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), Alternative Assets (12) and Alternative Assets (13) examined the first four Fees examples in the proposal. This article looks at the fifth example of the application of the Fees factor.

(5) Example. Fees; Active management—

(i) Facts. The named fiduciary of a plan (e.g., the plan sponsor or plan investment committee) considers six small-cap stock funds. Three of the funds passively track the same index while three of the funds are actively managed, attempting to outperform the passive index. The passive funds are all comparably priced to each other, and the actively managed funds are comparably priced to each other. However, the actively managed funds all have higher fees and expenses than the passive funds. The named fiduciary evaluates the funds with the assistance of a third-party investment advice fiduciary within the meaning of section 3(21)(A)(ii) of ERISA and finds that one of the passive funds has had lower tracking error and fees compared to the other two passive funds and one of the actively managed funds has had outstanding historical risk-adjusted returns compared to all of the passive funds as well as the other two actively managed funds, despite the other two actively managed funds having adopted a similar investment strategy. The named fiduciary selects both the highest performing actively managed fund as well as the passive fund with lowest tracking error and fees based on advice from the third-party investment advice fiduciary that allowing participants to gain exposure to actively managed and passive funds will increase their risk-adjusted return on investment net of the additional fees charged by the actively managed fund.

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

Comment: This is pretty straightforward.  The fiduciary selects the index fund with the best tracking record and the actively managed fund with the best risk-adjusted returns.  Perhaps the DOL’s point is that a plan can offer both an actively managed fund and an index fund in the same category (e.g., small cap companies).  I don’t think that is particularly noteworthy either.  I am a bit confused by the statement that “allowing participants to gain exposure to actively managed and passive funds will increase their risk-adjusted return on investment net of the additional fees charged by the actively managed fund.” In my experience, participants will typically select either the index fund or the actively managed fund, but not allocate to both of them.  Maybe I am misreading the example.

On another note, the DOL here, and elsewhere, says that fiduciaries should evaluate investments on the basis of risk-adjusted returns.  I have two problems with that.  First, I think that the DOL should more clearly point out that the job of fiduciaries is not to look at the past performance…other than to evaluate the manager of the fund and as a part of deciding whether the fund will perform well in the future. In other words, in my view the job of the fiduciaries is to be forward looking and to evaluate the manager of the fund, with past performance being only one part of the process.  Second, and this may be based on my limited experience with investments, I don’t think that the only way to look at past performance is to review risk-adjusted returns.  I get the point, but would it necessarily be imprudent to look at “raw”, or actual, returns?

(ii) Analysis. The named fiduciary must consider a reasonable number of similar alternatives to the funds it selects, and determine that their fees and expenses are appropriate, taking into account their risk-adjusted expected returns and any other value they bring to furthering the purposes of the plan. A plan fiduciary may choose to offer both an actively managed and a passive fund within a particular strategy to secure diversification benefits for participants across the plan investment menu. In so doing, the plan fiduciary may conclude that the value of these diversification benefits justifies the selection of an actively managed fund that charges higher fees than a passive counterpart.

Comment: This example continues the DOL’s theme that fiduciaries must consider a reasonable number of options and then uses 3 as the appropriate number.  I’m at a bit of a loss on that point.  It seems to me that the DOL is missing the first step, which is to look at a robust set of funds in a particular category, such that the process is statistically valid.  I don’t think that looking at 3 mediocre funds produces the result that the DOL is contemplating in the example.  As a result, I would read into the example that the fiduciaries had reviewed a robust set of investments in the category and then narrowed it down to 3 index funds and 3 actively managed funds as finalists for consideration.

As discussed above, the DOL confirms that fiduciaries can offer, as a part of the menu for a participant-directed plan, both index and actively managed funds in the same category.  I’m not used to seeing that in 401(k) plans (with the possible exception of the large cap blend category), but I don’t see any harm in the DOL using it as an example.

(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 both funds. The named fiduciary enlisted the services of an investment advice fiduciary. The investment advice fiduciary fully compared and analyzed the profiles of the actively managed and passive funds. The investment advice fiduciary also provided the named fiduciary with professional advice about the benefits of diversified portfolios. The named fiduciary considered and determined, within its discretion, that selecting the highest performing actively managed and passive funds furthered the purposes of the plan by increasing risk-adjusted return through the increased value of additional diversification.

Comment: Not much to add here.  As with other favorable examples, the fiduciaries sought and received the help of a qualified investment adviser.  One cautionary note, though.  A number of court decisions have said that, where a plan uses a 3(21) or non-discretionary adviser, the fiduciaries cannot just rubber stamp the recommendations of the adviser.  Instead, they must review the recommendations, ask questions and get answers, and then adopt the recommendation as their decision.  I wish the DOL had pointed that out.

The discussion of the example in the preamble is:

Paragraph (h)(5) of the proposed regulation provides an example involving active management, increased fees, and greater diversification benefits. In this example, a plan fiduciary enlists the services of an investment advice fiduciary to analyze several small-cap funds, half of which are actively managed and the other half passively managed. The passive funds are comparably priced to each other, and the actively managed funds are comparably priced to each other. However, the actively managed funds all charge higher fees than the passive funds. The plan fiduciary selected the best-performing active fund and the best-performing passive fund as designated investment alternatives. This example illustrates that a plan fiduciary may choose to offer both an actively managed and passive fund within a particular strategy to secure diversification benefits for participants across the plan investment menu. In so doing, the fiduciary may prudently conclude that the value of these diversification benefits justifies the selection of an actively managed fund that charges higher fees than a passive counterpart. This example is consistent with several court decisions that involve the offering of both actively managed and passive plan investment alternatives. [Citations omitted.]

Comment: The preamble discussion doesn’t add anything to the example, so no need to further discuss it.

Concluding Thoughts

Taken at face value, this value of this example seems to be that fiduciaries can offer both an index fund and an actively managed fund in the same category.  I don’t have any problems with that, even though it may not be common in 401(k) plans.

My issues are with the description of the process followed by the fiduciaries.  While I like the fact that the example describes a process and agree that the use of a competent, or qualified, adviser can be an important part of a prudent process, I wish there were more.

In particular, I think that DOL should have, at the least, added (i) fiduciaries cannot rubber stamp the recommendations of an adviser and must understand and adopt the recommendations, and (ii) the evaluation of an investment fund is of the manager of the fund (and that it is not enough to just look at past performance, even if risk-adjusted).  I acknowledge, though that my view would require either a longer example or summary statements (e.g., “The fiduciaries engaged in a prudent process to evaluate the adviser’s recommendation”).

This is the last of the Fee factor examples.  Let’ move on.