The DOL’s proposed regulation on selecting investments, including alternative assets, 2026-06178.pdf, identifies six factors that should be considered in the process of selecting any investments for participant-directed plans, such as 401(k) plans and private sector 403(b) plans. The six factors are: Performance, Fees, Liquidity, Valuation, Performance Benchmark, and Complexity. The proposal describes each of those factors and provides 20 examples of their application.

In my post Alternative Assets (9) I discussed the second factor, Fees. My last three articles, Alternative Assets (10) , Alternative Assets (11) and Alternative Assets (12), examined the first three Fees examples in the proposal. This article looks at the fourth example of the application of the Fees factor.

The fourth example is:

(4) Example. Fees; Risk mitigation strategies—

(i) Facts. A participant- directed defined contribution plan contains a custom-designed designated investment alternative that is a qualified default investment alternative (target date fund), managed by an investment manager within the meaning of ERISA section 3(38), with a strategy that targets specific percentages of stocks and bonds that trade on public exchanges. As part of a review of the plan’s investment menu, the named fiduciary with responsibility for selecting the qualified default investment alternative considers the investment manager’s proposed modification of the designated investment alternative’s strategy to target investment in specific percentages of hedge funds and private equity funds while reducing target percentages of publicly traded stocks and bonds. The purpose of the modification is risk mitigation—meaning, to decrease volatility and reduce the risk of large losses during a market downturn. Under certain market conditions, a potential consequence is the designated investment alternative may underperform as compared to the continued use of the unmodified strategy, but it provides downside protection as an additional value. The named fiduciary enlists the services of a third-party investment advice fiduciary within the meaning of section 3(21)(A)(ii) of ERISA to analyze the new target percentages and the hedge fund and private equity funds for investment by the designated investment alternative, as well as detailed information about the investment strategies and fee structures of these funds. The third-party investment advice fiduciary also provides the named fiduciary with a written report stochastically modeling estimated risk- adjusted returns stemming from the adoption of the modifications and comparing the target date fund, as modified, to a reasonable number of similar alternatives. Although the designated investment alternative’s expense ratio would increase slightly, the report shows an improvement in the risk-adjusted expected returns, net of fees, over a horizon determined to be appropriate for the target date fund.

(The bolding in this article is mine…just to emphasize the points that I consider the most important.)

Comment: These facts are almost identical to the Intel case which is currently pending before the Supreme Court (and which the DOL is supporting with an amicus, or “friend of the court”, brief).  So it’s not a surprise that the outcome of the example is that the fiduciaries were prudent. And I agree.

To me, a key in deciding whether a target date suite should be designed to reduce volatility is whether the fiduciaries believe that it is in the best interest of the covered participants to have that type of TDF design. If fiduciaries evaluate the workforce covered by the plan and make that determination, I can’t see a court deciding that it knows what is right for the workers and that the fiduciaries did not. Needless to say, though, fiduciaries (e.g., a plan committee) should go through a process for determining the right TDF design for those workers.  I worry that some, perhaps many, committees do not engage in a process to understand the allocation and glide path differences between different TDF suites and then pick one that fits the needs and circumstances of the participants.

Of course, where, as here, fiduciaries decide to manage volatility of their target date funds through the use of private funds, they must engage in a prudent process to evaluate whether private funds should be included as an allocation and then to prudently select the private funds to be included.  In most cases, that will necessarily involve the use of qualified investment advisers due to the complexity of private funds (including among other things, the fee structures and amounts; the valuation processes; and the liquidity issues).

(ii) Analysis. In this example, the named fiduciary is not making an original selection of a designated investment alternative. Yet because the change in strategy proposed by the investment manager implicates the principal objectives of the target date fund, implementing the described modification is tantamount to selecting a designated investment alternative from scratch. Consequently, the named fiduciary must consider a reasonable number of similar alternatives to the target date fund, as modified, and determine that its fees and expenses are appropriate, taking into account its risk- adjusted expected returns and any other value it brings to furthering the purposes of the plan. That the target date fund is customized does not negate the requirement to appropriately consider a reasonable number of similar alternatives. Whether the alternatives considered are similar depends on the facts and circumstances of the case. Factors commonly used by investment professionals in like circumstances include risk, return, liquidity, and allocation profile.

Comment: Throughout the DOL’s proposed regulation it says that fiduciaries must evaluate a reasonable range of competing products/investments.  (While the proposal doesn’t define a “reasonable range”, the examples use 3 to 5 options for that purpose.) In this case, the DOL is saying that fiduciaries should consider a reasonable range of TDF suites.  As a practical matter, do plan fiduciaries usually consider 3 to 5 competing target date fund families?  I don’t think that small and mid-sized plans do. Plan fiduciaries and advisers should consider adopting the DOL’s approach in the proposal.  To satisfy the DOL standard in the proposal, the 3 to 5 TDF suites should be meaningfully different, so that fiduciaries can evaluate the differences and make decisions appropriate for their participants.

(iii) Conclusion. The named fiduciary in this example satisfies the consideration and determination requirements of paragraph (h) of this section, and section 404(a)(1)(B) of ERISA, with respect to the fees and expenses of the target date fund as modified. The named fiduciary enlisted the services of an investment advice fiduciary. The investment advice fiduciary provided the named fiduciary with a written report stochastically modeling estimated risk-adjusted returns stemming from the adoption of the modifications and comparing the target date fund, as modified, to a reasonable number of similar alternatives. The named fiduciary considered and determined within its discretion that the modification to the target date fund to include the risk mitigation strategy furthered the purposes of the plan, including decreasing volatility and reducing the risk of large losses during a market downturn. In addition, the named fiduciary considered and determined, within its discretion, that the higher expense ratio associated with the modification was appropriate in light of the estimated higher risk-adjusted expected returns, net of fees and expenses, over an appropriate horizon for the target date fund.

Comment: Two additional thoughts:  First, the DOL here, and elsewhere, makes a point of fiduciaries using qualified advisers.  Plan fiduciaries should be aware of that emphasis. Second, here, and elsewhere, the DOL makes the point that fiduciaries can prudently allow their plans to pay higher costs where the value to the plan and the participants justifies the additional cost.  That is what ERISA has always required, but it is good for the DOL to remind the retirement plan community of the value side of the equation (and to provide that in writing so that it can be referenced in ERISA litigation).

The discussion of the example in the preamble is:

Paragraph (h)(4) of the proposed regulation provides an example involving a modification to a custom-designed designated investment alternative that is a qualified default investment alternative (target date fund) made for the purpose of risk mitigation—i.e., decreasing volatility and reducing the risk of large losses during a market downturn. The target date fund’s existing strategy of targeting specific percentages of publicly traded stocks and bonds would be modified by including investments in specific percentages of hedge funds and private equity funds while reducing the target percentages of publicly traded stocks bonds would be modified by including investments in specific percentages of hedge funds and private equity funds while reducing the target percentages of publicly traded stocks and bonds. This change would result in an increase in the target date fund’s expense ratio. Additionally, under certain market conditions, the fund might underperform compared to its existing strategy, but the change would provide downside protection as added value. The example indicates that because the change in strategy would so clearly implicate the principal objectives of the target date fund, implementing the modification would be tantamount to the selection of a designated investment alternative subject to the proposal. In this example, the named fiduciary enlisted the services of an investment advice fiduciary, as defined in ERISA section 3(21)(A)(ii), which provided the named fiduciary with a written report that stochastically modeled estimated risk-adjusted returns stemming from the adoption of the modifications and compared the modified target date fund to a reasonable number of similar alternatives. The named fiduciary considered and determined, within its discretion, that the modification to the target date fund to include the risk mitigation strategy furthered the purposes of the plan, including decreasing volatility and reducing the risk of large losses during a market downturn. Furthermore, the named fiduciary considered and determined, within its discretion, that the higher expense ratio associated with the modification was appropriate in light of the estimated higher risk-adjusted expected returns, net of fees and expenses, over an appropriate horizon for the target date fund. The example concludes that the named fiduciary would satisfy the requirements of proposed paragraph (h) and ERISA section 404(a)(1)(B) with respect to the fees and expenses of the modified target date fund. This is entirely consistent with ERISA’s statutory purpose, case law, and earlier statements from the Department. [Citations omitted.]

Comment: For the most part, this discussion is the same as the example. However, I want to emphasize one more thing.  The bolded example in the preamble discussion points out that underperformance in an up market is not per se a fiduciary breach.  If the investment’s design was to provide a more conservative, less volatile investment experience, that is permissible and is not a fiduciary breach. The key is for a committee to make a conscious decision about the characteristics of the investment in light of the needs and circumstances of the participant population.

Concluding Thoughts

As you have probably figured out by this point, I like this example and the DOL’s analysis.  This is one of the better examples, in my opinion.

The message is:

• It is permissible to have conservative investments…if it is a conscious, thoughtful decision by the fiduciaries.
• The use of a qualified adviser is evidence of a prudent process.
• Fiduciaries can “pay up” for investments (or services) that add value for the participants (but the added cost must be justified by the added value).