In my first post in this series, Alternative Assets (1), I said that a surprise in the DOL’s proposed regulation on selecting investments for participant-directed plans (2026-06178.pdf) was that it went beyond the alternative assets mentioned in last August’s Executive Order and instead applied to all investments in participant-directed plans—both traditional and alternative.

There were other surprises in the proposed regulation.  My second article, Alternative Assets (2), discussed the “maximum” discretion fiduciaries have to select investments in a participant-directed plan.

Another surprise, but a pleasant one, is a proposed rule that says that the selection of the plan’s menu must be prudent, in addition to the requirement that the selection of each investment option being prudent.  I suspect that we have acted in that way and believed that it was what ERISA intended, but I don’t recall seeing it in writing before.

The proposal says:

(d) Duty to act prudently when establishing a plan investment menu to maximize risk-adjusted returns. A fiduciary with responsibility or authority for selecting designated investment alternatives has a duty to act prudently also when establishing a diversified menu of designated investment alternatives to further the purposes of the plan by enabling participants and beneficiaries in such plan to maximize risk-adjusted returns, net of fees, on investment across their entire portfolios in their plan. [Bolding added by me to distinguish the heading from the body]

Comment: I like this provision.  As best as I can remember, this is the first time that the DOL has said that fiduciary responsibility for investment selection extends beyond the selection of individual investments and includes the selection of an appropriate lineup of investments for participant direction (although there is language in another regulation—which appears to apply to pooled investment arrangements-that could arguably apply to the selection of investment lineups in participant-directed plans).  In the past, I think that most fiduciaries have considered the 404(c) regulation’s provision on a “broad range” of investments (which discussed including at least 3 investment options that allowed participant to create appropriate balanced portfolios in their accounts) and then looked at industry practices to decide how many  and which investment options to include in the plan’s lineup.  Specifically, the 404(c) regulation provides in part:

(3)Broad range of investment alternatives.

(i) A plan offers a broad range of investment alternatives only if the available investment alternatives are sufficient to provide the participant or beneficiary with a reasonable opportunity to:

(A) Materially affect the potential return on amounts in his individual account with respect to which he is permitted to exercise control and the degree of risk to which such amounts are subject;

(B) Choose from at least three investment alternatives:

(1) Each of which is diversified;

(2) Each of which has materially different risk and return characteristics;

(3) Which in the aggregate enable the participant or beneficiary by choosing among them to achieve a portfolio with aggregate risk and return characteristics at any point within the range normally appropriate for the participant or beneficiary; and

(4) Each of which when combined with investments in the other alternatives tends to minimize through diversification the overall risk of a participant’s or beneficiary’s portfolio;…

I also think that most plan fiduciaries take into account the demographics of the participants in designing their investment lineups; however, my experience is that it was done as a practical matter as opposed to being seen as a legal requirement. This provision, even though in a proposal, should be seen as reflecting the DOL’s views on fiduciary responsibilities. For example, plan fiduciaries should consider adding a new section to their investment policy statements about the process and criteria for determining the appropriate investment menu for their plans. While there isn’t any clear guidance on how to design that menu, one approach—and probably a safe one–would be to base it primarily on the demographics of the covered workforce.

I also want to comment on the reference to “maximize risk-adjusted returns”.  I have two thoughts about that.  First, I don’t like the use of “maximize”.  That suggests some legal obligation to shoot for the highest returns as opposed to having a process for obtaining reasonable returns for a particular asset class and investment style. (To offset my criticism, I want to acknowledge that the DOL description of the process starts with identifying the appropriate risk profile of an investment type for the particular plan—probably based on the fiduciaries’ evaluation of the demographics of the covered workforce.)

The preamble augments the proposed rule by explaining:

4.3. Fiduciaries Have a Duty To Act Prudently When Establishing a Plan Investment Menu to Maximize Risk Adjusted Returns—Proposed Paragraph (d)

Paragraph (d) of the proposed regulation provides that a fiduciary with responsibility or authority for selecting designated investment alternatives has a duty to act prudently also when establishing a diversified menu of designated investment alternatives to further the purposes of the plan by enabling participants and beneficiaries in such plans to maximize risk-adjusted returns on investment, net of fees, across their entire portfolio. This in turn allows participants with different risk capacities to maximize their returns for a given level of risk. This provision is intended to serve as an important reminder that each designated investment alternative selected by a plan fiduciary plays a role in the larger investment menu and the fiduciary has a duty to prudently curate the menu of investments overall. Put differently, ERISA’s duty of prudence applies not just to the selection of each designated investment alternative but also to the collection of designated investment alternatives as a whole—i.e., to both the individual parts and the sum. While, as explained in the scope discussion above, the focus of the proposed regulation is on the application of the duty of prudence to a fiduciary’s selection of an individual designated investment alternative for a plan’s menu, the proposed regulation does not address the question of how to prudently curate a menu of investments overall. This question is beyond the scope of this proposed regulation. In this regard, the Department understands that, to obtain the fiduciary relief available under section 404(c) of ERISA, many participant-directed individual account plans establish menus that seek to comply with the requirements of regulations implementing section 404(c) of ERISA. These regulations, which are optional, generally require the menu to offer a broad range of investment alternatives that meets specified diversification and risk and return requirements. Comments are solicited on whether future guidance should address the question of what process is required to curate a prudent menu of investments overall or whether the requirements of the regulations implementing section 404(c) continue to be best practice. [Bolding added by me; footnotes and citations omitted]

 

Comment:  I bolded the parts about the fiduciary duty to curate the investment lineup as a whole (as opposed to the separate fiduciary duty to select each investment prudently) in order to highlight the DOL’s position.  I then highlighted the phrase about the lack of guidance on how fiduciaries should act to satisfy that duty in order to point out the lack of guidance about how to do that. Note that the DOL is asking for comments about how the private sector thinks that job should be done.

Concluding thoughts

I like—and agree with—the DOL’s position that it is a fiduciary duty to prudently establish the investment lineup (or “menu”) as a whole.  I believe it will encourage more thoughtful processes about developing the lineup and will, as a result, cause fiduciaries and advisors to focus even more on the development of investment lineups that are appropriate for the covered employees—the “demographics”.

The first step will be for advisors to engage fiduciaries (e.g., plan committees) in discussions about the plan investment design which, most likely, will lead to a conversation about the needs and circumstances of the covered workers. In turn, fiduciaries and advisors will need to amend their investment policy statements to reflect those discussions and decisions.

 

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The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Faegre Drinker.