the need for a plan fiduciary to make a good faith determination of the value of the assets. Generally, plans are required to engage an independent qualified public accountant for such purposes. Mr. Doyle addressed the limited scope audit, and he proceeded to explain the obligations of employee benefit plan administrators to file a complete and accurate annual report, and to determine whether the conditions for the limited scope of an accountant’s examination have been satisfied. These obligations are set forth in a May, 2002 letter to Richard M. Steinberg, Chair of the Employee Benefits Expert Panel, Department of Labor Liaison Taskforce of the American Institute of Certified Public Accountants issued by DOL.
Scott C. Albert, Chief, Division of Reporting Compliance of the EBSA’s Office of Chief Accountant, advises that he works with Form 5500 annual reports that plans file with the DOL. He stated that EBSA is examining what plan administrators are doing regarding properly valued alternative investments. It is Mr. Albert’s view that alternative investments such as hedge funds and private equity arrangements are to be categorized as “hard-to-value” and the DOL wishes to determine whether such investments, as audited, contain a sufficient basis for their valuation.
Mr. Albert underscored that plan sponsors remain responsible for knowing the fair market value of an asset. He stated that his office has started reviewing the valuation practices and documentation of administrators whose plans hold alternative investments. Mr. Albert strongly cautions administrators that so-called “limited scope audits” should not be relied upon for assurance that alternative investments have been properly valued. Instead, it is Mr. Albert’s view that administrators should carefully consider whether a limited scope audit is appropriate, given the investment portfolios.
In the ensuing discussion, Mr. Albert advised that the DOL has been speaking to various professional associations about the need to carefully evaluate “hard-to-value” assets. Consideration of the DOL developing best practices in this area was also addressed in the discussion.
Virginia Smith, U.S. Department of Labor, EBSA
Ms. Smith, Director of Enforcement, EBSA, discussed the effect of inaccurate asset valuation on pension plans. By way of providing background, Ms. Smith referenced the July 2008 testimony of Robert Doyle who previously had told the Council that plan sponsors who hold “hard to value” asset have the same responsibility to properly value these types of asset as any other asset class. She noted that the proper valuation of assets is essential to participants so they can properly plan for retirement.
Ms. Smith discussed the Department’s Voluntary Fiduciary Correction Program, explaining that, to date, this program has encountered 12 instances where hard to value assets were the subject of self-correction and stated her opinion that this category of investment will produce more VFCP activity in the near future.
She advised the Council that two current national enforcement initiatives involve Hard to Value Assets (or HVAs) including violations involving fraudulent valuation of ESOPS and the Consultant Advisor Project (CAP) that involves undisclosed indirect compensation, including where compensation is based on overvalued HVA. In its National ESOP enforcement initiative project the Department tries to review cases where Employee Stock Ownership Plans (ESOPs) include hard to value assets.
Ms. Smith reported that there are currently several active regional enforcement projects that involve HVAs, and noted that the review of the asset valuation process is part of the standard enforcement review procedure.
In her remarks, Ms. Smith reported on recent cases which had been involved in enforcement action that had been reported to the public, including the Hall Chemical ESOP and the Toms Sierra Company ESOP, where inappropriate valuations affected the price of the ESOP.
She also reported on other cases including SCT Yarns, and the Voorwood Company ESOP which included both inappropriately valued assets as well as fraud and embezzlements resulting in criminal prosecutions.
Ms. Smith responded to several questions from Council members, including a question from Mr. Archer who referenced a recent case from EBSA’s Boston regional office and inquired whether she believed that it would be appropriate for the Department to issue guidance or a checklist that plan sponsors can consult as to items they should consider (such as whether to have a formal written valuation policy) when addressing the question of hard to value assets. Ms. Smith noted that the Department’s enforcement manual is publicly available, but otherwise deferred to others at EBSA.
She noted that it is to the benefit of plan sponsors to understand the breadth and width of their fiduciary responsibility, including to obtain knowledge as to the value of their assets, so they understand that there is an appropriate process to engage in to meet those obligations, and noted that the Department has many publications to aid in that process.
Marilee Perrotti Lau, KPMG LLP, On Behalf Of the AICPA
When ERISA was first enacted plan trustees and custodians could certify the value of plan holdings with a high degree of confidence. Over time plans invested into non-exchange traded investments, with values that are not publicly available. Originally such investments were in DB plans but are now finding their way into DC plans.
ERISA requires that hard to value investments, be reported at current value. Fiduciaries must value the investments in good faith. Audited plans must report the value using GAAP.
Beginning November 15, 2007, the term “fair value” is defined in Financial Accounting Standards Board State of Financial Standards No. 157, Fair Value Measurements. Fair value is based on exit price as opposed to an orderly liquidation. So there will be a change coming.
In many instances, plan fiduciaries do not have the skills necessary to determine the fair value of hard to value investments and may require the assistance of third-party valuation specialists for assistance. Valuing HVAs may encompass a wide array of methodologies that involve many assumptions and the exercise of significant professional judgment. HVAs may or may not have been audited. In some cases, these financial statements may value the HVA on a date that differs from the plan year end. The K-1 does not generally provide fair value.
A number of certifications now say complete and accurate based on “best available information. Previously that just said “complete and accurate.” In cases where the plan invests assets without readily determinable values and where the trustee or custodian may have been hired only to provide custodial services, the values in the trust report typically will pass through of the values provided by the fund company or limited partnership for commingled funds or by a boutique vendor or broker for nonmarketable securities. In those cases, the reported values are based on the best information available to the trustee and custodian at the time of the report, which may or may not be fair value.
For full scope considerations, a plan with more than 100 participants must be audited by a qualified public accountant. If the plan administrator elects to have the independent auditor perform a full scope audit, the independent auditor needs to obtain appropriate audit evidence to provide him or her with a reasonable basis for expressing an opinion. Because of constraints on the availability of audit evidence, there may be circumstances where the auditor may not be able to obtain sufficient competent audit evidence over the existence or valuation assertions. In such cases and where hard to value investments are material to the plan’s financial statements, the auditor may not be able to express an unqualified opinion on the plan’s financial statements, as required by ERISA.
Due to the increased risk of misstatement inherent to these hard to value investments, the AICPA has issued a practice aid for auditors, “Alternative Investments, Audit Considerations.”
A plan sponsor may instruct a plan’s auditor not to audit investments certified by a bank or similar institution or by an insurance carrier. To qualify for this limited scope audit exemption, the trustee or custodian must provide the plan sponsor or administrator with a schedule of plan assets held in trust and income earned on those assets. They must certify both the schedule’s accuracy and completeness.
If, after receiving such certification, the plan sponsor instructs the independent auditor to perform only a limited scope audit, the auditor does not perform audit procedures to verify the existence or valuation of the certified plan statement. For that reason, the auditor declines to offer an opinion on the plan’s financial statements. In place of an opinion, the auditor disclaims any professional opinion on the plan’s financial statements. In the absence of an opinion, participants receive no independent assurance about the accuracy of the plan’s financial statements. Moreover, the certification is not included in the plan’s financial statements or Form 5500.
The decision of whether to authorize the auditor to look behind the certification lies solely with the plan administrator. Absent such authority, the auditor has no right to demand such information. In the course of a limited scope audit, it may come to the auditor’s attention that the valuations or other information in the certification appear to be inaccurate or out of date. For example, certifications by plan custodians are required as of the plan year end, to assess valuation information for hard to value investments; this valuation information may be several months old and, therefore, stale. In such instances, professional standards require the auditor to inform the plan sponsor of their concerns and that may lead to the auditor conducting further investigation or testing, and the auditor may decide to modify his or her report after performing further investigation.
Plan sponsors are choosing a limited scope audit due to the absence of regulatory guidance about the requirements for an acceptable certification and the meaning of the terms “complete and accurate,” as prescribed in ERISA Section 103(a)(3)(C). Absent such guidance, some plan sponsors may be unintentionally relying on inadequate certifications as the basis for electing a limited scope audit.
There appears to be misconceptions about what the certification provides. Plan sponsors believe that it is complete and accurate and they can rely upon it without doing anything more than presenting it to their auditors. I think that there needs to be a lot more education in this area.
Over the years, the Department of Labor, Government Accountability Office, and the AICPA have urged repeal of the limited scope exemption. However, there is no widespread or congressional support for a repeal of the limited scope audit exemption at this time.
Recommendations. The Department of Labor should make plan administrators aware of their fiduciary responsibilities when electing limited scope audits where the plan invests in HVAs and to ensure plan participants have proper information.
The Department of Labor should provide guidance on what constitutes an acceptable certification, including the meaning of “complete and accurate” for a proper certification that meets the requirements under the ERISA regulations.
The Department of Labor should issue guidance to plan administrators on the proper use of certifications in situations where the plan invests in hard to value investments that are not valued at current value as of the plan’s year end. This could include the plan administrator ensuring that those investments are excluded by the trustee or custodian in the certification, and this would be subject to full scope audit procedures by the plan’s independent auditor or requiring that such certifying institution take responsibility for measuring fair value as of the plan’s year end and certifying as to such date.
Randall Crawford, Lee Munder Capital Group, John Taylor, National Venture Captial Association, and David Larsen, Duff & Phelps
Mr. Crawford spoke on behalf of Lee Munder Capital Group, Mr. Taylor spoke on behalf of National Venture Capital Association, and Mr. Larsen of Duff & Phelps was an unscheduled panelist who joined the panel discussion near the end of the session.
Testimony was opened by noting that fair value, as defined in accordance with GAAP, is the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date, i.e. FASB Statement No. 157, paragraph 5. They also outlined the various sources and targets of capital within the private equity system.
Generally, pension plans, endowments and other portfolios that use alternative investments will target 4%-8% of their total assets to be invested in private equity. Approximately 50% of all funds invested in private equity come from pension plans.
Money committed to venture capital rose sharply in the late 1990s, decreased until 2003, rose sharply again until 2007, and has decreased into 2008.
Private equity has returned approximately 13%-14% over the past 20 years, as compared to 8.5% for the S&P 500 and 9.4% for the NASDAQ. Top-quartile funds have delivered substantially higher returns than the 13%-14% pooled return for private equity. Investors know and accept the higher standard deviations of private equity investments versus traditional investments, and they must also acknowledge and accept the illiquidity of these investments, along with the lack of a day-to-day market to value these investments, and the processes set up by accounting groups and funds to establish and report on these values.
Much attention has been paid to the development of guidelines and standards by various groups to develop valuation guidelines for the private equity industry. Guidelines by such groups emphasize the importance of using specific methodologies such as comparable company transactions and performance multiples. Private equity funds prepare their financial statements in accordance with GAAP (at estimated fair value) and FAS 157.
The National Venture Capital Association recommends that its members create, follow and communicate clearly the specific procedures and methodologies used for valuing their portfolios. At each valuation date, managers must make a determination of fair value for each investment that takes into consideration all relevant factors. A perfect valuation method may not exist.
It is important to have a process to establish, monitor, report and review valuations. The process must be correct, suitable, accurate, consistent, transparent and prudent. Regarding changes to valuation procedures, questions should be asked: Is it practical, does it make sense, is it too costly, is there enough benefit, and does the benefit make it worth it?
Venture capital fund statements have traditionally undervalued investments more often than they have overvalued investments. Indirect costs of additional regulation or procedures could cause investors to be excluded from top-quartile funds. The proposed solution, given the analysis of costs and benefits associated with valuation of private equity and venture capital investments, is to simply follow the current process.
Pension plan investment committees must ensure that a formal process is in place to obtain fair value of hard to value assets. The process must rely on the underlying fund manager to provide valuations. The underlying fund must have proper policies and procedures in place. The cost or benefit of additional regulation, use of valuation experts, or other costly analyses may not be worth the temporary change in unrealized value of interim statements that use cost basis or last transaction price to value investments.
Mr. Larsen noted that pension plans, and their respective fiduciaries, are valuing their limited partner interests, not the underlying companies in which they are invested, within given alternative investment instruments.
The three gentlemen recommended further and ongoing monitoring of FAS 157 to determine if it is effectively working.
Walter Zebrowski, Regulatory Compliance Association
Mr. Zebrowski spoke on behalf of the Regulatory Compliance Association.
He began by noting that historically, the primary investors in alternative investments were high net worth investors. Over the last seven to ten years, main stream investors have become interested in alternative investments, as opposed to more traditional vehicles like mutual funds.
Mr. Zebrowski feels that “enterprise risk” has not been well contemplated as it relates to alternative investments. Unlike standard investment risk, enterprise risk includes performance incentives, outsourcing of accounting, outsourcing of investor servicing, and internal valuation and pricing (versus third party valuation and pricing).
He views it as problematic that few alternative investment managers have detailed, written investment policy statements. He sees a lack of agreed upon best practices regarding coordination between back offices and front offices, as it relates to valuation. There is a lack of uniformity in overall administration of alternative investments.
Ultimately, he sees directors of hedge fund boards as being responsible for the accuracy of the net asset value of their investment vehicles. Such directors are not paid much, and are “spread way too thin” among many different hedge funds. Conflicts of interest exist in the performance duties of alternative investment managers, and segregation policies are needed.
Mr. Zebrowski recommends that professional development should be encouraged, at the senior level of alternative investment organizations, to ensure, for example, that CFOs are actually CPAs, that legal counselors are actually lawyers, and that compliance officers are duly qualified compliance professionals. It is critical, in his view, that people “know what they should know.”
He believes that the process, or at least having a process, is the key to addressing asset valuation issues for alternative investments. While independent valuation may be helpful, he feels that promoting professional development is more important.
John Connolly, State Street Corporation, on behalf of ABA, Mary Mohr and Rich Radachi, Retirement Industry Trust Association, and Susan Mangiero, Pension Governance LLC
The Working Group received testimony from a panel comprised of the following individuals:
- John Connolly – Senior vice president and Director of Customer Service, Master Trust Customer Services at State Street Corp.;
- Mary Mohr – Executive Director of the Retirement Industry Trust Association;
- Rich Radachi – Certified Public Accountant with the Retirement Industry Trust Association; and
- Dr. Susan Mangiero – President and CEO of Pension Governance, LLC.
Dr. Mangiero began the panel’s testimony by pointing out that the valuation process, while time consuming and potentially costly, is an integral part of good risk management. Dr. Mangiero noted a recent study that suggests that some plans may be coming up short in terms of effective risk management and that respondents to the study may be relying too heavily on simple numbers for valuation.
Dr. Mangiero continued by stressing that while a lot of attention is being currently focused now on FAS 157 and international equivalents, it would be better to focus on valuation process. In this regard, Dr. Mangiero cautioned that some plan sponsors may be relying too heavily on consultants or intermediaries without having a proper understanding of who is performing what function.
In response to a question from the Working Group, Dr. Mangiero stated her view that the Department of Labor (DOL) could assist with education and ensuring that sponsors effect a prudent process in evaluating external money managers and their service providers. Dr. Mangiero also responded that it appeared that the current structure of valuation oversight that applies to all ERISA investments should be applicable with alternative investments, hedge funds, and venture capital investments, provided that fiduciaries step up and take on the responsibility to actually perform the oversight.
Mr. Connolly next testified that hard-to-value assets are an increasing proportion of pension assets held by bank trust departments. In this regard, Mr. Connolly shared his view that hard-to-value assets are currently not independently valued by directed trustees, but rather the directed trustee seems to be relying on values communicated by the most knowledgeable investment party.
Mr. Connolly continued by stating that a directed trustee cannot value hard-to-value assets without creating an entire business dedicated to valuation due to the fact that there are too many asset classes to have true expertise in all asset classes. Mr. Connolly further noted his view that the practices advocated by the Managed Fund Association are guidelines for the industry to begin developing the relevant expertise.
With regard to the issue of limited scope audits, Mr. Connolly confirmed that the DOL allows a plan sponsor to request a limited scope audit where a bank, as trustee custodian, is willing to certify to the completeness and accuracy of the investment information. Mr. Connolly testified that the American Bankers Association would like to have continuing dialogue to ensure that the limited scope audit continues to be available for plans whose asset types are appropriate for such an audit.
Mr. Connolly next discussed with several members of the Working Group the fact that there is a lag between the date the limited scope audit certification is made and when an audit report for a venture capital, hedge fund or other investment is released several months later. Mr. Connolly speculated that going back and reopening records would be a very cumbersome and expensive process for a custodian bank. Mr. Connolly further noted that the focus should be on the process for reviewing alternative investment valuations, while at the same time he acknowledged a statement by a Working Group member that there exists the ability to get an actual update and adjust accordingly for purposes of plan reporting.
Ms. Mohr next presented views of the Retirement Industry Trust Association (RITA) and expressed support of the Advisory Council’s efforts to consider how fiduciaries and custodians value non-publicly traded investments. Ms. Mohr noted that based on current trends, it is reasonable to expect the percentage of plan assets invested in alternative assets will continue to increase as account holders look for ways to increase their portfolio diversification and returns.
In this regard, Ms. Mohr stated that a report by the SEC Advisory Committee on Improvements to Financial Reporting contained observations that impact the valuation of non-traditional investments for IRA holders and defined contribution plan participants. Ms. Mohr explained that the SEC Advisory Committee concluded that fair value should not be the only measure, but that a judicious approach should be taken to develop a systematic, rigorous framework.
Ms. Mohr continued her testimony by noting that valuation, particularly for investments in self-directed plans, should be tied to a taxable event, such as a distribution, since that is the time when there is a higher standard of scrutiny. In addition, Ms. Mohr noted that education and disclosure would be the areas of focus she would recommend for the DOL in this regard.
Lastly, Mr. Radachi commented that FAS 157 addresses a lot of the issues with regard to hard-to-value assets. Mr. Radachi concluded by noting that while enhanced disclosure to participants would be very important in a self-directed plan, more substantive valuation regulation would likely not be particularly helpful.
Peggy A. Bradley, Vice-President, The Northern Trust Company
Peggy Bradley offered the perspective of the custodian as it relates to the custodian’s role regarding valuation related services, fair value determination, implications for the limited scope audit exemption, and opportunities for industry collaboration. When ERISA was enacted in 1974, the custodial role was defined as holding and reporting on assets, providing information contained in the custodian’s ordinary business records, and certifying to the completeness and accuracy of the information provided. Plan sponsors have traditionally relied largely upon the certified statements provided by the custodian. However, those assets were largely invested in holdings with readily determinable values and those prices were obtained from industry recognized sources.
Per Ms. Bradley, arriving at a final fair valuation is a two step process. First is fair valuation determination, which is perhaps a valuation expert’s role. Second is valuation oversight, or monitoring the process which may be a financial preparer’s role. Ms. Bradley focused on three key questions around what the valuation process should entail:
- Who really owns the final determination of the fair value of plan assets?
- What does a prudent fair value determination process look like?
- What should the valuation oversight process look like?
There has been a trend in investments toward more non-marketable securities and new guidance has emerged surrounding the process for determining fair value. The market values reflected on the trust statements would be considered “pass through pricing”, which would be provided by the fund company, general partner, etc. and may not be deemed to be reflective of fair value. Ms. Bradley states that custody and trust clients need to be able to identify which assets were priced using independent recognized resources versus those that fall into the category of “pass through pricing”.
There have been a number of changes since 1974 regarding standards of fair value pricing and reporting, with guidance or alerts issued by the AICPA, PCAOB, and SEC. The process required of preparers of financial statements does not look like the process in 1974, when the limited scope audit exemption was designed.
The industry has raised the bar on what is required for oversight of the valuation process, and this will involve greater expense regardless of who performs the service. These recommended valuation oversight steps are broader than the historical or contracted services that custodians are obligated or geared up to provide and clearly fall outside their ordinary business processes. These expanded processes cannot be launched overnight or without a significant cost related to upgrading systems and hiring additional staff. What will emerge is a more focused class of valuation specialists to fill this void.
Ms. Bradley commented on the possible implications these changes may have on the limited scope audit. A limited scope audit presumes that the certifying custodian has performed the additional testing, examination and oversight in disclosing the fair value of plan assets. The task of certifying to fair value is more complex than generally appreciated. With the advent of FAS 157, custodians have moved to provide greater transparency to source and type of prices reported on the trust statements which should assist plan sponsors in ensuring their portfolios fit the model for limited scope audits.
Regarding the question of carve outs, Ms. Bradley recommended that more implementation details be provided for further discussion prior to finalizing any changes to the certification. “Hard to value assets” would need to be defined and lead time would be needed to reprogram systems to divide holdings into “certified” and “uncertified” buckets. Custodians should disclose how each asset was priced in order to assist users in the identification of those assets that may warrant further valuation analysis.
Ms. Bradley stated that Northern Trust strongly supports the need for all groups - custodians, pricing vendors, regulators, consultants, valuation specialists, and auditors - to continue to engage the plan sponsor community in dialogue about their pension governance responsibilities. Plan sponsors are willing to work proactively with auditors to reach a consensus on what specific steps should be included in a viable valuation oversight process and are awaiting further direction for FAS 157 audits and whether they need to secure the services of valuation experts.
Target Date Fund Witnesses
Troy Saharic, Mercer Investment Consulting
Mr. Saharic opened his testimony by defining “Target Date Funds” (or TDF) and described how they work, noting that the concept dates back to the 1950s. However, the concept received a renewed interest in the 1990s and assets managed under TDF have grown by 62% since 2003 with the proliferation of new TDF in the last five years created to address growing demand.
He explained that “off the shelf” funds are the dominant form of TDF funds with track records over five years. As markets become more competitive it has also become more creative. Some of the products have been designed to address longevity risk. Recent developments have fostered the creation of customized funds. He noted that the customized funds are more complex.
Mr. Saharic noted that defined contribution plan sponsors have increasingly embraced behavioral finance to help participants maximize wealth and provide some level retirement security. He also noted the most desirable features of TDF as well as their greatest shortcomings. He said that TDF are, by far, the most popular Qualified Default Investment Alternatives. They must be matched to the demographics of the participant group, but cannot be customized for the individual.
Mr. Saharic advised the Council the TDF must be evaluated periodically (most often quarterly). He reviewed several criteria for evaluating such funds. He said that the popularity of these funds has plan sponsors asking whether they should move everyone into one of these types of funs with a negative election to opt out. He cautioned, however, that to do so could jeopardize the plan sponsor’s 404(c) protection.
He noted the importance of communications that effectively explain the TDF so participants clearly understand the underlying investments and how the glide path works.
He then responded to questions from a number of the Council members addressing such issues as: What is the responsibility of the plan sponsor to explain the ramifications of a change in TDF providers as it affects the question of the glide path? He explained that this is an important consideration and may be the basis for determining the successor. He also stated that it was the position of his employer that the TDF should be the QDIA. He also reviewed what he considered the “best practices” in this area and opined that it would be valuable if the Department of Labor gave additional guidance on what issues should be considered in the selection of a TDF provider.
Michael Sasso, Greg McCarthy, and David Hudak, Portfolio Evaluations, Inc.
A panel of professionals from Portfolio Evaluations, Inc. provided testimony to the Working Group. The panel consisted of the following individuals:
- Michael Sasso – Principal at Portfolio Evaluations, Inc.;
- Greg McCarthy – Senior Consultant at Portfolio Evaluations, Inc.; and
- David Hudak – Senior Consultant at Portfolio Evaluations, Inc.
Mr. Sasso began the panel’s testimony by explaining that there has been a steady push in the industry to try to standardize the process of evaluating target date funds (TDFs). Mr. Sasso noted that his firm has issued a paper, co-authored by Messrs. McCarthy and Hudak, which attempts to elaborate on the process of selecting and monitoring a TDF.
Mr. Hudak continued the testimony by noting that while often overlooked, plan sponsors should consider the appropriate level of retirement income they would expect from the TDF. Factors that a plan sponsor should consider in this regard include what levels of defined benefit, Social Security benefit or other pension benefit that participants are likely to have.
In this regard, Mr. Hudak noted that TDFs may take very different approaches in their design and structure, and the design and structure should be compared to the plan’s unique demographics. For example, Mr. Hudak noted that some TDFs actually incorporate their own participant data into the TDF design while other TDFs will use more of a behavioral-based or “Monte Carlo” simulation. Other design differences may revolve around where the TDF sets its final static allocation. These issues need to be considered and be compared to the plan’s demographics.
Mr. Hudak noted that other differences may arise in that some TDFs focus on more passively managed underlying structures versus active management. In addition, TDFs may use different asset classes or may try to guard against other risks such as shortfall risks, the risk of not having enough money or longevity risks, the risk of outliving the assets.
Mr. Hudak next testified that another challenge with evaluating a TDF s that some products have changed over time, whether by moving away from being a strictly proprietary fund-of –funds, or through other underlying investment changes such as increasing the TDF’s equity or international exposure, or moving to a more market-neutral or commodities-exposure strategy.
Mr. Hudak next discussed customization and annuity-type options as trends in TDFs. Mr. Hudak noted that his view is that based on surveys his firm has conducted, it appears that customization will be big in the future, but has not yet gained significant share in the marketplace. He also noted his view that the annuity type options or managed payout type funds are going to become more and more prevalent.
Mr. McCarthy next testified about benchmarking, monitoring and selection techniques. Mr. McCarthy first noted three difficulties with benchmarking only against a TDF’s stated benchmark: (1) the benchmark does not give a perspective against peers since it is only measured against the benchmarks selected by the fund company, (2) sponsors must examine the underlying benchmark to see if it actually represents the asset allocation of the TDF, and (3) given the limited performance history of most TDFs, it is difficult to get a perspective based on a benchmark selected by the fund company.
Mr. McCarthy further testified that there are also problems with other benchmarks. For example, Mr. McCarthy noted that a benchmark by an agency such as Morningstar that attempts to benchmark by maturity year may have potential flaws because TDFs’ asset allocations could be significantly different. Also, Mr. McCarthy noted that attempts to benchmark in terms of risk and return characteristics (e.g., aggressive, moderate or conservative) would be difficult because individuals interpret those terms differently.
Mr. McCarthy continued his testimony by noting that his firm reviews the range of returns of products in the industry, by looking at risk measures, portfolio characteristics, any underlying organizational changes (such as manager underlying analyst changes), and fees and costs. In addition, Mr. McCarthy noted that his firm uses one set of forecasts of future market performance and runs all TDFs through the same set of assumptions.
Instead of overemphasis on benchmarks, Mr. McCarthy testified that it is his view that the focus should be on trying to define a “process” for evaluating these things and not relying on one particular measure to monitor it. Mr. McCarthy noted that this may be a problem particularly in the small end of the market where employers have been inclined to stop their inquiry into the appropriateness of a TDF once the employer determines that the TDF meets the definition of a qualified default investment alternative. This is a point with which Mr. Sasso concurred.
In response to a question from the Working Group, Mr. Hudak confirmed that it may be possible for the Department of Labor to develop a best practices letter similar to an RFI that Mr. Hudak’s firm has developed, which could help plan sponsors with the process of selecting an appropriate TDF.
In response to anther question, Mr. Hudak confirmed that his firm is working with clients to review TDF methodologies and the client’s plan demographics to counsel on the question of whether the TDF will address the plan’s retirement income needs. In this regard, Mr. Hudak noted that his firm analyzes data to determine what percentage of an individual’s final year ending salary will be able to be replaced in the first year of retirement.
In response to a question on the importance of using one firm to offer each TDF target date option, Mr. Hudak responded that it would be appropriate given that the plan sponsor should be comfortable with the overall philosophy and that should not change based on the target date of the fund. In addition Mr. Hudak responded that it may be appropriate to offer two different TDFs for the same target date if the participant demographics and different glide paths necessitated segmenting one group for one TDF and another group for another TDF.
Mr. Sasso next noted that looking at testing the underlying funds that may make a TDF could be illustrative since the underlying funds have likely been in existence long enough to build up a track record. However, Mr. Sasso cautioned that asset allocation of the TDF would need to also be considered heavily, since asset allocation is a much more critical determinant of ultimate performance.
Seth Masters, Alliance Bernstein Defined Contribution Investments
Seth Masters, Chief Investment Officer at AllianceBernstein, provided testimony on target date funds (“TDFs”). Masters noted that defined contribution plans are the future of the U.S. retirement system, and TDFs will represent the bulk of new funds in those plans. Masters believes that TDFs should be the default plan due to their simplicity and consistency. Customized plans are optimal for defined contribution plans that are large enough to administer them, but prepackaged plans will also be beneficial for smaller plans. The single most important decision is the design of the glide path of the TDF, providing enough equity in the early years to build principal to generate sufficient income in later years, along with diversification to mitigate risk. This would allow TDFs to approach the higher returns currently enjoyed by defined benefit plans.
Preserving liquidity is an important concern in a TDF, and Masters notes one solution: the Guaranteed Lifetime Withdrawal Benefit, or GLWB, type structure, which has a reasonable cost and will be able to be integrated into target date funds within the near future. Guaranteed Lifetime Withdrawal Benefits preserve the liquidity of the underlying asset. In strong markets, a participant will actually have what amounts to effectively an inflation pass-through that may provide protection from rising inflation.
Mr. Masters noted that TDFs are not actually an investment product, but are designed to be an investment solution. He warned that the DOL should not proscriptively try to give guidance as to exactly what a TDF should look like. Rather, it should rely on the fact that the choice of a TDF, whether it's a qualified default investment alternative (“QDIA”) or not, is the subject of ERISA and its protections. The DOL needs to think carefully about the implementation of the move to TDFs, and help to facilitate re-enrollment and transition to TDFs for participants who are currently in other defined contribution options, which current regulations do not do at present.
John Ameriks, Vanguard
John Ameriks, Vanguard principal and head of Vanguard's Investment Counseling & Research Group also provided testimony on TDFs. Mr. Ameriks supports the DOL's decision to include TDFs on the list of QDIAs, noting that TDFs are becoming the QDIA of choice as an all-in-one investment decision for retirement savers who really don't know much about investing, except when they plan to retire. The design of TDFs should reflect the principle of no surprises. Choosing the appropriate asset allocation glide path is also the primary concern for Mr. Ameriks, with active/passive management, value customization and participant impact the other important factors in considering the utility of TDFs. The lack of current homogeneity of TDFs makes it important for sponsors to understand the basic economic and investment rationale for the glide path. There is no particular default behavior for retirees, and similar date TDFs do not employ single benchmarks, so plan sponsors must consider these factors carefully as they exercise their fiduciary judgment.
Liquidity of investments in a TDF remains a challenge, along with pricing of private equity or real estate holdings. These issues will prevent these types of investments from being incorporated into TDFs at present. Mr. Ameriks believes the future of TDFs may end up looking like a fund of funds, or some type of mechanism that can pool these less liquid investments and price them in a liquid way, and can pool these investments across more managers and disparate holdings to get broad exposures.
Mr. Ameriks recommended that the DOL try to educate plan sponsors, fiduciaries and participants on the key aspects of choosing a TDF, focusing primarily on the glide path issue and shifting the focus toward asset allocation and away from ex-post performance. Simplification of instructions and guidance on the key fiduciary considerations would be helpful for smaller plan sponsors, who are not able to customize TDFs for their participants. TDFs, even if they're just limited to traditional asset classes and some, perhaps, of the more liquid alternatives, are easily going to be able to put up numbers that look like a lot of defined benefit plans going forward.
Robert Brokamp, The Motley Fool
Mr. Brokamp testified that target date funds (“TDFs”) are “the next best choice” for those individuals who may not be qualified to select their own investments. He believes that TDFs make a great default option in defined contribution plans. The biggest problem with TDFs is how you measure them. Most have not been around very long, and there are no standard benchmarks. According to Mr. Brokamp, there are three ways to measure TDFs: (1) evaluate the funds within the TDF; (2) evaluate the portfolio allocation; and (3) evaluate whether investors are getting their money’s worth.
In evaluating the funds within the TDF, it is necessary to review the TDF’s separate components. Because some TDFS have numerous funds – up to twenty or more – plan fiduciaries should at least review a one-page fact sheet that identifies the important facts of each component fund. The following are important facts to consider:
- asset class category;
- long-term performance compared to a relevant benchmark of its peers;
- management tenure; and
- similar information.
Important questions to ask are (1) are the fund components matching up with their peers or relevant benchmark; (2) does the TDF rely on one or two strong funds that maybe had a good year or two; (3) does that TDF have a certain amount of risk; (4) what are the potential consequences if the manager leaves; and (5) what are the potential consequences if the manager makes a bad call? It would also be important for plan fiduciaries to have information on exactly which components are in the TDF and the important metrics on each fund. It is unlikely that this information would be on a one-page description of the TDF. Asset allocation is important, but fiduciaries should not ignore the individual funds within the TDF. The identity of the individual funds may reveal the philosophy behind the TDF manager. There is a risk that within some TDFs may either be a training ground for a mutual fund company or a place to get more assets into a very mediocre fund. Thus, digging deep into the actual fund components is important.
Mr. Brokamp testified that it is important to evaluate the allocations in the TDFs. He didn’t discuss this issue in detail because he felt that other witnesses would address this matter further.
Fiduciaries should compare TDFs to their peers and relevant benchmarks. Some benchmarks have been, or will soon be, established by Dow Jones and Morningstar. Morningstar is coming out this fall with a series of three categories: conservative, moderate, and aggressive, then breaking those into different dates within the categories for a total of 39 indexes. Some pension consultants can create an index for a specific TDF based on the Russell 1,000, Russell 2,000, or other relative indexes that are available. In this way they can evaluate TDFs to a benchmark that has the same allocation. Combining these methods – reviewing peer comparisons, reviewing available indexes, and creating your own index – will go a long way toward solving the benchmarking problem, but will not necessarily resolve the problem that arises because so many TDFs are new. Mr. Brokamp recommends going back and looking at the component funds of the TDF and see what they would have done. This is not a perfect solution, but it should prove helpful.
Fiduciaries should also consider using different TDFs from different vendors. For example, if one vendor’s 2040 fund is good but the 2010 fund is bad, the fiduciary should consider finding a different vendor that has a better 2010 fund.
Fiduciaries should carefully evaluate costs. Costs matter for TDFs. Higher-cost stock funds may outperform their lower cost peers, but with other asset classes, such as bond funds and money market funds, it is more difficult to overcome a high-cost disadvantage. Plan fiduciaries should thus carefully review low-cost alternatives.
Fiduciaries should also consider individual participant risks. There is a legitimate question about whether everyone who is retiring around the same time should have the same asset allocation. Most 2040 funds now have more than 10 percent of their assets in bonds and cash, and less than 10 percent of their assets in small cap stocks. But using history as a guide, someone with a 30-plus time frame would likely earn higher returns from an all-stock portfolio, with a large helping of small cap stocks. On the other hand, some target date funds might be too aggressive. Despite all the talk about “stocks” for the long run, we know that some people just can’t stomach the drop in their portfolio. Then they sell stocks when the stocks’ values are down. For these investors, the stock in the portfolio is not appropriate no matter when they’re going to retire, yet because these funds have names like “2040 target retirement” and not “fund that has 88 percent of its assets in stocks that can drop 20 percent in a year,” uninformed investors may not be aware of the risks. So the solution here is education. Participants need to understand the limitations of these funds.
Carmelo Elco, Resources for Retirement and Wes Schantz, The Corporate Consulting Group
Ms. Elco is with Resources for Retirement. Resources for Retirement is a retirement plan advisory firm in the mid-market. It handles plans between $1 million in assets up to $200 million, or in participant terms, 50 participants up to about 3,000 participants.
TDFs have evolved from using a fixed asset allocation, usually a 60/40 split, to a lifestyle, age-based fixed allocation that changes over time. Some TDFs allow participants to select both an age-based product and a risk tolerance within the age-based products.
According to an Investment Company Institute study, assets in defined contribution plans grew 6,100 percent over a ten-year period, largely due to automatic enrollment. By the end of 2015, we are expecting to see 35 percent of all assets in a target date type product.
Different participants have different needs. Some prefer managed accounts, others like make their own asset allocation, and a select few utilize self-directed brokerage windows. These needs should be a suite of offerings the plan sponsor should consider when adding TDFs rather than limiting investment options solely to TDFs.
Plan sponsors do not appear to be actively selecting the plan’s investment options. Rather, they generally accept whatever funds a particular vendor may offer. Plan sponsors should actively select from among active and passive investments and proprietary and non-proprietary funds. Some target dates are made up of, like, an investment trust. That’s a newer addition. There are customized target dates based on core funds already in the plan. So the nice thing about that product would be that you can evaluate and select underlying investments within the product and you can remove them or add them as you see fit if you’re a plan sponsor. There’s also the individually created customized target date. This would be more for the jumbo-sized market. Another available component is ETF, or Exchange Traded Funds. We’ve seen that being introduced as target date as well. So there’s a lot of different target dates. Plan sponsors need to make a conscious decision on what methodology, what flavor they select and have a documented reason why.
TDFs are in many ways very similar to typical mutual funds. What makes them different? TDFs used to have an overlay fee which was on top of the fees derived from the underlying investments, but those have gone away. Mutual funds typically are static with one stated objective; TDFs are fluid. Typical mutual funds do not have a glide path, but the glide path is a core component of TDFs.
As for best practices, plan sponsors should ask vendors for an investment policy statement. These statements should be widely distributed to plan sponsors so they can review the strategy. They should also review the risks associated with a particular TDF. The TDF should be compared to benchmarks, and overlap of underlying investments should be reviewed. There should be an exit strategy if there’s a problem.
Mr. Schantz testified that, as a consultant, he finds it challenging to evaluate the different TDFs available and then be able to communicate their differences to plan sponsors.
Plan sponsors should review the TDF’s glidepath. Doing so may help the sponsor learn about the investment manager’s philosophy. Each glidepath should be reviewed for the TDF’s accumulation phase and pay-out phase, and then reviewed to assess whether the asset allocation is appropriately adjusted over time. The sponsor should also do an assessment of participants’ risks. Plan sponsors should look at different fact sheets, including internal fact sheets and third-party fact sheets.
Mr. Schantz testified that sensitivity analysis is also very important for participants and plan sponsors. He testified that another issue to be assessed is retirement readiness. Sponsors should also look at the portfolio structure, such as active versus passive management and proprietary versus non-proprietary. Mr. Schantz further testified that the industry needs to generate appropriate benchmarks for TDFs. Finally, Mr. Schantz testified that more education is needed for participants and plan sponsors.
Anne Lester, JPMorgan Asset Management
Ms. Anne Lester is a managing director and senior portfolio manager with JP Morgan Asset Management's Global Multi-Asset Group. Ms. Lester submitted a lengthy supplement, including a PowerPoint presentation to which she referred throughout her testimony. and commended to the Council for reading.
Sponsors should strive to maximize the number of participants who reach a minimum level of income replacement in retirement. Ms. Lester testified that absent this measure of success, it is very difficult to identify which of the many glide paths are appropriate. In the universe of target date funds and glide paths, there are two broad categories; the first seeks to minimize downside outcomes, and the second tries to maximize up-side outcomes. JP Morgan has learned that participants generate lots of volatility in the way they save making it crucial to minimize negative outcomes. They start saving, stop saving, take loans, and take pre-retirement distributions. In fact, in a survey of 1.3 million participants, actual behavior differs dramatically from the ideal way employed by many money managers. Ms. Lester strongly urges plan sponsors to consider the actuality of participant behavior as they incorporate TDF’s or any QDIA into their plans.
Diversification is critical and will lead to better portfolio outcomes. She compared two portfolios, one “aggressive” with a higher equity allocation to maximize the upside and one more diversified to minimize the downside. Theoretically, the earnings outcome for both is the same. But, once observed participant cash flow behavior is factored in, the aggressive portfolio performs much better on the up side. If markets are strong, there will be a higher portfolio balance. However, if markets are weak or participants take lumps sums, the aggressive portfolio produces the worst result.
JP Morgan has developed the Target Date Navigator to assist sponsors in identifying appropriate spend down strategies. It asks a series questions about sponsor objectives and their views on diversification and participant behavior. There are no right answers. Rather, it helps plan sponsors articulate their values in terms of diversification and ultimate outcomes. It illustrates the trade-off of an up-side return and downside volatility management.
The classic way of evaluating fund performance--is it outperforming its benchmark, does it have low fees—does not work well with TDF’s because it just compares returns rather than outcomes. This leads to a peer universe of funds that try to accomplish the same thing.
JP Morgan firmly believes in mapping according to birth date and assuming retirement at 65. Ms Lester discussed situations involving stable value or company stock. This adds complexity that might affect trading volume and share value. One solution may be to employer a derivative strategy.
Absent any DOL guidance, sponsors are very reluctant to map, both because of the volatility of any single stock and its relative performance to portfolio in which it is mapped.
Peter Bobick, Charles Schwab Investment Management
Mr. Bobick is a client portfolio manager with Charles Schwab Investment Management (“Charles Schwab”) services group. His testimony was accompanied by a written supplement.
There is no one-size-fits-all solution. A TDF for engineers is going to be a bit different from a target solution for a group of machinists. Asset allocation and diversification should not be considered in isolation of participant demographics, like age group and salary.
There is a lot of attention to investment risk but there are other important considerations beyond traditional risk. For example, a fund could close or merge if cash flows are insufficient or the fund family does not grow as quickly as the vendor would like. There must be financial and human resources dedicated to the suite of funds to allow the TDF to flourish now and the future.
For the most part, sponsors still focus on the accumulation phase and on the participants who continue to work for them during such phase. Much less attention is paid to people who have departed via retirement or to another employer. There is change in the offing, driven by the financial services industry more than by sponsors or participants.
TDF’s are difficult to benchmark. Charles Schwab’s clients rely on a customized benchmark developed by Charles Schwab. They also rely on peer group comparisons from Morningstar. Neither method is optimal. Both have limitations, but are a start until the industry further develops. Performance history is often lacking. There is validity in encouraging a plan sponsor to look at the track record of the individual managers when the portfolio record as a whole is limited. In general, Charles Schwab prefers non-proprietary TDF’s because this allows best-in-class manager selection.
In terms of education, Charles Schwab offers a three-path approach. Everyone will find a different path to retirement even with a core menu of options. Those who want some level of professional management or involvement might be offered advice. Others might highly value choice and could be offered brokerage services. Before making these choices, a sponsor has to determine the level of involvement it wants and pick the most suitable path.
Mr. Bobick urges sponsors to pay more attention to investment policy statements of the Funds, which will provide qualitative and quantitative guidance to monitor performance.
He turned responses to underperforming TDF’s. In reality, different record keepers may restrict choices among TDF’s. Therefore, plan sponsors should select a record keeper with flexibility and open architecture, so there are reasonable choices.
On mapping, his experience suggests it is becoming more common to map to TDF solutions based on age. Plan sponsor continue to be very hesitant to do wholesale mapping. Unlike other witnesses, he does not generally advocate re-enrollment because it is cumbersome and costly.
On the introduction of a new TDF, he would resort to the three-path approach he described above to educate participants. While he may personally advocate moving folks wholesale over to TDF in reality, it is very rare.